An Impact Assessment of Negative Interest Rates of Central Banks

Online ISSN 2424-6166. EKONOMIKA 2017 Vol. 96(1) DOI: https://doi.org/10.15388/Ekon.2017.1.10662

AN IMPACT ASSESSMENT OF NEGATIVE INTEREST RATES OF CENTRAL BANKS

Linas Jurkšas* Vilnius University, Lithuania

Abstract. The central bank community has been split into those who started to employ negative interest rates (NIR) and those who do not intend to do so, irrespective of the similarity of the economic situation. Moreover, while five central banks have applied negative policy rates from 2012, the launch time, scope and motives behind differ significantly. The fact that central banks have simultaneously pursued NIR at a time when the global financial system is not in a crisis is unprecedented and is a consequence of several fundamental and mu- tual factors. So, the purpose of this paper is to find out the motivation behind employing negative policy rates and assess how NIR affect different economic sectors. The statistical analysis reveals that the overall outcome is highly controversial, depending on the weight assigned to each economic sector as well as to short- and long-term goals. On the one hand, NIR lead to an overall positive impact on aggregate consumption, increased well-being of net borrower, investing NFCs, indebted governments and even financial institutions in the short run. On the other hand, savers and banks with high excess reserves and less room to reduce net interest margins are the most negatively affected. The impulse-response functions of created vector autoregression model for the euro area confirms these results: an interest rate reduction shock decreased borrowing and deposit rates, net interest margins but positively affected confidence, bond and equity prices, leading to somewhat higher expectations of economic growth and inflation in the longer term. While the lower bound of NIR remains uncrossed, further rate cuts in the negative territory or keeping them for a prolonged period of time might alter negative externalities. If expectations start looming over the material policy change or materialization of financial systematic vulnerabilities, positive effects of NIR could become more muted in the longer term. Key words: negative interest rates, central banks, policy rates, lower bound, financial institutions.

1. Introduction Although early mathematicians thought that the idea of negative numbers was absurd, five central banks from Europe and Japan have moved their policy rates into negative territory. Danmarks Nationalbank (DNB), European Central Bank (ECB), Sveriges Riksbank (SRB), the Swiss National Bank (SNB) and the Bank of Japan (BoJ) have been charging NIR on deposited excess reserves. While real interest rates have been a norm rather than an exception in some countries (notably, Germany and Japan), nominal policy rates are still novel. For instance, negative short-term government bond yields

* I would like to thank Dr. Sigitas Šiaudinis for his valuable comments and insights in preparing this paper.

* Corresponding author: Faculty of Economics, Vilnius University, Sauletekio av. 9, LT-10222 Vilnius, Lithuania. E-mail: [email protected]

25 (that highly correlate with policy rates) have been an extremely rare phenomenon: US rates were never negative even during the Great Depression, while during the height of the recent global financial crisis in 2008, some US Treasury bill yields only very briefly fell below zero (Wold Bank, 2015). The motivation for employing NIR differ somewhat across central banks, but it is essentially a result of a long-lasting trend of decreasing growth and inflation prospects. However, other central banks that have near zero policy rates (e.g., FED, Bank of Eng- land) still avoid introducing NIR, mainly stating concerns of the viability of the banks. So, it is very important to understand why central banks that face similar fundamental circumstances undertake different decisions and, ultimately, how these decisions affect real economy and the well-being of residents. This is of particular importance in the current economic environment as many countries suffer from low economic growth and inflation that implies policy rates should be set near the zero lower bound or even below it. The main purpose of this paper is to ascertain the motivation behind the introduction of negative policy rates and assess what impact NIR have on different economic sectors. The sectors that are mostly discussed of being affected by NIR are money markets, households, non-financial corporations, financial institutions, governments and -as set markets. The impact on these sectors ultimately affects the economic growth and inflation, i.e., the main determinants of central banks’ goal function. However, various exemptions weaken the direct effect of negative policy rates. Also, while previous studies mainly examined the effects of positive interest rates, this paper puts more focus on the short- and long-term impacts of low or even negative rates on different economic sectors. The use of econometrical models in analyzing NIR effects is seldom used mainly due to the short history on NIR and complexity in determining causal links between various sectors. Due to this reason, a generalization of the findings of other authors’ papers as well as statistical and graphical analyses are employed in this paper. This analysis is based on the data of the Statistical Data Warehouse, Thomson Reuters, IMF Finan- cial Soundness Indicator and other sources for the five countries (whenever available) that introduced NIR. Also, the impulse-response functions of the vector autoregression model for the euro area from 2000 to March 2017 were performed. This analysis helps to examine the effects of the interest rate reduction shock, which is a close proxy of an NIR shock, and cross-check the results of statistical and graphical analysis. The results of this broad-based analysis are important to both the academic society and policy makers as the history of NIR is quite short and full effects will materialize only gradually in the longer term. Without the introduction and conclusions, this paper consists of four main parts: the examination and comparison of the central banks’ rationale to introduce negative policy rates; a literature review of the fundamental reasons behind decreasing and even intro-

26 of the interest rate reduction shock, which is a close proxy of an NIR shock, and cross-check the results of statistical and graphical analysis. The results of this broad-based analysis are important to both the academic society and policy makers as the history of NIR is quite short and full effects will materialize only gradually in the longer term. Without the introduction and conclusions, this paper consists of four main parts: the examination and comparison of the central banks’ rationale to introduce negative policy rates; a literature review of ducingthe fundamental negative reasonsrates; the behind statistical decreasing and graphical and even introducinganalysis and negative a discussion rates; the of statisticalthe effects and of NIR on different economic sectors; the econometrical analysis of interest rate reduc- graphical analysis and a discussion of the effects of NIR on different economic sectors; the tion shock effects in the euro area. econometrical analysis of interest rate reduction shock effects in the euro area.

2. Central Banks and Their Motives for Employing NIR 2. Central Banks and Their Motives for Employing NIR During the period between 2012 and 2015, five central banks began charging NIR on depositedDuring the excessperiod between reserves 2012 (see and Fig. 2015, No. five 1). centr Earlieral banks episodes began chargingof negative NIR ondeposit deposited rates excess in Switzerlandreserves (see Fig.in 1972No. 1). or Earlier Sweden episodes in 2009-2010 of negative depositwere applied rates in Switzerlandto only a smallin 1972 fraction or Sweden of in deposits,2009-2010 so were it did applied not tohave only any a small significant fraction of and deposits, long-lasting so it did noteffects. have any significant and long- lasting effects.

2,0

1,5

1,0

0,5

0,0

-0,5

-1,0 2010.01.01 2011.01.01 2012.01.01 2013.01.01 2014.01.01 2015.01.01 2016.01.01 ECB: Overnight Deposit Facility DNB: Certificate Of Deposit SNB: Target 3 Month LIBOR SRB: Repo Rate BoJ: Interest on Current Account FIG. No. 1. Policy rates from 2010, % FIG. No. 1. Policy rates from 2010, % Source: author’s calculations based on the data of Thomson Reuters. Source: author’s calculations based on the data of Thomson Reuters. The motivations behind the decisions vary somewhat across jurisdictions, leading to differences in policyThe motivationsimplementation behind (see Table the Nodecisions. 1). The varyeuro areasomewhat is the largest across region jurisdictions, to introduce leadinga negative topolicy differences rate and in the policy motivation implementation of the ECB was (see a persTableistent No. risk 1). of The deflati euroonary area and is weak the largest recovery, region to introduce a negative policy rate and the motivation of the ECB was a persistent risk of deflationary and weak recovery, excessive risk aversion and concentration of liquidity surplus in core banks. Due to the sovereign debt crisis of the euro area in 2012 and the ECB easing measures (including NIR), central banks from some smaller Euro- pean countries (SNB, SRB, DNB) began feeling pressure from markets to appreciate their exchange rates and suffered from an increasing deflationary risk. For instance, the DNB’s announcement of its interest rate reduction at 4.00 p.m. on 5 July 2012 followed the ECB interest rate reduction at 1.45 p.m. (DNB, 2012). BoJ introduced negative policy rates only from the start of 2016, motivating its decision by a persistently low inflation and yen appreciation in the face of an increasing search for safe heaven.

