Back in July, 2012 the Danish central bank, Nationalbanken, lowered the deposit rate to -0.2 per cent. Back then we wrote that it was going to be costly for the banks, and that money market rates were going deeper into negative territory. With Draghi’scomments last week, how did that whole negative deposit rate action turn out for Denmark?
Nordea had a note out last week on that very subject. Now, before we move, let’s remember that Danish monetary policy is tailored around the FX peg. The deposit rate was there to assure outflow because of mounting pressure on the EUR/DKK pair.
The deposit rate (“Certificates of deposit rate” or CD rate) is the main mechanism for changing the demand for DKK. This is because Danish banks and mortgage institutions have excess liquidity and with money markets trading at negative rates, the CD rate becomes the ‘peg’ for money markets, including the difference between Danish money market rates and European ones:
It’s also what Nationalbanken said in regard to which central bank rates are actually important when they hiked rate last week:
The low monetary policy rates leave a limited leeway for a reduction of Danmarks Nationalbank’s lending rate.
In the current situation where the monetary policy counterparties have a large need to place funds at Danmarks Nationalbank, the monetary deposit rates determine the money market rates and the exchange rate.
So we can check the ‘make money market interest rates go negative’ box, and move on.
Next up were the costs to banks. We speculated at the time that it was going to cost Danish banks around DKK 300m. Nordea comes up with a number not too far from that (remember, though, that the CD rate was hiked in January):
The most direct effect of the negative CD rate is the (unintended) cost to Danish banks and mortgage lenders. At end-March the monetary policy counterparties had deposited DKK 147bn with the central bank using CDs. This happened even though the central bank had tried to lower the cost of negative interest rates by sharply raising the current account deposit limits to a total of currently just over DKK 101bn, up from DKK 23bn prior to the rate cut in July last year. The current account rate is currently 0.00%.
We estimate that Danish banks and mortgage lenders as a result of the massive excess liquidity in the Danish money market have incurred interest expenses to the tune of DKK 150m.
So if you don’t care about banks’ profitability, or the FX peg, how about pass through rates to consumers? It turns out banks are considerably less likely to change their lending and deposit rates post financial crisis. While this is generic, it’s not exactly an argument for negative deposit rates. One argument is that, since banks will lose money on their excess liquidity, they will have to make up margins elsewhere (raising rates):
Finally, the effect on government bond yields and mortgage backed securities. Even before negative deposit rates, t-bills and 2-year government bonds traded at negative interest rates. Since negative deposit rates, all but one t-bill auction has had negative interest rates.
Nordea say this is applicable throughout the eurozone:
Spanish mortgage bond yields have periodically traded below comparable government bond yields, which clearly illustrates how the collateral backing mortgage bonds can justify negative yields. However, Danish mortgage bond coupons will likely stay above zero as it is not practically feasible for investors to pay mortgage lenders for being allowed to hold their bonds.
So that’s Denmark. Let’s turn to JP Morgan’s Flows and Liquidity team for a little more perspective for Europe and the consequences of negative deposit rates from the ECB:
Last summer’s move by the ECB to cut the deposit rate to zero had led to the closure to new money of a number of European money market funds. This is because with rates at zero, these funds would have a negative yield after fees, which presents a significant obstacle to investors. Since August last year, the outstanding amount of the Euro area money fund industry had shrunk by €70bn or 7% to €900bn as of last February. That process will certainly accelerate if the ECB were to cut the deposit rate to negative.
The other unintended consequence is in repo markets. A shrinkage of the money market fund industry hampers liquidity in money markets as the former are important participants. We have mentioned in the past three impacts on repo markets: 1) Narrowing spreads in the repo market are likely to induce some lenders of collateral to draw back from the market, on the grounds that returns from securities lending are no longer adequate. That would impair bond market liquidity, by making it more difficult to cover short positions in repo. 2) Incentives to cover shorts are reduced at zero rates which can result in higher fails volumes than seen before, hampering liquidity and volumes even further. 3) Some counterparties (mainly real money) may not be able to trade repo at negative levels (operational, legal, economic reasons etc) which will again likely reduce repo market volume/activity. Indeed the European repo market contracted in H2 2012 according to the latest ICMA repo market survey.
Another unintended consequence is the damage to the profitability of banks and the risk that banks increase lending rates. Assuming that banks will be reluctant to pass negative rates to retail or corporate depositors, they might increase lending rates to offset the decline in their profitability. This is especially true for core banks that hold lots of deposits with the ECB such as German, Dutch and French banks which held €223bn, €152bn and €98bn of deposits with the ECB, respectively, as of last March (Figure 8).
In fact a deposit rate cut will likely drain liquidity from the Euro area banking system and accelerate the early repayment of LTRO funds. Negative interest rates on deposits incentivize banks to “get rid” of their excess deposits rather than suffer an erosion of capital. But the amount of reserves in the system can only be changed if Euro area banks decide to collectively reduce their reliance on the ECB. If a commercial bank makes a loan or buys a bond to avoid negative rates, they simply pass reserves on to another bank, which ultimately end up back at the ECB. As such, excess reserves would become something of a ‘hot potato’, with no bank wanting them at the end of the day. Core banks are more susceptible to negative deposit rates. Core banks have €620bn of deposits and have borrowed €190bn (gross) from the ECB. In other words they are collectively “long cash” by around €430bn (€620bn – €190bn). In contrast peripheral banks are “short cash” by €650bn.
The first response by core banks would be to repay most of the extra funds they borrowed via the 3y LTROs. But for the excess deposits in the Euro area banking system to decline further, we would need to see peripheral banks reducing their reliance on the ECB. The resulting search for yield and increase in the velocity of reserves, i.e. passing on the “hot potato”, within the Euro area banking system has the potential to improve capital flows back to peripheral banks and reduce TARGET2 imbalances further, especially now that the ECB has back-stopped the system with the OMT. From this perspective, negative deposit rates, could be a useful policy tool to allow the periphery to reduce its reliance on the ECB and ultimately induce financial reintegration in the Euro zone, even if they result in a reduction in liquidity. And the ECB has the tools to cushion the reduction in liquidity i.e. excess reserves by cutting reserve requirements to zero. This mechanically increases excess reserves in the Euro area banking system by €100bn ceteris paribus.
All of which seems rather reasonable given the Danish experience. But it is nonetheless liquidity draining.
