Back in 2014, the Swiss National Bank imposed a negative interest rate on large deposits in the country at -0.25%. Following further reductions, it now stands at -0.75%.

Switzerland, along with Sweden, set a precedent as one of the first countries to set a negative interest rate on deposits.

How do Banks Work?

Traditionally, banks take small deposits from multiple “lenders” (the saver in this case), and pay an interest rate to each of them.

Once the bank has received a sufficient number of deposits, it then lends out a proportion of this to potential borrowers who have a need for money to invest.

The bank sets aside a certain amount for capital adequacy requirements (to ensure that there is money for the lender to withdraw at any time), and then lends out the rest at an interest rate which is higher than the rate it pays to its savers.

The difference of this is typically the profit that a bank takes.

Now with the advent of the negative interest rate, this relationship between the bank and the saver has been reversed.

The bank now expects the saver to pay for the privilege of storing money, and paying for the right for the bank to lend out to institutions that require immediate access to liquidity.

Why Implement a Negative Interest Rate?

The trigger for this was due to the fact that the Swiss Franc had been increasing in value as investors have been looking to the country as a safe haven for their money.

Economic issues during 2015 such as the fall in oil prices and the uncertainty in Ukraine meant that Switzerland had been seen as a safe asset (with investors flooding their money into the currency), and the result of this was to boost the value of the Swiss Franc.

The national bank appreciated the benefit of this (to an extent); however the currency became too ‘strong’, and exports become less competitive.

As products were relatively expensive in the international market, this affected domestic revenues.

By imposing a negative interest rate, this aimed to devalue the currency relative to the euro, and helped to kick-start spending in the country’s exports.

Additionally to this, it has the ability of penalising banks who often hold too many customer deposits.

Banks who are reluctant to invest in small businesses and other institutions looking for loans (potentially though risk aversion), were being targeted to provide additional stimulus to the growth of the private sector in the country.   

The Swiss National Bank clearly has decided to implement a policy which would have a similar outcome to traditional quantitative easing.

By forcing high net worth individuals not to invest in the Swiss Franc, this effectively reduces the value of the currency to a more manageable level.

Why Don’t They Use Quantitative Easing?

Rather than artificially creating more money in the economy to devalue the Swiss Franc with quantitative easing, this policy would essentially free up Swiss Francs in the economy for domestic use (a similar outcome).

Swiss Francs which would have been otherwise stored as an appreciating asset.

Are Switzerland and Sweden Isolated Cases?

Not quite. The Danish have adopted the negative interest rate policy too, and the last interest rate change in 2016 puts the current rate at -0.65%.

Japan is the only other country with a negative interest rate, setting it at -0.1% also in 2016.

The fact that economies are able to pursue negative interest rates as a legitimate policy means that we now need to revise our expectations of what the lowest band for the rate can be (previously at zero).

Will we get to a time where the only safe option is to withdraw all of our money, and store it in the mattress (hey, at least you don’t have to pay for it to be there)?

Of course this is a real possibility, and then economies could be at a real risk of becoming cash systems.

This is a situation where banks do not hold sufficient reserves to put into companies who need it – the complete opposite of what policymakers are attempting to achieve.

Of course there are significant risks to holding cash (theft which could be otherwise protected by deposit protection schemes by banks), not to mention the difficulty in paying for large transactions, and also for companies to pay for international goods.

What is the Optimal Interest Rate?

There is clearly an unobserved equilibrium where the saver will assess whether the security from storing deposits provides an equal amount of utility to withdrawing all of their cash.

Until that equilibrium is found, policy makers will likely continue to reduce their saving rates. 

We do not have much practical evidence that negative interest rates work, but we should continue to watch with curiosity to see if it achieves the desired outcome that these economies want.

Personally, I fear that negative interest rates could become the normal method used to weaken a domestic currency to boost exports.

This could lead to a huge number of people rushing to the bank refusing to pay to store their hard earned money (remember Northern Rock?)

Because a bank stores a certain amount for liquidity availability for customer withdrawals, a bank run caused by negative interest rates could be devastating.

The capital adequacy ratio currently stands at about 10% for Tier 1 and Tier 2 capital reserves.

This means that for every £100 you store in your savings account, the bank will likely lend out £90 of that.

This becomes a problem when you ask for your money back all at once!

If every person with deposits in the specific bank asks for £11 of their deposit back, they will need to liquidate their assets at a lower rate than they are worth, and this can collapse the system.

It will be interesting to see how the world takes to this new, unconventional monetary policy.