27 TABLE No 1. The dates, decisions, exemptions and motivations of centrals banks to introduce NIR

Central Date and action taken Exemptions Reasons bank SNB 1972 onward: penalty charge To discourage capital inflows, of 2% applied to the increase particularly from oil-exporting in CHF deposits from non- countries. residents (in 1978 increased to 10%). December 2014 onward: rate Negative interest levied on To lower the upward pressure on sight deposits at the SNB sight deposit account bal- on the franc so as to stabilize lowered in 2 steps to -0.75% ances exceeding a determined price developments and sup- (and, in January 2015, the threshold to each individual port economic activity, as well abandoned franc peg with account holder. as to prevent the SNB balance the euro that was introduced sheet from further unprec- in 2011). edented expansion. SRB July 2009 (till September The range of deposits subject Deep economic downturn. 2010): deposit rate cut to to NIR was very small and -0.25%. banks could buy debt certificates issued by SRB. July 2014 onward: deposit rate SRB conducts weekly liquidity- Persistently low inflation as lowered to -0.5 %. absorbing operations by issu- well as the prevention of SEK Beginning in February 2015, ing SRB Certificates. appreciation. the repo rate was lowered in 4 steps to -0.5%, bringing the deposit rate to -1.25%. DNB July 2012 (till April 2014): Only reserves beyond a pre- To discourage capital flows Certificates of deposit rate determined limit are convert- that persisted already from lowered to -0.2%. ed into certificates of deposits 2010 due to upward pressure with negative rates. on the krone. September 2014 onward: Cer- Reserves beyond pre-deter- To manage upward pressure tificates of deposit rate cut in mined limit are converted into on the krone and defend the 5 steps to -0.75% (in January certificates of deposit with ERM II peg (mostly a conse- 2016 – increased to -0.65%). NIR. quence of the rate reduction and other measures of the ECB and SNB). ECB June 2014 onward: lowered Average reserve holdings in Persistently low inflation, the Deposit Facility Rate to excess of the minimum re- weak recovery, excessive risk -0.4% in 4 steps. serve requirements. aversion and concentration of liquidity surplus in core banks. BoJ January 2016: lowered the Outstanding balance of each Persistently low inflation. interest rate applied to current financial institution’s cur- accounts to -0.1%. rent account at the Bank are divided into three tiers, to one of them a negative rate is applied. Source: prepared by the author on the basis of the information provided by the central banks (SNB, 2013; SNB, 2015; SRB, 2009; SRB, 2016; DNB, 2012; DNB, 2016; ECB, 2015; BoJ, 2016).

28 However, even though a couple of banks (SRB, SNB) have lowered deposit rates to lower than -1%, the effective “tax”, due to various exemptions, can be much lower. For instance, BoJ lowered the interest rate applied to current accounts to -0.1%, but institutions that have such accounts at BoJ are on average paying almost nothing. As a result, the effects of negative rates are weakened due to these exemptions. Still other central banks that have a near-zero policy interest rate avoid introducing NIR due to several reasons. According to BoE (2013), lower interest rate margins might reduce the banks’ profitability and capital adequacy. As quantitative easing and other measures ini- tiated after the financial crisis caused upward pressure on the excess reserves, the charges of these reserves may further reduce banks’ profitability. Moreover, if negative policy rates were perceived to be long-lived, banks might decide to convert a part of their reserves into cash or even raise lending rates. Yellen (2013) added that FED had discussed the possibility of lowering interest rates, but the closer the rate is to (or even below) zero, the bigger the risk of disruption to the money markets that help fund banks. Due to these consequences, the transmission of NIR to the real economy may be more muted than normal.

3. Literature Review: the Fundamental Reasons of Low and Even Negative Interest Rates In advanced economies, central banks have been mostly lowering nominal policy rates for more than 3 decades (though with some notable exceptions during the late 80s or the start of this century) due to certain secular forces behind interest rates. According to Constancio (2016), four main components – the expected inflation over the lifespan of the asset, inflation premia, real term premia and the expected path of short-term real interest rate – contributed to the decline of nominal long-term interest rates. The decline of the first two components can be attributed to a successful monetary policy of the central banks, possibly linked to the adoption of inflation targeting in the 1990s, though inflation expectations fell even below the target rate in the last two years (Haldane, 2015). There are several possible reasons of the decline of the real term premium: an increased demand for safe assets at the global level due the desire of emerging markets to build in- ternational reserves for precautionary reasons after the Asian crisis, demographics, new liquidity regulation for banks etc. (Constancio, 2016). Nevertheless, the decline of nominal rates mostly follows the trend of real rates. Broadly speaking, central banks use policy interest rates to achieve, over the medium term, a level of real interest rates that is consistent with a rate of inflation in line with policy objectives and a level of economic activity close to its full potential (World Bank, 2015). When inflation was high in the past, it was not unusual for real (inflation-adjust- ed) interest rates to be negative ex post in some countries (Labonte, 2016). Negative real rates of interest on deposits have been the norm rather than the exception in Germany in the recent decades (Coeure, 2016). In that sense, negative rates are not novel; what is novel is for the nominal interest rates to be negative.

29 Importantly, real rates appear to have fallen similarly among advanced and emerging economies, so the forces driving this decline may be global in nature (Rachel, Smith 2015). For instance, Haldane (2015) states that the explanations for this secular fall in global real rates include excess savings in the East, deficient investment in the West, worsening demographic trends and rising inequality. IMF (2014) mentions 3 main factors: a steady increase in income growth in emerging market economies, rapid reserve accumulation in some emerging market economies and a sharp and persistent decline in investment rates in advanced economies since the global financial crisis. Constancio (2016) argues that real interest rates are mostly linked to the dynamics of potential output that can further be described by the relation of productivity and population growth with savings behavior – studies show that total factor productivity and population growth have been slowing in advanced economies for decades, while the savings have been increasing. Rachel and Smith (2015) identified 5 factors that account for around 310 out of 450 overall basis points fall of long-term real interest rates over the past 30 years and none of them are likely to reverse quickly: a lower trend growth (100 basis points); worsening demographic trends (90 basis points); low investment rates due to the falling price of capital goods (50 basis points); rising inequality (45 basis points); savings gluts in emerging markets (25 basis points). In summary, there are five most cited explanations why real and, as a result, nominal interest rates have fallen. First, a continued decline in global trend growth reduces spending (and thus increases saving) at any given level of interest rates (Summers, 2013). In particular, the 2008-2009 financial crisis has triggered a wider reassessment of growth prospects and provoked a pessimistic attitude regarding the future. Second, the aging and declining pace of population growth (already in a decrease from 1975) further reduce spending and compress investment demand. For instance, populations from regions that experience low or even negative interest rates, e.g., Japan and the most of Europe, have been growing at dismal rates for more than two decades and are projected to decline further (United Nations, 2015). Third, rising inequality implies a higher saving rate as richer individuals tend to save more, while lower-income households may be unable to invest sufficiently towards education, resulting in less human capital accumulation. Fourth, according to the saving glut theory, the increase of the global supply of savings is a long-lasting phenomenon that has not been matched by a corresponding rise in de- sired investment, especially in the emerging markets (Bernanke, 2005). Also, China and some other emerging countries intend to rebalance their economies from exports toward domestic demand that will further increase the savings glut. Fifth, an investment-to-GDP ratio in advanced economies has showed a marked decline due to a reduced investment profitability and lower growth of public investment (IMF, 2014). All these dynamics lead to the decline of investment and the increase of saving, and, as a result, to even negative rates in the regions that are mostly affected by these trends. As low and even negative rates are the result of real economy developments and global factors, monetary policy is therefore part of the solution and not part of the prob-

30 lem (Constancio, 2016). Coeure (2016) adds that a failure to take into account the downward trend in real equilibrium interest rates would have resulted in downward pressure on inflation and activity, pushing real interest rates up and driving the economy further away from full employment. If the shock of negative policy rates will attain the main goals, i.e., a higher inflation and economic growth as well as the prevention of currency appreciation, central banks, due to possible negative externalities, will feel the pressure to abolish the “experiment” of NIR. It is important to note that the current cyclical recovery lasts for more than seven years in most of the advanced economies, so the next recession might materialize sooner or later. In order to have the possibility to use the most powerful monetary policy instru- ment at hand, i.e., to significantly decrease interest rates and thus stimulate real economy, central banks seek to attain higher rates before the next economic recession looms. Also, monetary policy makers are afraid that rates that are “too low for too long” might cause excess risk taking that often leads to the build-up of systematic vulnerabilities in financial institutions and markets in the long-term. This implies that central banks do not favor having NIR for a prolonged period of time. Notwithstanding this, persisting trends of underlying factors imply that interest rates will remain negative or at least very low for quite some time, meaning that various economic sectors will feel the effects of NIR and will have to adapt both in the short- and long-term.

