From ZIRP (zero interest rate policy) to NIRP (negative interest rate policy), just what does negative interest rates really mean.
Today, the European Central Bank announced negative interest rates. Put simply, instead of paying banks for holding their cash, bank now pay it.
Big deal you might think, about time banks got hit in their pockets for all the damage they have done…and you would be right on the money. Unfortunately, what is bad for bankers is even worse for bank customers.
This new territory of negative interest rates has come about because the ECB wants to force banks to earn income elsewhere, such as using the traditional channels such as lending, where they charge a premium (a.k.a interest rates and fees) for their services. If they do, expect funds to start flowing.
Commercial banks (Bank of Ireland, AIB) maintain their reserves electronically at the European Central Bank. When economies are bubbling along, banks are paid interest by the ECB on their deposits held with the bank. Now, to put it simply, banks pay for the privilege of storing their money with the ECB.
Why would the E.C.B. do that? Inflation! Or lack of it! Sure, while the price of health insurance, transport and a host of other services across Ireland are increasing rapidly, believe it or not, inflation across the wider Euro area is near negative. This is a major, major problem as it means, in the long run that unemployment could shoot back up across the region. This is a move designed, in the long run to boost employment.
How will banks react to negative rates?
The surest bet is banks will cut deposit rates. They may also increase fees and charges…or introduce both! Over the course of the last few weeks, a number of banks have announced a cut in deposit interest rates (AIB, Permanent TSB, KBC).
Won’t savers just take their cash home and stash it under the bed? Good question but probably not. There are certainly some that may do so to avoid detection (or the perception) out of fear for medical card and pension entitlements (largely through misinformation) but studies show that savers are often motivated more by security than returns. Stashing cash at home, from a security perspective is a really bad idea!
Has negative interest rates been tried in the past? Yes, Denmark tried it imposing a -0.2 percent rate on bank deposits in 2012. There was no drastic effect one way or another — neither a remarkable boom in lending and economic activity, nor wholesale withdrawals of deposits from the Danish banking system.
Frank Conway is founder of moneywhizz.org, the financial literacy programme developed for students and adults.