Negative monetary policy rates can undermine financial transmission, because they encourage cash hoarding and reduce the profitability of traditional banking. This danger increases with depth and duration of negative interest rate policies. Therefore, some countries (Japan, Sweden, Switzerland, and Denmark) have introduced tiered reserve systems, effectively exempting a part of the banking system’s excess reserves from negative rates. Importantly, a tiered reserve system is now also considered by the European Central Bank for the second largest currency area in the world. Since tiered reserve systems are on the verge of “going mainstream” their impact on asset pricing formulas and quantitative trading strategies deserves careful consideration.

The post ties in with SRSV’s summary lecture on non-conventional monetary policies, particularly the section on side effects (“exhaustion”).

The below are quotes from various papers, all of which are listed at the end of the post. Emphasis and cursive text have been added.

Why the world needs tiered reserve systems?

“Negative rates restore the signaling capacity of the central bank by effectively removing the zero lower bound…If banks hold excess reserves, cuts to the central bank deposit rate can effectively lower the interbank and other interest rates [below zero], encouraging banks to take greater risks and facilitating portfolio rebalancing… The economic lower bound of negative interest rate policy is largely determined by the impact of negative rates on financial intermediation.” [Jobst and Lin, 2016]

“With regard to potential problems associated with negative interest rates, the following can be mentioned:

  • if the decrease in financial institutions’ earnings due to negative interest rates become sizable, it could impair their functions as financial intermediaries; and
  • if financial institutions reduce their outstanding balances of the central bank’s current accounts with which a negative interest rate is charged and significantly increase their cash holdings which yield zero interest, the effects of negative interest rates will be lessened.” [Bank of Japan, 2016]

When the nominal interest rate on safe assets turns negative, holding cash becomes attractive. Cash has a fixed zero gross nominal rate of return. And, while it is true that there are costs and inefficiencies associated with holding large amounts of cash in the form of banknotes, these are bounded. It follows that an effective lower bound on interest rates should exist at which agents switch their holdings into cash…
When rates approach the point at which most agents switch into cash, further cuts will become ineffective, or counterproductive if they hinder financial intermediation. Also, should rates remain negative for prolonged periods, markets could develop mechanisms to reduce the costs associated with switching to cash. Pressures could then grow on banks’ business models, profits and charter values, with negative consequences for financial stability.”

“If negative policy rates are transmitted to lower lending rates…banks are likely to see their interest earnings decline…But retail deposit rates tend to be downward sticky since (i) households and small businesses do not face the same set-up cost as banks and corporations in storing cash, and (ii) a zero percent interest rate could be a psychological threshold. The stickiness of deposit rates reflects the avoidance of being penalized to save and is determined by the actual costs of holding cash rather than deposits.
As a result, banks’ net interest margins defined as net interest income relative to average interest-earning assets, compress as lending rates for new loans decline and existing (variable-rate) loans re-price while deposit rates remain sticky…Also… the downward stickiness of deposit rates encourages banks to substitute less stable wholesale funding for deposits.” [Jobst and Lin, 2016]

“In theory, sufficiently negative interest rates would jeopardize financial intermediation; in which case further cuts would prove counterproductive…[Moreover] the potential for lower intermediation margins and bank profitability raises concerns about financial stability, should NIRPs remain in place for prolonged periods.” [IMF, 2017]

How do tiered reserve systems work?

“A tiered reserve regime enhances central banks’ capacity to lower the effective policy rate by reducing the direct cost of negative rates on excess reserves. Exempting a certain amount of excess reserves from the marginal policy rate avoids imposing the full impact of negative deposit rates on banks. Thus, at the same direct costs to banks, the marginal policy rate can be lower in a tiered reserve regime. The cost of holding depends on excess reserve holdings in the tier with the lowest marginal policy rate (i.e., deposit rate). The tiering (and the difference of policy rates in each tier) determines the extent to which the interest rate of an additional unit of (excess) reserves differs from the average interest rate for all reserves.” [Jobst and Lin, 2016]