4. Statistical Analysis of NIR Effects on Different Economic Sectors Central banks that introduce NIR hope to achieve their stated goals through various transmission channels, such as the money market interest rate, expectations and other channels. In the central banks’ opinion, this transmission is almost identical as in a case with lowering the positive interest rate. According to Praet (2016), the implications of the ECB rate cuts to negative levels were similar to those of equally-sized rate cuts taking place in positive territory. NIR should induce a decline in short-term money market rates, which via financial market arbitrage transmits along the yield curve and to a wide range of asset classes. The resultant loosening in financial conditions induces firms and households to bring forward consumption and investment decisions. This intertemporal substitution from future to current spending should subsequently support the cyclical recovery. However, in practice, the effects of a negative interest rate can be quite different than encountering positive rates and may pose additional risks. • Money Market and Longer Term Rates The starting point to analyze the transmission of policy rates to real economy is by determining the pass-through to the money market and longer term rates. The transmission from NIR to money market rates occurred in all five countries that introduced NIR,though in different scale (see FIG. No. 1 in the Appendix). Short term money market rates remained close to policy rates in Switzerland and Sweden, but are higher in the euro area and,

31 especially, in Japan (by 10 bps) and Denmark (by 20 bps), possibly due to the exemptions applied to charges on excess reserves. These results are in line with the results of other authors (e.g., Bech, Malkhozov, 2016) – modestly negative policy rates have transmitted to short term money market rates in very much the same way as positive rates are, in line with the notion that the effective lower bound on policy interest rates can be lower than zero. The transmission of negative policy rates to longer-term rates, e.g., sovereign yields, is more complicated. The belief shared by investors that central banks would not lower policy rates to negative territory creates the monetary tightening bias that arises when market expectations on future interest rates are truncated by a perceived lower bound – this drives a wedge between actual market rates and the rate path that investors consider most likely (Praet, 2016). What is more, NIR helped to mitigate the bias of these expec- tationsconsumption of a zero-lower and house purchases bound – afyieldter NIR curves were have introduced become (see flatter FIG. inNo. all 2). five Although countries the downward (see FIG. No. 1 in the Appendix). However, market rates may be affected by other measures trend could be seen even before negative rates, the subsequent declines were mostly bigger than the of the central bank or even the computation methods of benchmark rates (Jurkšas, 2016). reduction of policy rates, possibly due to other easing measures and an increasing competition among It is also important to note that very low or even negative yields might lead to a funda- mentalbanks. Theovervaluation biggest decline of sovereign can be observed bonds, thusin De increasingnmark and theespecially risk of inmarket lending reversal for consumption. that wouldHowever, have mortgage a negative rates spill-over declined marginally effect to otherin Sw marketsitzerland, and while bond in Swedenholders. it has declined not as much• asHouseholds the policy rate. Overall, ECB (2015) determined that households’ interest payments have decreasedNIR had substantially: mostly redistributional from around 4 effectsto 1.1% on as purchasing a share of powerdisposable from income net savers since to2008; net this is borrowers.especially evident First, inthe coun decreasingtries where money fixed rate market loans areand less longer wide spread,rates encouraged e.g., Finland, banks Portugal, to Spain lowerand the lending Baltic countries.rates for newAlso, loans lower for lending consumption rates (even and in house the negative purchases zone) after led NIRto an wereincrease in introduceddemand to borrow (see FIG. and, No.as a result,2). Although supported the cons downwardumption today trend through could intertemporalbe seen even substitution before for future consumption (World Bank, 2015). 9 8 7 ECB DNBSNB SRB 6 5 4 3 2 1 0 2013.01.01 2014.01.01 2015.01.01 2016.01.01 Consumption: House purchases: Deposits:

FIG. No. 2. Rates of new loans to households for consumption, house purchases, and deposit rate, FIG. No. 2. Rates of new loans to households for consumption, house purchases, and deposit rate, % % Note: Vertical lines denote the date when central bank implemented negative policy rates. Japan is omit- tedNote: from Vertical this and lines many denote other the figures date wh areen toocentral due bankto too implemented short time series. negative policy rates. Japan is omitted from Source:this and author’s many other calculations figures are based too dueon theto too data short of the time Statistical series. Data Warehouse and Thomson Reuters. Source: author’s calculations based on the data of the Statistical Data Warehouse and Thomson Reuters. 32 Deposit rates decreased, though less than with lending rates for mortgages or house purchases (see FIG. No. 2). However, there seems to be not much space for any further decrease of the deposit rate due to the zero lower-bound. Policy rates decreased much faster than deposit rates, e.g., in Switzerland, the deposit rate decreased by only a 0.08 percentage point. Overall, an average household’s net interest income has been largely unaffected due to the higher absolute amount of savings. But as the resources moved from net savers to net borrowers, who have a higher marginal propensity to consume, the overall impact of NIR on aggregate consumption is more positive (Praet, 2016). negative rates, the subsequent declines were mostly bigger than the reduction of policy rates, possibly due to other easing measures and an increasing competition among banks. The biggest decline can be observed in Denmark and especially in lending for consumption. However, mortgage rates declined marginally in Switzerland, while in Sweden it has declined not as much as the policy rate. Overall, ECB (2015) determined that households’ interest payments have decreased substantially: from around 4 to 1.1% as a share of disposable income since 2008; this is especially evident in countries where fixed rate loans are less widespread, e.g., Finland, Portugal, Spain and the Baltic countries. Also, lower lending rates (even in the negative zone) led to an increase in demand to borrow and, as a result, supported consumption today through intertemporal substitution for future consumption (World Bank, 2015). Deposit rates decreased, though less than with lending rates for mortgages or house purchases (see FIG. No. 2). However, there seems to be not much space for any further decrease of the deposit rate due to the zero lower-bound. Policy rates decreased much faster than deposit rates, e.g., in Switzerland, the deposit rate decreased by only a 0.08 percentage point. Overall, an average household’s net interest income has been largely unaffected due to the higher absolute amount of savings. But as the resources moved from net savers to net borrowers, who have a higher marginal propensity to consume, the overall impact of NIR on aggregate consumption is more positive (Praet, 2016). Currently, there are no signs of deposits’ decrease or odd increase of cash holdings (see FIG.Currently, No. 3). thereCash are holdings no signs have of deposits’ been increasing decrease or steadily odd increase and haveof cash not holdings jumped (see after FIG. No. the3). introductionCash holdings of have NIR, been while increasing in Sweden steadily it hasand beenhave notin ajumped long-term after downwardthe introduction trend. of NIR, Thiswhile is in partly Sweden a resultit has beenof the in incompletea long-term downwardpass-through trend. to Thisdeposit is partly rates. a Asresult a result,of the incompletethe physicalpass-through lower to bounddeposit (cash rates. storageAs a result, costs) the still physical remains lower uncrossed. bound (cash storage costs) still remains uncrossed.

ECB DNB SNB SRB BoJ 120

110

100

70 2013.01.01 2014.01.01 2015.01.01 2016.01.01 Euro Area Denmark Switzerland Sweden Japan

FIG.FIG. No. No. 3. Banknotes 3. Banknotes and and coins coins in circulation in circulation (normalised (normalised to 100 to at 100 01/01/2013) at 01/01/2013) Note:Note: Vertical Vertical lines lines denote denote the the date date whenwhen a centralcentral bank had implemented implemented negative negative policy policy rates. rates. Source: author’s calculations based on the data of the Statistical Data Warehouse and Thomson Reuters. Source: author’s calculations based on the data of the Statistical Data Warehouse and Thomson Reuters.

 Non-financial Corporations 33 Reduced and even negative rates led to substantially lower non-financial corporations’ (NFCs) funding costs (see FIG. No. 4). The biggest rate reduction can be observed in the euro area, where rates increased by almost 1 percentage point, i.e., 2.5 times more than the decrease of policy rates. In Sweden, lending to NFCs rates had been declining substantially both before and after SRB introduced negative rates and in line with policy rates both in positive and negative territory. As a result, these decreases led to lower the NFCs debt-to-equity ratios and higher profitability. Also, NIR helped to further compress not only the level, but also the dispersion of banks’ lending rates, e.g., in the euro area countries, leading to the recovery of investment growth (Rostagno et al., 2016). • Non-financial Corporations Reduced and even negative rates led to substantially lower non-financial corporations’ (NFCs) funding costs (see FIG. No. 4). The biggest rate reduction can be observed in the euro area, where rates increased by almost 1 percentage point, i.e., 2.5 times more than the decrease of policy rates. In Sweden, lending to NFCs rates had been declining substantially both before and after SRB introduced negative rates and in line with policy rates both in positive and negative territory. As a result, these decreases led to lower the NFCs debt-to-equity ratios and higher profitability. Also, NIR helped to further compress not only the level, but also the dispersion of banks’ lending rates, e.g., in the euro area countries, leading to the recovery of investment growth (Rostagno et al., 2016).

3,00 ECB DNB SRB 2,50

2,00

1,50

1,00

0,50

0,00 2013.01.01 2014.01.01 2015.01.01 2016.01.01 -0,50 Loans: Euro Area Denmark Sweden O/N deposit: Euro Area Denmark Sweden

FIG.FIG. No. No. 4. Rates4. Rates of new of new loans loans to NFCs, to NFCs, % %

Note:Note: Vertical Vertical lines lines denote denote the the date date when cecentralntral bankbank implemented implemented negative negative policy policy rates. rates. Source:Source: author’s author’s calculations calculations based based on on thethe data of the StatisticalStatistical Data Data Warehouse Warehouse and and Thomson Thomson Reuters. Reuters.

