Speculation that the Bank of England may be contemplating a move to negative interest rates has been further stoked.
The Bank said that Sam Woods, its deputy governor for prudential regulation and chief executive of the Bank’s Prudential Regulation Authority, had written to lenders to ask how ready they were for Bank Rate moving to zero or even going negative.
In the letter, Mr Woods wrote: “We recognise that a negative policy rate could have wider implications for your firm’s business and your customers.
“The Bank and PRA will consider the wider business implications, including on financial stability, safety and soundness of authorised firms and pass-through to the wider economy.
“This letter, however, is seeking information to understand firms’ operational readiness and challenges with potential implementation, particularly in terms of technology capabilities.”
Mr Woods said that responses to his letter would help the Bank identify whether there were any technical operational challenges involved with implementing a zero or negative Bank Rate. He said it would help the Bank consider how best to prepare for such an event and prevent any unintended operational disruption.
He went on: “It is important for the Bank, PRA, and firms to understand the implications of these potential approaches to implementing a zero or negative Bank Rate, since the MPC may see fit to choose various options based on the situation at the time.”
The news ought not to come as a surprise.
Andrew Bailey, the governor of the Bank, said in May that negative interest rates were being actively reviewed.
Meanwhile, only last month, the Bank said it wanted to engage with lenders on the “operational considerations” of a negative policy rate.
The Bank stressed that the sending of the letter was “not indicative that the MPC will employ a zero or negative policy rate”.
Yet the letter will nonetheless heighten speculation that such a move is coming. The money markets are already beginning to price in negative interest rates. Both two-year and five-year gilts (UK government bonds) already have negative yields, in other words, anyone lending to the government by investing in gilts is effectively paying for the right to do so.
The question is what the impact will be on savers, borrowers and the banks themselves.
A number of central banks have already introduced negative interest rates during the decade following the global financial crisis.
Denmark’s Nationalbank, the Danish central bank, was the first to introduce negative interest rates in 2012.
It has since been followed by the European Central Bank, the Swiss National Bank, the Riksbank in Sweden and the Bank of Japan. In December last year, the Riksbank became the first central bank to announce it was moving away from negative interest rates, taking its main policy rate back to zero.
The experience of these countries gives us some idea what might happen were the Bank to adopt a similar policy here.
The evidence, certainly from the Euro area, is not especially reassuring.
One of the main reasons the European Central Bank adopted negative interest rates was to encourage banks, especially in the eurozone ‘periphery’, to lend more.
However, in a recent note to clients, David Owen, chief European economist at the investment bank and brokerage Jefferies International, noted: “When it comes new bank lending, there is no obvious evidence that the introduction of negative interest rates significantly altered the underlying behaviour of banks in the periphery in either direction.
“The banks in Italy and Spain were in the process of deleveraging and shrinking assets prior to 2014 and that seems to have simply carried on after [negative interest rates] were implemented.”
According to Mr Owen, the experience in the eurozone may not be the best guide to what might happen in the UK, because the latter may have a higher ‘reversal rate’ – the rate at which very low or negative interest rates actually deter banks from lending more rather than encouraging them to do so.
For that reason, the Bank may be looking as closely at the experience in Sweden and Denmark as it is the eurozone.
Again, the findings are not very encouraging, with many economists now of the view that negative interest rates – because they hurt savers – merely encourage households to save more and spend less.
This can be illustrated, for example, in the fact that the inflation rate in economies such as the eurozone and in Sweden remains well below target.
Allan Monks, of the economic and policy research team at JP Morgan Securities, believes this may be why the Bank has been steadily turning up the volume in its discussions on negative rates.
He told clients recently: “There is an alternative theory as to why the Bank keeps talking so frequently about [negative interest rates] despite not being close to delivering it.
“That is because it wants to warn people far in advance so there won’t be such a great shock if it does happen. One key issue around negative rates is how the policy affects confidence.
“The Bank is probably hence watching the reaction from the public very closely, and this is a factor that will feed back into its final decision.”
And, again, the comparison with the Scandinavian economies is not a precise one. The Danes, for example, used negative interest rates at the outset mainly because they wanted to bring down the value of the kronor against the euro.
It is well known that negative interest rates further squeeze the profitability of the banks.
Not only does it squeeze further the ‘net interest margin’ – the difference between what it pays savers and charges borrowers – but, where commercial lenders have to pay their central bank to deposit with it, this also eats into their profits.
Under those circumstances, it would be no surprise to see banks introducing more charges on accounts, as a way of recouping the cost of holding money. This has been the experience in Switzerland.
Banks may even start charging some savers a negative interest rate themselves. That happened when, in September last year, Jyske Bank of Denmark became the first lender in the country to charge some customers for leaving money on deposit, charging savers with more than 7.5million kronor (£927,000) an annual interest rate of 0.6%. UBS in Switzerland has done something similar for savers with more than £450,000 on deposit.
If customers fear they may be charged for leaving their savings on deposit, this might even have the baleful effect of triggering a run on banks. Even in less extreme cases, customers would be more inclined to hoard banknotes, preferring to run the risk that the mice, rather than the banks, will gnaw away at their savings. It is no coincidence that sales of safes in Japan doubled after the BoJ launched negative interest rates.
So, if savers were to suffer under negative interest rates, would it follow that borrowers would benefit?
Not necessarily. For a start, many mortgages in the UK are fixed, which means that the banks would not pass on any further rate cuts until a borrower’s existing home loan deal had expired. Meanwhile, a number of floating or variable rate mortgage deals carry small print, stating that interest rates will never go below zero.
That said, it is perfectly possible that some lenders might follow the example of Jyske Bank, which in August last year launched a 10-year mortgage with an interest rate of -0.5%. It worked by the bank reducing the amount left outstanding on the loan by more than the mortgage borrower repaid each month.
But homeowners would be unwise to expect too many deals like that in the UK.
If negative interest rates were bad for savers and indifferent for borrowers, they would be catastrophic for pension funds, since they would further magnify the liabilities of schemes.
Companies would be forced to put ever increasing sums into reducing scheme deficits – reducing their ability to invest in their business in the process. Even workers in generous ‘final salary’ pension schemes – as with university and college lecturers in recent times – would probably be asked to raise their contributions.
In short, negative interest rates would have a lot of malign consequences. And, as the experience of economies like the eurozone and Switzerland have shown, they are difficult to escape once implemented.