LOS ANGELES, Feb. 18, 2016 /PRNewswire/ -- Douglas E. Johnston, Jr., Banking and Financial Expert Witness and Economic Analyst at Five Management, LLC, shares his unique perspective regarding the emergence of negative interest rates.
Negative interest rates are a confusing topic and they may be coming to the U.S. this year. If so, they may bring with them significant changes to everyday banking for Americans. In 2014, leading European central banks initiated 'negative interest' terms for many new government bond issues to help stimulate the economy. Negative rates began where major buyers of low-risk government bonds agreed to accept a return less than their original investment at bond maturity. As government bond issues led the way for corporate bond activity, these once-improbable 'negative interest' bonds quickly captured over $2 Trillion of the European bond market, and they soon found homes within major bank bond portfolios. The Federal Reserve and U.S. banks are now looking at them.
The policy goal of negative rates is to help stimulate the economy by influencing the day-to-day operations of commercial banks as financial intermediaries. Whether it is in Europe, New York or Los Angeles, commercial banks have long performed the fundamental role of matching savers and depositors with borrowers. Negative rates are designed by policy-makers to modify this historical model, by encouraging more lending and by discouraging traditional savings.
In normal operations, commercial banks accept deposits and then re-deploy those deposits in two basic ways: 1) they lend most of their funds out to businesses and individuals, and 2) they invest the remainder in bonds – usually low-risk government bonds and large highly-rated corporate bonds. In the US, an average bank will dedicate about 75% of its surplus deposit funds toward loans and 25% toward the purchase of low-risk (and low-rate) bonds. A bank will usually earn far higher yields on its loan portfolio than from its bond portfolio, so it will therefore usually want to deploy more of its earning assets in more profitable loans.
In times of pending economic slowdown (now emerging across the globe) a bank often shifts toward investing a higher percentage of its surplus funds into 'safer' low-risk government and corporate bonds - rather than make higher-risk loans - as the economy weakens. But in an emerging negative-rate environment, the bank is mathematically 'penalized' if it remains invested in low-risk bonds – because it will realize either super-low or even negative yields on many bonds. Thus, in an emerging world of negative rates, banks will have an even more challenging task in balancing profitability and soundness/safety issues.
Since the days of Adam Smith, bank lending has been viewed as 'the grease of the wheels of commerce' in the economy. A borrower with new loan funds uses the money to buy equipment, and the equipment seller is thus able to hire more staff, and so on. Negative rates strike at the heart of the decision-making process for any bank, which becomes reluctant to make new loans. By 'forcing' banks to lend to businesses rather than invest in unprofitable bonds, negative rates are designed to produce stimulus via increased lending activity. Greater lending activity also accelerates the turnover or 'velocity' of the money supply, which is a parallel economic policy goal in a slowing economy.
However, negative rates clearly influence multiple sectors in unusual ways. They effectively penalize banks that do not lend enough to businesses and individuals in their markets, and they also penalize depositors and savers. At the same time that a bank sees that it must choose to make more higher-risk/higher-rate loans rather than invest in low-rate (or negative rate) bonds, its depositors also see low or negative rates on their CDs and MMAs. The average depositor is faced with the prospect of effectively paying negative interest 'rent' just to have an account, instead of being rewarded for savings. In this regard, negative rates encourage spending over saving, and thus they may herald the advent of a theoretical 'cashless' economy. Significantly, the European Central Bank and former US Treasury Secretary Lawrence Summers have recently called for the abolition of large-denomination E500 and $100 bills within the European and US economies.
Negative rates have virtually no measurable precedent in history, and so the long-term impacts of negative interest rates are not yet fully clear. Consequently, there are no current textbooks on the effects of negative rates. Even John Maynard Keynes, the legendary architect of much of the current global monetary system, did not anticipate negative rates.
The central banks of Japan and Sweden have recently announced their intentions to adopt expanded negative rate structures of their own. And on February 12, Federal Reserve Chairman Janet Yellen also acknowledged that the U.S. Fed will keep open the option of pursuing negative rates as a means of further stimulating the US economy. Should this happen, it will constitute a dramatic reversal from the Fed's widely anticipated December 2015 initiative to begin raising rates for the first time in many years.
As noted, the linkages and consequences of negative rates in Europe are becoming better understood. The Basel-based Bank for International Settlements, also known as the 'central bank for central banks,' noted in 2015 that it is closely monitoring the effects of negative interest rates and expanded monetary policy options across Europe. The Fed has noted negative rates are under active consideration in the U.S., and they may soon be with us among U.S. banks as a new economic stimulus measure.
About Douglas E. Johnston, Jr.
Doug Johnston is an expert witness in finance and banking, and a global M&A consultant. He has designed, built and managed five bank offices in two states, and is a former President of a CAMELS 1-rated bank. Mr. Johnston also has significant experience in mergers and acquisitions as former EVP-Finance & Administration and a 'Founding Father' of Platinum Equity, LLC, now the largest private company in Los Angeles. He has lived and worked across the US and Europe, and lives in Santa Monica. www.fivemanagement.net
SOURCE Five Management, LLC