SimilarlySimilarly as inas thein thecase case with with households, households, banks banks alsoalso loweredlowered their deposit ratesrates to to NFCs. NFCs.Negative Negative overnight overnight deposit rates deposit have beenrates even have app beenlied toeven some applied institutional to some investors institutional and some large investorsfirms – this and is especiallysome large evident firms in –Denmark’s this is especially case. The evidentpossible in reason Denmark’s might be case. the fact The that pos interest- siblerates reasonon new mightloans tobe NFCs the fact is lower that interestthan on househorates onlds, new so loansbanks tofeel NFCs even moreis lower pressure than toon reduce households,deposits rates so to banks NFCs. feel Interestingly, even more deposit pressure growth to reduce rates for deposits NFCs showrates tothat NFCs. there Interestis no sign- of a ingly, deposit growth rates for NFCs show that there is no sign of a disintermediation disintermediation risk at the moment (Coeure, 2016). But a lower deposit earnings income mean puts risk at the moment (Coeure, 2016). But a lower deposit earnings income puts pressure pressure on the profitability of firms with high spare money. Overall, the NFCs that have higher on the profitability of firms with high spare money. Overall, the NFCs that have higher willingness to invest win over those NFCs with higher deposits. willingness to invest win over those NFCs with higher deposits.

• Banks and Non-bank Financial Institutions  Banks and Non-bank Financial Institutions Banks in the countries where NIR are applied reduced their net interest margins (see Banks in the countries where NIR are applied reduced their net interest margins (see FIG. No. 5). This FIG. No. 5). This decrease is mostly evident on loans for NFCs and in countries where decrease is mostly evident on loans for NFCs and in countries where floating rate loans dominate. 34However, despite the downward stickiness of deposit rates, margins for house purchases remained remarkably steady and in some cases even increased, especially on loans for house purchases in the euro area. Also, NIR stimulated banks to increase lending volumes, so smaller interest margins did not materially affected the viability of banks (Praet, 2016). floating rate loans dominate. However, despite the downward stickiness of deposit rates, margins for house purchases remained remarkably steady and in some cases even increased, especially on loans for house purchases in the euro area. Also, NIR stimulated banks to increase lending volumes, so smaller interest margins did not materially affected the viability of banks (Praet, 2016).

3,50 ECB DNB SNB SRB 3,00

2,50

2,00

1,50

1,00

0,50

0,00 2013.01.01 2014.01.01 2015.01.01 2016.01.01 Euro area: NFCs Euro area: house purch. Denmark: NFCs Denmark: house purch. Sweden: NFCs Sweden: house purch. Switzerland: house purch. FIG.FIG. No. No. 5. Net 5. Net interest interest margins, margins, % % Note:Note: Vertical Vertical lines lines denote denote the the date date whenwhen a centralcentral bankbank implemented implemented negative negative policy policy rates. rates. Source: author’s calculations based on the data of Thomson Reuters. Source: author’s calculations based on the data of Thomson Reuters.

In theIn shortthe short term, term, the profitabilitythe profitability of ofbanks banks should should increase increase asas the the positive positive effectseffects outoutweigh- weighnegatives negatives ones. Rising ones. lendingRising volumeslending andvolumes non-intere and stnon-interest income, higher income, values higher of securities values portfolios of securitiesdue to lower portfolios yields, smaller due to NPLslower because yields, smallerof the decr NPLsease becauseof clients’ of debt the servicedecrease burden of clients’ and reduced debtfunding service costs burden partly offsetand reduced the problem funding of deposit costs ratepartly stickiness. offset theAll problemin all, ba nks’of deposit return ofrate asset in stickiness. All in all, banks’ return of asset in countries with NIR has not changed materi- countries with NIR has not changed materially (see FIG. No. 6). Highest returns are generated in ally (see FIG. No. 6). Highest returns are generated in Sweden and Switzerland, while Sweden and Switzerland, while the lowest – in Denmark and the euro area. the lowest – in Denmark and the euro area. However, in the longer term, one-off gains will fade away and banks will feel a higher pressure on profitability and,ECB as aDNB result,SNB the SRBneed to alter businessBoJ models. The 0,8 longer NIR are kept, the higher the possibility that banks will need to reduce margins due0,6 to deposit rate stickiness, while flatter yield curves imply lower profits from maturity transformation. Also, banks will need to replace matured higher-yielding bonds with negative-yielding0,4 assets – this implies lower profitability in the future. As investors reas- sess how low rates can go, focus on the downside risks to earnings and capital adequacy will0,2 increase. As a result, banks will need to change their business models: they will have to rebalance0,0 toward riskier assets and borrowers, increase the share of market financing and decrease the amounts of retail deposits, rely more on non-interest income and/or increase-0,2 cost efficiency (Borio et al., 2015, The Bank of Lithuania, 2016). 2012.11.01 2013.11.01 2014.11.01 2015.11.01 Euro area Denmark Switzerland Sweden Japan 35 FIG. No. 6. Return of asset of deposit taking institutions, % Note: Vertical lines denote the date when a central bank implemented negative policy rates. 3,50 ECB DNB SNB SRB 3,00

2,50

2,00

1,50

1,00

0,50

0,00 2013.01.01 2014.01.01 2015.01.01 2016.01.01 Euro area: NFCs Euro area: house purch. Denmark: NFCs Denmark: house purch. Sweden: NFCs Sweden: house purch. Switzerland: house purch. FIG. No. 5. Net interest margins, % Note: Vertical lines denote the date when a central bank implemented negative policy rates. Source: author’s calculations based on the data of Thomson Reuters.

In the short term, the profitability of banks should increase as the positive effects outweigh negatives ones. Rising lending volumes and non-interest income, higher values of securities portfolios due to lower yields, smaller NPLs because of the decrease of clients’ debt service burden and reduced funding costs partly offset the problem of deposit rate stickiness. All in all, banks’ return of asset in countries with NIR has not changed materially (see FIG. No. 6). Highest returns are generated in Sweden and Switzerland, while the lowest – in Denmark and the euro area.

ECB DNB SNB SRB BoJ 0,8

0,6

0,4

0,2

0,0

-0,2 2012.11.01 2013.11.01 2014.11.01 2015.11.01 Euro area Denmark Switzerland Sweden Japan

FIG.FIG. No. 6.No. Return 6. Return of asset of ofasset deposit of deposit taking takinginstitutions, institutions, % % Note:Note: Vertical Vertical lines lines denote denote the the date date when when a centrala central bank bank implemented implemented negative policypolicy rates.rates. Source: author’s calculations based on the data of the IMF Financial Soundness Indicator and the Statistical Data Warehouse.

The effect of NIR on non-bank financial institutions is very similar to banks. These institutions (especially pension and life insurance companies) may be unable to meet their long-term liabilities due to fixed costs of their offered products, e.g., two-thirds of life insurance policies in force in the EU today offer some sort of guarantee that is not linked to market interest rates (The Economist, 2016). The biggest part of non-bank financial institutions’ assets consists of investment grade fixed-income securities that have mostly risen in value after the central banks set negative policy rates, but in the longer term, the extremely low income of newly purchased securities could fall below the promised pay-outs to the policyholders (IMF, 2015). These challenges mean that non-bank financial institutions must change their business models, too: they ought to increase their search for higher yield, shift toward more market-based financing, merge with other institutions to reduce costs and/or begin developing new products whose pay- outs are more linked to market interest rates. • Governments Negative policy rates had reduced the borrowing costs of governments in all five countries as the bond yields have decreased substantially, particularly at the shorter end of the yield curve and, more recently, also at the longer term (see FIG. No. 1 in the Ap- pendix). While policy rates have a more direct effect on the short-end of yield curve (the “signalling channel”), its impact on market participants’ expectations about the path of future policy rate had an impact on longer-end yields too, mostly through the “balance sheet channel“. The extra savings of refinancing led to lower deficits and, to some extent, higher spending. Moreover, NIR also has helped to reduce market fragmentation among

36 euro area countries as the difference spreads of Italian, Spanish and Portuguese bonds have decreased (Coeure, 2016). The Thenegative negative implications implications of ofNIR NIR might might become become more more evident evident in in the the long-term long-term as as many many countries have already spent the extra savings for short-term political gains, but countries have already spent the extra savings for short-term political gains, but have not implemented have not implemented necessary structural reforms or build reserves. Borio et al. (2016) necessary structural reforms or build reserves. Borio et al. (2016) emphasized that governments need to emphasized that governments need to break their reliance on exceptionally low interest ratesbreak as their it does reliance not haveon exceptionally long lasting low effects interest on rate reals aseconomy. it does not Many have analysts long lasting (e.g., effects Slok, on real 2016)economy. often Many highlight analysts that (e.g., the Slok, reform 2016) momentum often highlight has thatslowed the reformand political momentum uncertainty has slowed and haspolitical increased uncertainty after NIR has were increased introduced after NIR and were that theyintroduced also have and political that they implications also have political inimplications highly savings-dependent in highly savings-de countriespendent as countries Germany, as Germany, Japan etc. Japan When etc. policy When rates policy will rates will finallyfinally bebe raised raised and and become become positive, positive, many many countries countries might findmight themselves find themselves financially financially unprepared for unprepared for increased debt servicing costs and could even be unable to pay their debts increased debt servicing costs and could even be unable to pay their debts on the agreed terms, meaning on the agreed terms, meaning increased vulnerability in financial markets, reduced bond increased vulnerability in financial markets, reduced bond holders’ willingness and ability to consume holders’ willingness and ability to consume as well as invest and, ultimately, restrained economicas well as development.invest and, ultimately, These effectsrestrained could econ becomeomic development. even more These severe effects the longercould become NIR even aremore kept severe and the the longer faster NI policyR are keptrates and are the raised. faster policy rates are raised.

