Opinion: The possibility of negative interest rates on your deposits (pt. 1) | SierraSun.com

Opinion: The possibility of negative interest rates on your deposits (pt. 1)

Robert Barone

The very concept of negative interest rates appears, at least at first blush, to be an oxymoron. What rational entity would "loan" money and expect, under the contract, to get less back than loaned?

If you think "no one would," think again! In this two part narrative, I explain how this is possible, how it is actually occurring in Europe, and what consequences there might be for the American saver/investor.

The European Circumstance

Today, in Europe, we actually see negative interest rates. Believe it or not, accepting a negative interest is actually very rational behavior under the circumstances there.

The socialist economies in Europe have been stagnating for many years with economic growth barely positive. Most of this is due to big government and over-regulation.

For example, in Italy, it is nearly impossible to fire an employee, even if they don't show up for work. Only the big companies (most of which were there before all of the regulation) can afford to hire an army of compliance people.

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Because small businesses can't survive the cost of regulation as they grow, they can't get bigger than the mom and pop (family run) stage.

In most mature (slow growing) socialist economies, the objective of government policy is to get consumers to spend more, either by borrowing or by dipping into their savings. (It is the onerous regulations imposed by big socialist governments that constrain growth, so, in effect, government policy is aimed at fixing what government broke in the first place.)

The belief is that lower interest rates, including negative ones, stimulate the economy.

The ECB's Negative Rate on Deposits

Following this theory, last year the European Central Bank (ECB) set a negative interest rate of .20% on deposits held there by its member banks.

In order to avoid the negative rates, the banks are incented to use those deposits — they can either loan them out to the private sector, or loan them to the various governments of Europe in the form of purchasing various European government bonds (like, German, French, Spanish, Italian, etc.).

But, since over-regulation is so dreadful that small businesses can't grow, there isn't much opportunity for banks to lend to that sector. Yes, they can lend to large businesses, but large companies that need cash can access it through the capital markets and avoid the bank fees.

So, with little opportunity to lend to the private sector, the banks have relied on lending to the various governments by buying government securities.

Under current banking regulation in Europe and in the U.S. too, holdings of government bonds are considered "riskless," and no capital buffer on the banks' balance sheets are required.

But loans to the private sector are "risky," and capital is required to buffer that "risk." Therefore, if the bank is capital constrained (as many are in Europe), or just because there is little demand for loans, a huge percentage of European bank assets are held as various government securities. (Even the bonds of Cyprus and Greece were considered riskless under the European banking regs — most of those have been purchased by the ECB, and are now held there.)

Last year, the ECB embarked upon a version of Quantitative Easing (QE), first pioneered by the Bernanke Fed in 2008. Under QE, the central bank buys up huge volumes of government debt, and in doing so, it drives down the yields on these bonds, and, at the same time, through the payment mechanism, the commercial banks end up with deposits at the central bank.

The ECB then competes in the bond markets with the banks for the available government securities and the banks continue to end up with deposits at the ECB that they cannot effectively use. Of course, the laws of supply and demand (which governments can't regulate) drive the price of those bonds up to such an extent, that, for some of the higher quality bonds, the coupon payments are less than the premium paid on the bonds, leaving the holder with a negative interest rate.

The fact is, it is rational behavior for the banks to accept a negative interest rate if that negative rate is not as negative as they would have to pay to the ECB where the deposits are held. That is, paying -.10% in negative interest on a high quality bond to rid itself of the ECB deposit is better than paying the negative -.20% that would be charged on that deposit at the ECB.

So, now the mystery is solved as to of why the much lower rated bonds of Spain and Italy with similar maturities as those of higher quality U.S. government bonds have lower yields, and why high quality German bund yields are actually negative.

Look for part two in the coming days.

Robert Barone (Ph.D., Economics, Georgetown University), an adviser representative of Concert Wealth Management, is a principal of Universal Value Advisors, a Reno-based business entity. He can be reached at 775-284-7778.