U.K., Europe Discover New Divide Over Negative Interest Rates

The BOE has ruled out pushing rates below zero, a decision that puts it at odds with the ECB, Simon Nixon writes

By Simon Nixon

The Bank of England’s headquarters in central London. BOE Gov. Mark Carney has said that negative interest rates would be self-defeating. Photo: justin tallis/Agence France-Presse/Getty Images

A new European cross-Channel divide has opened up, and this time it has nothing to do with Brexit. Instead, the question is one of monetary policy: How low can interest rates go? This is more than simply a theoretical debate. Europe’s economic and political stability may hinge on it.

On one side sits the Bank of England and its governor, Mark Carney. Mr. Carney last week responded to clear evidence of a post-Brexit slowdown by cutting its benchmark rate by a quarter of a percentage point to 0.25%—its lowest level in the BOE’s 322-year history—and signaled that a further cut was likely this year. But he ruled out pushing the interest rate below zero, reiterating his longstanding view that this would be self-defeating since banks are unlikely to be able to pass a negative rate on to their customers and so might be tempted to push up lending rates to protect their margins. “The effective lower bound is close to but slightly above zero,” he said.

That puts the BOE at odds with the European Central Bank, which has already driven its deposit rate to minus 0.4% and indicated rates could go even lower. In a speech last month, ECB executive director Benoît Coeuré noted that despite the ECB’s negative rate, bank deposits are still growing, which indicates that rates are above the “physical lower bound” where the cost of keeping cash in a bank outweighs the costs of alternative methods of storage.

At the same time, eurozone bank lending is growing, borrowing costs are falling and net interest income is rising despite pressure on margins. That suggests that banks still haven’t hit the “economic lower bound” at which negative rates do more harm than good.

But the BOE points to Switzerland as an example of a country where negative interests rates have led to compression of bank margins, causing some lending rates to rise. Indeed, the BOE is sufficiently worried about the possible harmful effects of even its 0.25% bank rate that it has introduced a funding program to compensate banks for lost profits by allowing them to borrow directly from the BOE at the new rate providing they maintain or increase their loan books—a generous subsidy.

Many analysts share the BOE’s concerns. The 30% drop in the Euro Stoxx bank index year to date is a warning that banks face a new “doom loop” with net interest income already under pressure, says Alastair Ryan of Bank of America Merrill Lynch. Only a quarter of the European banks that Bank of America Merrill Lynch covers trade at book value or more.

Another quarter trade at less than half of book value, while two-thirds are likely to fall short of the market’s estimated 10% long-term required return on equity. “We believe that the ECB’s intention of monetary loosening may be increasingly undermined by weakness in profits potentially driving banks into seeking to withdraw capital from the business.”

Why does the ECB remain wedded to such a risky strategy? One reason is that it believes the benefits outweigh the costs, particularly when compared to the cost of doing nothing. Lower borrowing costs stimulate the economy, reduce default risk and boost the value of bond portfolios, easing pressure on bank capital positions. At the same time, banks can take other steps to boost profits other than pushing up borrowing costs, including cutting costs. Besides, the ECB hopes that other policies including its corporate-bond buying program will stimulate nonbank market-based lending, thereby further increasing the supply of credit.

But the ECB’s enthusiasm for negative rates may also be driven by necessity, given the political obstacles to the alternative of expanding its government bond-buying program. With much of the eurozone-government bond market trading at negative yields, the ECB will soon run out of bonds that meet its strict criteria: that their yields are above the ECB’s deposit rate to avoid saddling it with an upfront loss; and that it only buys bonds in proportion to a country’s ECB shareholding to avoid accusations that it is funding governments. Abandoning these criteria is politically toxic. Indeed, Bundesbank President Jens Weidmann reiterated last week his opposition to abandoning the so-called capital key.

Yet pushing ahead with negative interest rates may pose political challenges too. ECB President Mario Draghi acknowledged last monththe potential risks that plunging bank share prices posed to the transmission of monetary policy, noting how a higher cost of capital could affect lending decisions. One solution could be to follow the example of the Bank of Japan 8301 3.80 % and buy equity Exchange-traded funds, which given the size of the European bank sector are heavily weighted toward banks. That would boost bank share prices, lowering their cost of capital and reduce pressure to shrink their balance sheets. But the ECB would need political cover to take stakes, even indirectly, in institutions that it supervises.

One way or another, if the BOE is proved right, a fresh political confrontation over monetary policy may be in the cards.

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