• Asset markets  NIR Asset contributed markets to lower (or at least stable) value of domestic currency. Similarly asNIR in contributedthe case with to lower a cut (orof atpositive least stable) rate, valueNIR throughof domestic the currencyportfolio. Similarly rebalancing as in channelthe case with a ledcut toof higherpositive capital rate, NIR outflows through and, the portfoliosubsequently, rebalancing depreciation channel ledof the to highedomesticr capital currency outflows – and, insubsequently, the short term, depreciation nominal of effective the domestic exchange currency rates – in fell the or short at least term, stabilized nominal effective in all five exchange countriesrates fell or(see at FIG. least No. stabilized 7). However, in all five the countr depreciationies (see FIG.of domestic No. 7). However,currency thecan depreciationlead to of thedomestic so-called currency “currency can lead wars” to theby causing so-called a “currencycle ofcy rate-cutting wars” by causing in dif ferent a cycle countries. of rate-cutting in different countries. 120 ECB DNB SNB SRB BoJ 115

110

105

100

85 2014.01.01 2015.01.01 2016.01.01 Euro Area Denmark Switzerland Sweden Japan

FIG. No. 7. Nominal effective exchange rate, normalised to 100 at 01/01/2014 FIG. No. 7. Nominal effective exchange rate, normalised to 100 at 01/01/2014 Note: Vertical lines denote the date when central bank implemented negative policy rates. Note:Source: Vertical author’s lines calculations denote the based date whenon the central data of bank Thomson implemented Reuters. negative policy rates. Source: author’s calculations based on the data of Thomson Reuters.

37 NIR positively affected prices of other asset markets to some extent. Increased risk taking, wealthNIR effectpositively and loweraffected borrowing prices of costsother contributed asset markets to increasingto some extent. house Increased prices, though risk taking, inwealth a much effect slower and lower manner borrowing than in co previoussts contributed cycles to of increasing house price house increases prices, though(Rostagno in a muchet al., slower 2016).manner Also,than inNIR previous led to cycles a similar of house effect price on corporate increases bonds(Rostagno as inet theal). caseAlso, of NIR government led to a similar bondseffect on – corporate lower yields. bonds Corporate as in the case bonds of gove payingrnment negative bonds interest– lower ratesyields. account Corporate for bonds about paying $500 billion out of nearly $10 trillion in securities that yields below zero – the reason for negative interest rates account for about $500 billion out of nearly $10 trillion in securities that yields this could be that negative policy rates are expected to stay for a long time (Cowen, 2016). below zero – the reason for this could be that negative policy rates are expected to stay for a long time However, values of stock indices in four countries (the only exception – Denmark) had not increased(Cowen, 2016). substantially However, after values NIR of were stock introduced indices in four (see countries FIG. No. (the 8). onlyOne exceptionof the possible – Denmark) rea- had sonnot increasedcould be substantiallythe negative after expectations NIR were onintroduced financial (see institutions FIG. No. ’8). prospects One of the in thepossible long-term. reason could be the negative expectations on financial institutions’ prospects in the long-term.

ECB DNB SNB SRB BoJ 180 170 160 150 140 130 120 110 100 90 2013.01.01 2014.01.01 2015.01.01 2016.01.01 Euro Area Denmark Switzerland Sweden Japan FIG. No. 8. Stock market indices, normalised to 100 at 01/01/2013 FIG. No. 8. Stock market indices, normalised to 100 at 01/01/2013 Note: Vertical lines denote the date when central bank implemented negative policy rates. Note: Vertical lines denote the date when central bank implemented negative policy rates. Source: author’s calculations based on the data of Thomson Reuters. Source: author’s calculations based on the data of Thomson Reuters. The long-term implications of NIR on asset markets might outweigh the positive short-term effects.The If long-term NIR are kept implications for too long, of portfolio NIR on rebalancing asset markets could leadmight to fundamentallyoutweigh the overvalued positive asset short-termprices. So, wheneffects. chances If NIR of arethe keptreversal for oftoo monetary long, portfolio policy accomm rebalancingodation could become lead more to fun priced-in,- damentally overvalued asset prices. So, when chances of the reversal of monetary policy investors might pull back their money – history tells that the slump of asset markets often leads to accommodation become more priced-in, investors might pull back their money – history economic downturn. Also, market liquidity might become impaired as financial institutions alter their tells that the slump of asset markets often leads to economic downturn. Also, market liquiditybusiness models might becomeand their impaired ability to asprovide financial liquid institutionsity diminishes. alter This their could business make themodels asset and markets theireven moreability vulnerable to provide to monetary liquidity policy diminishes. shocks or Thisexpectations could makeas witnessed the asset by, for markets instance, even the Taper moretantrum vulnerable in 2013 and to Bundmonetary tantrum policy in 2015. shocks or expectations as witnessed by, for instance, the Taper tantrum in 2013 and Bund tantrum in 2015. • Macroeconomy All the above-mentioned effects (e.g., improved confidence, lower interest payments, higher exports, the profitability of firms and asset prices) have an impact on real econ-

38 omyAll the of abovementionedcountries with effectsNIR in (e.g., the shortimproved run. confid However,ence, lowerthe macroeconomic interest payments, implications higher exports, the ofprofitability negative ofpolicy firms rates and assetare notpric straightforwardes) have an impact as onthere real areeconomy both “standardof countries effects” with NIR of in the ashort monetary run. However, easing theand macroeconomic “non-standard implications effects” related of negative exclusively policy rates to NIRare not that straightforward become as morethere areevident both “standardin the long effects” run. of a monetary easing and “non-standard effects” related exclusively to NIRPurchasing that become market more evident indexes in the(PMI) long have run. not yet responded in a common manner after NIR hadPurchasing been introduced market indexes (see FIG. (PMI) No. have 9). notNevertheless, yet responded it is in important a common to manner note that after not NIR had all central banks introduced NIR to stimulate growth. For instance, DNB, SNB and, to been introduced (see FIG. No. 9). Nevertheless, it is important to note that not all central banks some extent, SRB wanted to lower the pressure on domestic exchange rate, while banks introduced NIR to stimulate growth. For instance, DNB, SNB and, to some extent, SRB wanted to lower in Japan and Switzerland escaped a part of “tax” on excess reserves due to exemptions. the pressure on domestic exchange rate, while banks in Japan and Switzerland escaped a part of “tax” on As a result, the effects had been comparatively small. excess reserves due to exemptions. As a result, the effects had been comparatively small. 85 ECB DNB SNB RIX BoJ 80 75 70 65 60 55 50 45 40 35 2013.01.01 2014.01.01 2015.01.01 2016.01.01 Euro Area Denmark Switzerland Sweden Japan

FIG.FIG. No. No. 9. Purchasing9. Purchasing market market index index (output) (output) Note:Note: Vertical Vertical line line denote denote the the datedate when centracentrall bankbank implemented implemented negative negative policy policy rates. rates. Source: author’s calculations based on the data of Thomson Reuters. Source: author’s calculations based on the data of Thomson Reuters.

Medium-term inflation expectations had not recovered in the euro area (see FIG. No. 10). This Medium-term inflation expectations had not recovered in the euro area (see contradicts the conventional thinking that lowering interest rates could heighten inflation expectations. FIG. No. 10). This contradicts the conventional thinking that lowering interest rates couldHowever, heighten the monetary inflation policy expectations. package (including However, the negativethe monetary deposit policyfacility packagerate) helped (includ to increase- ingboth the inflation negative and depositGDP by facility 0.3-0.8 rate)percentage helped points to increase a year in both 2015-2017 inflation (Rostagno and GDP et al., by 2016).0.3- The 0.8confidence percentage effect, points the fall a ofyear domes in 2015-2017tic currency value(Rostagno and higher et al., wealth 2016). should The provide confidence an upward ef- push fect,to economic the fall growthof domestic and inflation currency expectations value and in higherall the countrieswealth should with NIR provide (The anEconomist, upward 2015). pushStill, theto economiclong-term effects growth are and harder inflation to predict expectations due to the concerns in all the of financialcountries institutions’ with NIR viability (The and Economist,excessive risk 2015). seeking Still, in asset the marketslong-term that effects lead to arehigher harder systemic to predict vulnerability due to in the the concernsfuture – if these of financial institutions’ viability and excessive risk seeking in asset markets that lead risks materialize, both inflation expectations and economic growth might be overwhelmed. to higher systemic vulnerability in the future – if these risks materialize, both inflation expectations and economic growth might be overwhelmed.

