BoE requests readiness for zero or negative rates

UK’s central bank considers market preparedness for negative interest rates

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October 14, 2020 Categories

The Bank of England (BoE) has further increased speculation on the possibility of negative interest rates as it requests information from high street banks and lenders to their operational readiness for zero or negative interest rates.

“For a negative bank rate to be effective as a policy tool, the financial sector –as the key transmission mechanism of monetary policy –would need to be operationally ready to implement it in a way that does not adversely affect the safety and soundness of firms,” wrote Sam Woods, deputy governor at the BoE and CEO of the Prudential Regulation Authority in a letter to CEOs.

This is one in a number of steps to prepare the UK financial sector to the possibility of a negative rate environment.

“If you look at the forward interest rate markets, they’ve been expecting negative interest rates in the UK since the BoE announced it was under active consideration back in May”, says Andrew Probert, managing director of transaction advisory at Duff & Phelps.

“They’ve only just started discussions with banks around how to operationalise it in the last few weeks. When or if the BoE goes and introduces negative interest rates, they want to know that high street banks have the practical ability to then pass those rates to corporates and consumers alike.”

Negative interest rates discourage entities from holding cash and encourage borrowing activity.

James Orlando, senior economist at TD Bank says however that negative policy rates do not always necessarily translate into negative deposit rates.

“What we found is that this doesn’t always necessarily happen, where if the central bank goes negative that household or business deposit rates also go negative. When you look at what happened in Europe, you didn’t have household deposit rates go negative initially when the ECB introduced negative interest rates.”

Overall, bank profitability has not been adversely affected by negative interest rates. A report by TD Economics cited research which found that, “lower net interest earnings are wholly offset by higher non-interest income and lower deposit expenses.”

“That’s a great narrative for potentially going negative. If banks are able to remain profitable, then they can keep lending”, says Orlando.

Ultimately the effects of negative policy rates will only filter down if commercial banks and lenders pass on those rates to corporates and households. The same report also cited a paper which said that as policy rates went further into the negative, banks became more reluctant to drop their own lending rates, leading to diminishing marginal returns of interest rate cuts.

Although policy rates are a key consideration for banks when setting deposit and lending rates, uncertainty and financial risk also play a large role and right now they seem to be driving up lending rates. For example, mortgage rates in the UK have been on the rise since August.

“We are also seeing the spreads on loan products be higher than they otherwise would be. Since the credit risk is higher, the lending rate is also higher,” says Orlando.

“It makes sense for spreads to be a little bit wider than they might be in a year or two from now when things would have calmed down and there’s less credit risk.”

“Tool of last resort”

If the BoE goes through with introducing negative rates, it would leave Canada and the US as the only two G7 countries with positive, albeit close to zero interest rates. Both the Bank of Canada and the US Federal Reserve have said negative interest rates are not under active consideration.

Although the BoE’s letter brings the UK one step closer to introducing negative rates, Probert says such a scenario would at the minimum be three to six months away.

“My view is that they’ll use this as a tool of last resort, probably post pandemic realistically. Negative interest rates are most effective when there are some signs of recovery. The maximum benefit you’re going to get is when you’re investing in a recovery scenario.”

Probert believes quantitative easing remains the preferred tool of the BoE and the Monetary Policy Committee (MPC).

“From my readings of the MPC’s minutes, it seems that quantitative easing is probably still their preferred mechanism for economic stimulus.

“But nonetheless, it’s something that corporates at a certain point in time will need to start considering because indications are certainty pointing that the UK is preparing itself for the practical ability to implement negative rates.”

Despite real world examples of negative interest environments such as in Japan, the Eurozone and Sweden, Orlando cautions that there are still many unknowns as to the consequences of negative rates.

“There’s still risks that we don’t fully understand the impact of negative rates and we’re just relying on case studies that are pointing us in a certain direction. I understand why the BoE is debating this very seriously.”

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