What If the BoE Goes Negative?

For months, one question has preoccupied Bank of England watchers and British savers: Is the BoE about to take short-term interest rates negative in the UK? Monetary policymakers have admitted it is under discussion. Futures markets show it happening by early 2021. While BoE Governor Andrew Bailey recently said it wasn’t on the docket, his institution sent UK banks a letter on Monday asking them to explain their “current readiness to deal with” zero percent or negative rates. This, predictably, sent banks and commentators into a tizzy, with many warning about looming trouble for banks’ earnings and savers’ deposits if rates drop below zero. In our view, there is some merit to this criticism, however overstated it might be, and considering these risks can help folks set expectations. On the bright side, though, negative rates haven’t caused recession or bear markets in other countries using them in recent years.

In theory, negative rates’ purpose is to discourage banks from hoarding reserves at the central bank. If banks must pay the central bank to store their excess reserves instead of earning a tiny return on them, the theory goes, banks will find lending more attractive—stimulating the economy as banks dole out more funding to households and businesses.

It is a nice seeming theory, but reality hasn’t totally vetted this out. In the eurozone, the ECB adopted negative rates in June 2014. At the time, loan growth was negative—tied to the eurozone’s sovereign debt crisis-driven regional recession. It did improve from there, returning to positive year-over-year growth in February 2015 and accelerating in the months and years ahead. But relative to the eurozone’s history, loan growth in the negative rates era wasn’t robust, as Exhibit 1 shows—it was in line with the recovery from the financial crisis, before the debt crisis, but far below the prior bull market.

Exhibit 1: 15 Years of Eurozone Loan Growth

Source: FactSet, as of 10/12/2020. Loans to Euro Area Residents, year-over-year percentage change, October 2005 – August 2020.

This doesn’t surprise us at all. Negative rates are just a tax on bank balance sheets, and to presume a small tax alone is going to juice lending is grossly oversimplified. Banks lend at long-term interest rates. One thing all negative short-term rate nations have in common? Ultra-low long-term rates, which take a huge bite out of loan revenues. That sapped the incentive to lend to all but the most creditworthy borrowers, largely shutting out small businesses and companies with below investment-grade credit ratings. Avoiding a small tax, for many banks, just wasn’t a good reason to lend to shaky borrowers for a pittance. Instead, many just settled for holding cash and letting their earnings take a hit.

The San Francisco Fed examined this in a wide-ranging study published last month. It found that, while negative rates corresponded with improving loan growth in the short term, their impact turned negative the longer they lingered. The same held for bank profitability: “While banks suffer losses on net interest income, due in part to their reluctance to pass negative interest rates along to retail depositors, they more than offset those losses through increases in profits on noninterest income. In particular, banks charge higher fees and experience capital gains on securities holdings when rates go negative. However, the data clearly show that losses on interest income accelerate over time and begin to outweigh the gains from noninterest income. As a result, the impact on overall profitability falls below zero.”^[i]

Some banks found ways to minimize the damage—but by charging fees on large deposits. This happened at several banks in Denmark and Germany. While this didn’t directly hit most small savers, it did hit pension funds with cash reserves stored at commercial banks, as they were subject to fees on institutional deposits—indirectly hurting retirees depending on them.

We think there is enough evidence that negative rates don’t work to make it rather mind-boggling that the BoE would consider them after having held out for all these years. In our view, savers and the broader economy would benefit most if monetary policymakers resisted the temptation. If they don’t, however, other countries’ experiences at least give us a framework to set expectations. Pundits speculate that negative rates would spell the end of “free banking” in the UK, with savers potentially facing monthly fees. That is possible, but if other countries are a reliable guide, then those fees would at least start with the largest accounts, sparing most retail depositors.

As for stocks, negative rates didn’t trigger bear markets in the eurozone, Japan, Sweden or Denmark. The eurozone and Japan largely underperformed global markets since adopting negative interest rates, but that was tied more to fundamental issues that predated negative rates, in our view. To say it differently, negative rates didn’t alter pre-existing trends in relative performance. We suspect it wouldn’t be different for the UK, which is already underperforming the world during this bull market—largely due to its lack of Tech stocks, which are leading, and heavy tilt toward value stocks, which are lagging. Negative rates probably just exacerbate this trend, as they add a headwind to the value-heavy Financials sector, which is nearly 17% of UK market capitalization.^[ii]

In our view, adopting negative rates is a faulty solution to a self-imposed problem: Flat yield curves. This, to us, is the real reason lending is weak. If the spread between short- and long-term rates were wider, banks’ potential lending profits would be bigger, boosting the incentive to lend to a wider swath of companies. The easy solution to this is for the BoE and its global brethren to stop quantitative easing bond purchases, which reduce long rates and are therefore directly responsible for flat yield curves. That would enable more lending despite the small interest rates paid on excess reserves, because the risk/reward tradeoff would be more favorable. We have over a century of economic theory and data showing steeper yield curves boost lending and economic growth. Allowing that to happen, rather than trying to offset flat yield curves by taxing bank balance sheets through negative rates, strikes us as a much simpler way to address the problem. One that doesn’t come with a list of unintended side effects, to boot.