39 2,0 ECB 1,8 1,6 1,4 1,2 1,0 0,8 0,6 0,4 0,2 0,0 2013.10.01 2014.04.01 2014.10.01 2015.04.01 2015.10.01 2016.04.01

FIG. FIG.No. 10. No. Inflation 10. Inflation expectations expectations (2y2y inflation (2y2y inflationswap forward) swap in forward) the euro area,in the % euro area, % Note:Note: Vertical Vertical line denote line denote the date the when date whenECB implemented ECB implemented negative negative policy rates. policy rates. Source: author’s calculations based on the data of the Statistical Data Warehouse. Source: author’s calculations based on the data of the Statistical Data Warehouse.

5. Econometrical5. Econometrical Analysis Analysis ofof the Impact Impact of of In Interestterest Rate Rate Reduction Reduction Shock Shock in the inEuro Area the Euro Area As the regime of negative policy rates has been operational only for several years, it is still quite early to As the regime of negative policy rates has been operational only for several years, it is form an accurate and full-encompassing econometrical model for a quantitative evaluation of NIR still quite early to form an accurate and full-encompassing econometrical model for a quantitativeeffects. However, evaluation the of analysis NIR effects. of interest However, rate redu thection analysis shock ofis interesta good starting rate reduction proxy on what ultimate shockeffects is a NIRgood might starting entail. proxy The on impulse what -responseultimate effects function NIR of themight vector entail. autoregression The impulse- model is a suitable responsemethod function for assessing of the thevector effects autoregression of interest rate model reduction. is a suitable This mode methodl helps for to assessing identify what the impact the effects of interest rate reduction. This model helps to identify what the impact on on variable is in t, t + 1, t + 2, etc., periods from a shock that happened in the t – 1 period of another variable is in t, t + 1, t + 2, etc., periods from a shock that happened in the t – 1 period of variable; in this analysis – from a shock of interest rate reduction. The assumptions of impulse-response another variable; in this analysis – from a shock of interest rate reduction. The assump- tionsfunction of impulse-response are that this shock function completely are that disappears this shock incompletely the next period disappears and that in the the next shocks of all other periodvariables and that are the equal shocks to 0 (Jurkšas,of all other Kropien variablesė, 2014). are equal to 0 (Jurkšas, Kropienė, 2014). As the euro As the area euro is the area largest is the region largest to region introduce to intr NIRoduce and NIR other and central other banks central with banks NIR with NIR reacted reacted to ECB actions, the analysis is performed on how the possible shock of a 3-month to ECB actions, the analysis is performed on how the possible shock of a 3-month Euribor rate (which Euribor rate (which closely tracks the ECB policy rate) impacts various economic sectors. Severalclosely relevant tracks variablesthe ECB forpolicy each rate) economic impacts sector variou weres economic selected: sectors. deposit Severa and lendingl relevant variables for rateseach of householdseconomic sector and NFCs,were selected: as well depositas the indicesand lending of consumer rates of householdsand industrial and confi NFCs,- as well as the dence;indices the netof consumerinterest margin and industrial of banks, confidence; capital position the net and interest stock prices;margin the of broadbanks, stock capital position and marketstock index; prices; long-term the broad government stock market bond index;yields andlong the-term political government uncertainty bond index; yields ex and- the political pectations of inflation and economic growth. The longest period of all data was obtainable uncertainty index; expectations of inflation and economic growth. The longest period of all data was from 2000 to March 2017. These daily or monthly variables were transformed to monthly timeobtainable series, and, from for 2000a stationarity to March condition 2017. These of the daily vector or monthly autoregression variables model, were alltransformed vari- to monthly ablestime were series, integrated and, forby findinga stationarity the first condition differences. of the Variables vector autoregressionof stock market moindicesdel, alland variables were the capitalintegrated of banksby finding were transformedthe first differences. into a linear Variable forms byof usistockng logsmarket of suchindices data. and the capital of banks were transformed into a linear form by using logs of such data. 40 The impulse-response functions of the constructed vector autoregression model revealed that a standard deviation unit shock of interest rate reduction significantly affects deposit Theand impulse-response borrowing interest functions rates of (see the constructeFIG. No.d 11).vector Banks autoregression lower both model deposit revealed and that a lendingstandard rates deviation soon unitafter shock the ECBof interest decreases rate repolicyduction rates. significantly Interestingly, affects lendingdeposit andrates borrowing ap- pliedinterest to NFCsrates (see decrease FIG. No.more 11). rapidly, Banks whilelower thebot hdeposit deposit rates and arelending stickier rates than soon in after the casethe ECB withdecreases households, policy rates. possibly Interestingl due toy, thelending fact rates that appliedNFCs toreceive NFCs muchdecrease lower more deposit rapidly, rateswhile the thandeposit households. rates are stickier What thanis important, in the case the with net hous interesteholds, margins possibly ofdue banks to the decreasefact that NFCssignifi receive- cantlymuch lowerand abruptly, deposit rates too. than This househ meansolds. that What households is important, and the netNFCs, interest on marginsaverage, of dobanks “win” decrease oversignificantly the banks, and atabruptly, least shortly too. This after means the interestthat households rates decrease. and NFCs, on average, do “win” over the banks, at least shortly after the interest rates decrease. 0,00 123456789101112 -0,01 -0,02 -0,03 -0,04 -0,05 -0,06 -0,07 -0,08 HOUSEHOLD DEPOSIT RATE HOUSEHOLD BORROWING RATE NFC DEPOST RATE NFC BORROWING RATE NET INTEREST MARGIN

FIG. No. 11. Response of interest rates to a standard deviation unit shock of interest rate reduction FIG. No. 11. Response of interest rates to a standard deviation unit shock of interest rate reduction for 12 months for 12 months Source: author’s calculations based on the data of the Statistical Data Warehouse and Thomson Reuters. Source: author’s calculations based on the data of the Statistical Data Warehouse and Thomson Reuters.

However, market expectations of the banking sector prospects do not diminish so quickly. As However, market expectations of the banking sector prospects do not diminish so quick- higher equity prices and lower long-term yields positively affect the banks’ securities portfolio and their ly. As higher equity prices and lower long-term yields positively affect the banks’ securities portfoliocapital position and their in the capital first periodsposition after in the shock,first periodsthe stock after prices the of shock, banks theare somewhatstock prices positively of banksaffected are by somewhat lower interest positively rates affected(see FIG. by No. lower 12). interestNevertheless, rates (seethis FIG.effect No. swiftly 12). disappearsNeverthe- after less,several this months, effect swiftlyprobably disappears when one-o afterff gains several fade outmonths, and investors probably shif whent their one-off focus to gains the net fade interest outincome and investorsof banks, theirshift capitaltheir focus position to theand netlong-term interest viability. income Although of banks, stock their prices capital of positionthe insurance andsector long-term fluctuate viability. widely, they Although are on averagestock prices not materi of theally insurance affected during sector the fluctuate 12 month widely, period theyafter the areshock. on average not materially affected during the 12 month period after the shock. Overall, the improvement of consumer and industrial confidence as well as increasing the bank and broad market indices lead to improving longer-term real economy prospects (see FIG. No. 13). The political uncertainty index decreased soon after the interest rate cut, possibly due to the reduced concerns of funding and debt-servicing costs, but this effect becomes overall muted in the longer term. Although consumer and industrial confidence might fall immediately after the reduction of interest rates, confidence gradually strength-

41 ens due to income (lower interest expense) and wealth (higher value of securities) effects of households and NFCs. More importantly, economic growth and, especially, inflation expectations pick up much slower and more gradually than other factors, confirming that the transmission from shock of interest rate reduction to real economy is long and indirect.

0,20

0,15

0,10

0,05

0,00 123456789101112 -0,05

-0,10

-0,15

-0,20 BANKS CAPITAL BANK STOCK INDEX INSURANCE INDEX BROAD STOCK INDEX LONG TERM YIELD FIG.FIG. No. No.12. Response 12. Response of banks’ of banks’ position position and financialand financial markets markets to a standard to a standard deviation deviation unit shock unit shockof interestof interest rate reductionrate reduction for 12 for months 12 months Source:Source: author’s author’s calculations calculations based based on on the the data ofof StatisticalStatistical Data Data Warehouse Warehouse and and Thomson Thomson Reuters. Reuters.

