Negative Interest Rates is 'Indeed' Negative

Negative Interest Rates

"By putting downward pressure on interest rates, the Fed is trying to make financial conditions more accommodative - supporting asset values and lower borrowing costs for households and businesses and thus encouraging the spending that spurs job creation and a stronger recovery." - Janet Yellen

What is Interest Rate?

The interest rate is made up of Expected Inflation + Real Interest Rate.

Interest rate must cover loss of purchasing power and reflect current over future consumption

Like we all know, Interest is something we pay to the lender to cover the risk and inconvenience of not having their money with them. Risk encapsulates credit and liquidity risk. 

For example, Person A (Borrower) wants to borrows  100,000 loans from ABC Bank; the interest rate is 7%, Tenure of one year. At the end of one year, A as to pay principal + Interest, i.e., the Interest of 9,000 (9% of 100,000). So A as to pay 109,000. So this is the usual scenario of the favorable interest rate.

Can the Interest rate be negative? Will Bank pay Interest (incentive) to borrow?

Why would banks opt for a negative interest rate?  

How will banks make money?

What will happen to deposits?

Which countries have been doing this?

Let us understand, Who sets the rates?

The countries' central banks influence interest rates by setting policy rates, also called as Policy Repo Rate.RBI Policy Repo Rate as on 23-07-2020 rate stands at 4%. This is the rate at which commercial banks can borrow from RBI. Central banks tend to use the Repo rate to influence growth, employment, inflation, and liquidity. Commercial Banks charges some spread above the repo rate this spread on the funds it lends out from those it takes in as a deposit. This is called the net interest margin (NIM). In our Example A borrowed at 9%, 4% is repo rate, 5% is the spread above the repo rate for banks (NIM's) (4% +5%  =9%).

In case of growth rate and inflation above target -> Central bank Increases the interest rate -> Makes it Costly (Expensive) to borrow -> Which will lead to a decrease in spending and investing ->Decreases demand for goods and services -> slower economic growth—ViceVersa if there is a slowdown in growth rate and inflation below the target.

In the case of a sharp slowdown, central banks have to decrease the interest rates to attract the borrows to spend and invest. So central banks bring the policy rate to below 0% levels.

What does it mean when we have a negative interest rate—Does it mean borrowers are paid Interest to borrow? Instead of being charged for it? 

Yes. Borrows get incentivized to borrow. Taking an example, if the interest rate is at -2%, principal 100,000, then at the end of the Tenure A as to pay 98,000.

The motive of the Central Bank to keep negative Interest is for currency consideration and stimulate the economy. Countries like Sweden, Denmark, ECB (European Central Bank), Switzerland, and Japan have adopted. The negative interest rates a lot of implications on the money market and LIBOR/MIBOR.

why is the interest rate negative?

1. A very less expected growth or No growth in economic activities.

2. Deflation in the countries currency.

How will banks make money?

Banks make money by accepting deposits and lending loans. The difference in deposits and lending rates is how it makes make money. In over example spread is 5% + (-2%) repo rate. Summing up, banks lend at 3%. 3% is the operating margin.

What will happen to depositories?

In the usual case, if the deposit rate is 2% and the lending rate is 9%. The difference between 7% (9% - 2%) is the spread that it makes. 

Can the interest rate for the deposit be negative? 

Yes, It can be with a caveat.

Ideally, 'NO,' Depositories will withdraw their deposits and keep it under their mattresses, why would individuals pay banks to keep there own money. 

However, Big corporates, HNI, or an Individual with a big deposit will incur the cost of holding cash is costly (security cost), and Transaction in cash is complicated (Income tax-related). So big depositories will be okay for a negative interest rate considering their costs. Nevertheless, it depends on individual cases of how much negative it can be. Say one depositor will incur 1% cost for holing the cash below, which he may withdraw. 

Which countries have been doing this?

Namely, some have been doing this from decades like japan.

Countries with Negative Intrest rate and near-zero

Implications and Consequences of Negative Intrest Rate

1. Banks may lend less due to unfavorable profit spread, nudging by policymakers to keep a negative rate.

2. It shows the economy's health and growth.

3. Investors who are related to fixed income will be further away from their preferred avenues. That potential leads to risky investment or financial scams that will lead to immense investment pain.

4. Borrows would demand a lower interest rate on their loans as overall policy rates have fallen in the economy. Thus transferring wealth from savers to borrowers.

5. Negative interest rates penalize the savers. It will not encourage saving instead of spending and investment.

'Stay Away from Negative Interest rate they have a problem for every solution'.

What does Jerome Powell, Chair of the Federal Reserve (Central Bank, USA) think about 'Negative Interest Rate'? There is 'No Clear Finding', He says.

Watch it for yourself!

https://www.youtube.com/watch?v=J5RXQLAgdDk - Jerome Powell

Read Disclaimer.

Data source:

-Abhishek Jain blog - Finix School

https://bit.ly/3eV1t

-Leanings from Aswath Damodaran and Mark Meldrum.

-Vinay Dwarakanath