0,2 Overall, the improving of consumer and industrial confidence as well as increasing the bank and broad market indices lead to improving longer-term real economy prospects (see FIG. No. 13). The 0,1 political uncertainty index decreased soon after the interest rate cut, possibly due to the reduced

concerns0,0 of funding and debt-servicing costs, but this effect becomes overall muted in the longer term. Although123456789101112 consumer and industrial confidence might fall immediately after the reduction of interest rates, confidence-0,1 gradually strengthens due to income (lower interest expense) and wealth (higher value of

securities)-0,2 effects of households and NFCs. More importantly, economic growth and, especially, inflation expectations pick up much slower and more gradually than other factors, confirming that the transmission-0,3 from shock of interest rate reduction to real economy is long and indirect.

-0,4 CONSUMER CONFIDENCE INDEX PMI INDUSTRIAL CONFIDENCE INDEX INFLATION EXPECTATIONS POLITICAL UNCERTAINTY INDEX FIG. No. 13. Response of expectations and confidence to a standard deviation unit shock of interest FIG. No. 13. Response of expectations and confidence to a standard deviation unit shock of interest rate reduction for 12 months rate reduction for 12 months Source: author’s calculations based on the data of Statistical Data Warehouse and Thomson Reuters. Source: author’s calculations based on the data of Statistical Data Warehouse and Thomson Reuters.

It is important to note that while the low and negative rates have mainly positive impact for most It is important to note that while the low and negative rates have mainly positive of the economic sectors, negative effects might get exacerbated in the longer term. There are several impact for most of the economic sectors, negative effects might get exacerbated in the negative externalities that negative policy rates might entail or that could materialize in the long run: an longer term. There are several negative externalities that negative policy rates might entailincreased or that systematic could materialize risk due to higher in the borrowing long run: with anin increased the private systematicsector and governments, risk due to the higher market concerns on the viability of banks to sustain lower net interest income and excess reserve charges and 42thus a need to alter business models, non-bank financial institution problems to meet long-term liabilities of fixed-rate products, cash hoarding, mispriced and more volatile asset markets etc. As a result, NIR might have more muted positive effects and entail more systematic vulnerabilities than in a case with a rate reduction in the positive territory, especially if negative policy rates are kept for a prolonged period of time.

6. Conclusions

The analysis of the central banks’ stated goals to introduce negative rates revealed that the main reasons were persistently low inflation and upward pressures on domestic currency. Various exemptions effectively soften the burden of NIR and weaken the ultimate effect of negative policy rates. Still, many central banks that have a near zero interest rate resist introducing NIR due to the fear of lowering commercial banks’ viability to lend and thus impairing the crucial element of effective monetary policy transmission. borrowing within the private sector and governments, the market concerns on the viability of banks to sustain lower net interest income and excess reserve charges and thus a need to alter business models, non-bank financial institution problems to meet long- term liabilities of fixed-rate products, cash hoarding, mispriced and more volatile asset markets etc. As a result, NIR might have more muted positive effects and entail more systematic vulnerabilities than in a case with a rate reduction in the positive territory, especially if negative policy rates are kept for a prolonged period of time.

6. Conclusions The analysis of the central banks’ stated goals to introduce negative rates revealed that the main reasons were persistently low inflation and upward pressures on domestic currency. Various exemptions effectively soften the burden of NIR and weaken the ultimate effect of negative policy rates. Still, many central banks that have a near zero interest rate resist introducing NIR due to the fear of lowering commercial banks’ viability to lend and thus impairing the crucial element of effective monetary policy transmission. The literature review carried out in this paper revealed that low and even negative rates are the results of real economy developments and global factors, some of which are of a secular nature, while others relate to the business cycle. Monetary policy should not be blamed for a long-lasting period of rate cuts and, ultimately, NIR, because policy makers respond to the dynamics of natural interest rates. The statistical analysis showed that negative policy rates have significantly affected various economic sectors, but with different magnitude and efficacy. First of all, the pass-through from policy rates to the money market and the longer-term rates was full. Second, NIR led to an overall positive impact on aggregate consumption and redistribu- tion of purchasing power from net savers to net borrowers. Third, NFCs that are more reliant on investments have benefited more than NFCs with higher share of deposits at banks. Fourth, the positive effect on banks’ securities holdings, higher non-interest income, expanding lending volumes and lower loan losses offset the losses of reduced net interest margins and charges on excess reserves, but, in the longer term, one-off gains will fade away and banks may feel pressure to alter business models. Fifth, the mismatch between short-term assets and longer term liabilities may create increasing problems for non-bank financial institutions, though these risks will materialize not as fast as in the case with banks. Sixth, if the usage of extra savings from lower funding costs is spent duly by governments, the positive effects of economic growth might outweigh the negative implications of higher spending in the short-run, but a reliance on the reduced debt- servicing costs might diminish the necessity to implement reforms and decrease debts, implying certain increased vulnerabilities in the future. Seventh, NIR led to a somewhat downward pressure on value of domestic currency, but contributed to the increasing prices of majority of other asset markets. If prices and excessive borrowing keep increasing, asset markets might become fundamentally overvalued. Finally, the impact on economic

43 growth and inflation is highly uncertain in both short- and long-term due to the complex and indirect transmission mechanism of NIR. Impulse-response functions of the vector autoregression model revealed what effects an interest rate reduction shock had for different economic sectors in the euro area. A decreasing short-term Euribor rate have reduced deposit and lending rates of households and NFCs, lowered the net interest margin, but, to some extent, positively affected bank equity prices in short-term due to a higher value of securities prices. Although these effects subsequently diminished, increased consumer and NFCs confidence as well as the muted effect on political uncertainty contributed to somewhat higher expectations of economic growth and inflation in the longer-term. With the current size of NIR, both physical and economical lower bounds seem to remain uncrossed. However, in the long run, the positive effects should be more muted for a rate reduction in a negative rather than in a positive territory. There is increasing uncertainty about the behavior and risk seeking of individuals and institutions if rates were to decline further or remain negative for a prolonged period of time. This is especially true for the financial institutions’ viability and asset market vulnerability. Also, if market expectations start looming over a turnaround of economic policy, or the sharp adjustment of securities’ prices, positive effects could quickly evaporate and systemic risks might materialize in the longer run. The results of this broad-based graphical, statistical and econometrical analysis provide the background for any further research of NIR effects as a longer history of time- series data becomes available and the impact on different economic sectors materializes in full and becomes more evident.

REFERENCES Bank of England (2013). Note on Negative Interest Rates for Treasury Committee. Retrieved from http://www.bankofengland.co.uk/publications/Documents/other/treasurycommittee/ir/tsc160513.pdf Bech, M., Malkhozov, A. (2016). How have central banks implemented negative policy rates? BIS Quarterly Review, 6 March 2016. Bernanke, B. S. (2005). The Global Saving Glut and the U.S. Current Account Deficit. Remarks at the Sandridge Lecture. Borio, C., Gambacorta, L. Hofmann, B. (2016). The influence of monetary policy on bank profitability. BIS Working Papers, No 514. BoJ (2016). Key Points of Today’s Policy Decisions. Retrieved from: https://www.boj.or.jp/en/an- nouncements/release_2016/k160129b.pdf Constancio, V. (2016). The challenge of low real interest rates for monetary policy. Lecture at Mac- roeconomics Symposium at Utrecht School of Economics. Retrieved from http://www.ecb.europa.eu/ press/key/date/2016/html/sp160615.en.html Coeure, B. (2016). Assessing the implications of negative interest rates. Speech at the Yale Finan- cial Crisis Forum in New Haven, 28 July 2016. Cowen, T. (2016). Maybe Negative Yields Are a Sign of Prosperity. Retrieved from: http://www. bloomberg.com/view/articles/2016-07-27/maybe-negative-yields-are-a-sign-of-prosperity

44 DNB (2012). Negative interest rates. Monetary Review, 3rd Quarter 2012. DNB (2016). Negative interest rates. Monetary Review. 3rd Quarter 2016. ECB (2015). Euro area banks’ net interest margins and the low interest rate environment. Box 5 from Financial Stability Review, November 2015. Haldane, G. (2015). Growing, Fast and Slow. Speech given at University of East Anglia, 17 February 2015. Jurkšas, L., Kropienė, R. (2014). Macroeconomic Determinants of Lithuanian Government Secu- rity Prices. Ekonomika 2014 Vol. 93(4). Jurkšas, L. (2016). Euribor Skaičiavimo Reformos Prielaidos ir Galimos Pasekmės. Monetary Studies 2016, No 1. IMF (2014). Perspectives on global real interest rates. World Economic Outlook, April 2014. IMF (2016). Globally Important German Financial System is Resilient. IMF Country Report No. 16 Yellen, J. (2016). Chance Fed Could Cut Rate It Pays Banks on Reserves. Retrieved from http:// www.bloomberg.com/news/articles/2013-11-15/yellen-sees-chance-fed-could-cut-rate-it-pays-banks- on-reserves Labonte, M. (2016). Negative Interest Rates. Retrieved from https://fas.org/sgp/crs/misc/IN10481.pdf Praet, P. (2016). Transmission channels of monetary policy in the current environment. Speech at the Financial Times Festival of Finance. Rachel, L., Smith, T. D. (2015). Secular drivers of the global real interest rate. BoE Staff Working Paper, No. 571. Rostagno, M., Bindseil, U., Kamps, A., Lemke, W., Sugo, R., Vlassopoulos, T. (2016). Breaking through the zero line. The ECB’s Negative Interest Rate Policy. Presentation at Brookings Institution in Washington DC, 6 June 2016. Slok, T. (2016). Is negative interest rates an option for the Fed? Deutsche Bank newsletter of 23 March 2016. SNB (2013). Reflections on negative interest rates in Switzerland. Swiss National Bank, Monetary Review 2013. SNB (2015). Monetary Policy Report. Quarterly Bulletin, 2015, 3. SRB (2009). Repo rate cut to 0.25 per cent. Retrieved from http://www.riksbank.se/en/Press-and- published/Press-Releases/2009/Repo-rate-cut-to-025-per-cent/ SRB (2016). Monetary Policy Report. February 2016 Summers, L. (2013). Speech at IMF Fourteenth Annual Research Conference in Honor of Stanley Fischer. Retrieved from http://larrysummers.com/imf-fourteenth-annual-research-conference-in-hon- or-of-stanley-fischer/ The Bank of Lithuania (2016). Survey: greatest risk to financial system — impact of protracted low interest rates period on profitability. Retrieved from http://www.lb.lt/survey_greatest_risk_to_finan- cial_system_impact_of_protracted_low_interest_rates_period_on_profitability The Economist (2015). Why negative interest rates have arrived—and why they won’t save the global economy. Retrieved from http://www.economist.com/blogs/economist-explains/2015/02/economist-explains-15 The Economist (2016). Insurers regret their guarantees. Retrieved from http://www.economist. com/news/finance-and-economics/21693247-insurers-regret-their-guarantees-lowdown World Bank (2015). Negative interest rates in Europe: A Glance at Their Causes and Implications. Box 1.1 from Global Economic Prospects (June 2015).

45 APPENDIX

APPENDIX 3,63,6 ECBECB introduces introduces NIR NIR 2 2 FIG3,1 1. Central banks’ policy, money market and long-term rates DNBDNB re-introduces re-introduces NIR NIR 3,63,1 3,6 1,521,5 FIG2,6 1.1. Rates in the euro areaECB ECB introduces introduces NIR NIR FIG 1.2.2 Rates in Denmark 3,12,63,1 DNBDNB re-introduces re-introduces NIR NIR 1 3,62,12,1 1,511,5 2,62,6 ECB introduces NIR 2 DNB re-introduces NIR 3,11,61,6 0,510,51 2,12,1 1,5 2,61,1 1,61,11,6 0,500,50 1 2,10,60,6 1,11,1 -0,50-0,50 1,60,1 0,5 0,60,10,6 -0,5-1-0,5-1 -0,41,1-0,4 0,10,1 2013.01.0102013.01.01 2014.07.01 2014.07.01 2016.01.01 2016.01.01 2013.01.010,62013.01.01 2014.07.01 2014.07.01 2016.01.01 2016.01.01 -1 -1 DNB: Certificate Of Deposit -0,4-0,4 ECB:ECB: Overnight Overnight Deposit Deposit Facility Facility DNB: Certificate Of Deposit -0,52013.01.012013.01.01 2014.07.01 2014.07.01 2016.01.01 2016.01.01 2013.01.010,1 ECB: 2014.07.01 EURIBOR 2016.01.01 DNB:DNB: CITA CITA 2013.01.01ECB: EURIBOR 2014.07.01 2016.01.01 DNB:DNB: Certificate Certificate Of DepositOf Deposit ECB:EuroECB: Overnight Area: Overnight 10 Deposit year Deposit yield Facility Facility -1 Denmark:Denmark: 10 10year year yield yield -0,4 Euro Area: 10 year yield DNB: CITA ECB:ECB: EURIBOR EURIBOR 2013.01.01 2014.07.01DNB: CITA 2016.01.01 2013.01.01EuroEuro 2014.07.01Area: Area: 10 year10 year yield yield 2016.01.01 Denmark:Denmark: 10 year10 year yield yield FIG.FIG.FIG. No. No. No. 1.3. 1.3.1.1. Rates RatesRates ECB:in inSwitzerland in SwitzerlandOvernight the euro Deposit area Facility FIG.FIG.FIG. No. No. No.1.4. 1.4. Rates1.2. Rates Rates inDNB: Swedenin Sweden inCertificate Denmark Of Deposit DNB: CITA ECB: EURIBOR SNBSNB introduces introduces NIR NIR 2,92,9 FIG.FIG. No. No. 1.3. 1.3. Rates Rates in Switzerland in Switzerland FIG.FIG. No. No. 1.4. 1.4. Rates Rates inDenmark: Sweden in Sweden 10 year SRByieldSRB introduces introduces NIR NIR Euro Area: 10 year yield 1 1 SNB introduces NIR 2,92,42,42,9 SNB introduces NIR SRBSRB introduces introduces NIR NIR FIG 1.3. Rates in Switzerland FIG 1.4. Rates in Sweden 1 1 2,41,91,92,4 0,50,5 2,9 SNB introduces NIR 1,91,41,41,9 SRB introduces NIR 0,510,5 2,4 0 0 1,40,90,91,4 1,9 0,50 0 0,90,40,40,9 -0,5-0,5 1,4 -0,10,4-0,10,4 -0,50-0,5 0,9 -1-1 -0,1-0,6-0,6-0,1 2013.01.01 2014.07.01 2016.01.01 0,42013.01.01 2014.07.01 2016.01.01 -12013.01.01 2014.07.01 2016.01.01 -0,62013.01.01 2014.07.01 2016.01.01 -0,5 -1 SNB:SNB: Target Target 3 Month3 Month LIBOR LIBOR -0,6 SRB:SRB: Repo Repo Rate Rate -0,1 2013.01.012013.01.01SNB:SNB: 2014.07.01 CHF 2014.07.01 CHF LIBOR LIBOR 2016.01.01 2016.01.01 2013.01.012013.01.01 2014.07.01SRB:SRB: 2014.07.01 STIBOR STIBOR 2016.01.01 2016.01.01 SNB:SNB: Target Target 3 Month 3 Month LIBOR LIBOR SRB:SRB: Repo Repo Rate Rate -1 Switzerland:Switzerland: 10 10 year year yield yield -0,6 Sweden:Sweden: 10 10year year yield yield SNB:SNB: CHF CHF LIBOR LIBOR SRB:SRB: STIBOR STIBOR FIG.FIG. No. No. 1.5. 1.5. Rates Rates in inJapan Japan 2013.01.01Switzerland: 2014.07.01Switzerland: 10 year10 year yield yield 2016.01.01 2013.01.01Sweden: 2014.07.01Sweden: 10 year10 year yield yield 2016.01.01 1 1 SNB: Target 3 Month LIBOR SRB: Repo Rate FIG.FIG. No. No. 1.5. 1.5. Rates Rates in Japan in Japan BoJ introduces FIG. No. 1.3. RatesSNB: in CHFSwitzerland LIBORBoJ introduces FIG. No. 1.4. RatesSRB: in STIBOR Sweden 0,810,81 NIR Switzerland:BoJ 10NIRBoJ yearintroduces introduces yield Sweden: 10 year yield 0,80,60,6 FIG 1.5.0,8 Rates in Japan NIRNIR 0,60,41 0,40,6 BoJ introduces NIR 0,40,80,20,20,4 0,20,600,20 -0,20,4-0,20 0 -0,2-0,40,2-0,4-0,2 2013.01.01 2014.07.01 2016.01.01 -0,42013.01.01 2014.07.01 2016.01.01 0-0,4 BoJ: Interest on Current Account 2013.01.012013.01.01BoJ: 2014.07.01 Interest 2014.07.01 on Current Account 2016.01.01 2016.01.01 -0,2 BoJ:BoJ: InterestJPY JPY LIBOR LIBOR on Current Account BoJ: Interest on Current Account FIG. No. 1. Central banks’ policy, money market Note:-0,4Note: Vertical Vertical line BoJ:line denoteBoJ: JPYdenote JPYLIBOR the LIBOR the date date when when centra central bankl bank implemented implemented negative negative policy policy rates. rates. Source: author’s calculations based on the data of Thomson Reuters.and long-term rates Note:2013.01.01Source:Note: Vertical Vertical author’s line line denotecalculations 2014.07.01denote the the date based date when whenon centrathe 2016.01.01centra datal bank lof bank Thomson implemented implemented Reuters. negative negative policy policy rates. rates. Source:Source: author’s author’s calculationsBoJ: calculations Interest based on based Current on onthe Accountthe data data of Thomsonof Thomson Reuters.Note: Reuters. Vertical line denote the date when central BoJ: JPY LIBOR bank implemented negative policy rates. Japan: 10 year yield FIG. No. 1.5. Rates in Japan Source: author’s calculations based on the data of Thomson Reuters.