“The implementation of a second effective deposit rate for excess reserves would increase the central bank’s general capacity to pursue negative interest rate policy while mitigating the direct cost to banks. More specifically, excess reserves can be held in both the current account and the deposit facility of central banks. In a tiered regime, the exemption typically applies to the current account (which satisfies the minimum reserve requirement); thus, banks would have an incentive to shift excess reserves from the deposit facility to the current account to reduce the cost of negative rates up to a certain limit.” [Jobst and Lin, 2016]

“Existing tiered regimes can be broadly categorized based on the number of tiers and the allocation of excess reserves across these tiers:

  • constant allocation (e.g., Norway and Switzerland), where the exemption threshold for deposits is specific to each bank as a fixed multiple of a bank’s required reserves..
  • dynamic allocation, where fine-tuning operations determine the share of excess reserves to be placed with the central bank as more costly overnight deposits (Sweden), excess deposits above the aggregate and individual limits for the current account deposits are converted into certificates of deposit (Denmark), or the portion subject to negative rates is designed to increase over time in line with the monetary base target (Japan).

“The exemption threshold should be as high as possible to minimize the banks’ average cost of holding excess reserves while being sufficiently low to transmit the marginal policy rate to money markets. Central banks tend to adjust the tiering over time so that the amount of excess reserves below the exemption threshold is sufficient to keep money market rates aligned with the marginal policy rate.” [Jobst and Lin, 2016]

How to prevent cash withdrawals with negative policy rates?

“The opportunity to invest in cash implies an effective lower bound or constraint on overnight interest rates and thus presents a potential obstacle to the implementation of monetary policy.” [Boutros and Witmer, 2017]

“Most central banks operate by setting a target for the overnight interest rate, along with rates on standing facilities through which participants can borrow from or deposit with the central bank
Monetary policy is not constrained when just the deposit rate is below the yield on cash…[That is because market participants]…do not have the ability to exchange cash for reserves at the end of the day after the uncertain payment shock. The marginal cost of borrowing an extra dollar in the overnight market…is equal to the respective probabilities of accessing the two central bank standing facilities at the end of the day multiplied by their respective rates with these probabilities… Thus, the yield on cash does not impact the overnight rate as long as the target for the overnight rate is above the effective lower bound.
However, [monetary policy] could be constrained when the target overnight rate is below the yield on cash [somewhere below zero]“[Boutros and Witmer, 2017]

“Storing, moving, and insuring cash entails non-negligible costs making the net return on cash holdings negative. Costs are likely to vary across different types of agents depending on cash balances and liquidity needs. Depositors with larger balances and those with more frequent payment needs (such as larger corporations as opposed to households) are likely to tolerate lower rates, as the costs associated with switching to cash grow non linearly with the size and frequency of transactions…Deposit rates may need to be sufficiently negative, or be expected to remain negative for long, before large-scale switching into cash becomes optimal.” [IMF, 2017]

“In principle, the “effective lower bound” could be reduced through reforms aimed at lowering the nominal yield on cash holdings. But these are untested and politically controversial.” [IMF, 2017]

“A varying reserve requirement… with a tiered deposit rate that allows the tier thresholds to adjust depending on the cash withdrawals of each participant…will better help a central bank maintain its influence over the overnight rate when rates are potentially constrained by the lower bound…It is not the tiered remuneration in and of itself that changes incentives to withdraw from the central bank; rather, it is the fact that this tiered remuneration is a function of cash withdrawals that can dis-incentivize these withdrawals such that the overnight rate once again equals the target rate.” [Boutros and Witmer, 2017]

Why would a tiered reserve system be a big issue for the euro area?

“We will continue monitoring how banks can maintain healthy earning conditions while net interest margins are compressed. And, if necessary, we need to reflect on possible measures that can preserve the favourable implications of negative rates for the economy, while mitigating the side effects, if any.” [Draghi, 2019]

“While the ECB was the first central bank to move its deposit rate significantly into negative territory, it continues to maintain a single (negative) rate for excess reserves. In contrast, other central banks put in place tiered reserve regimes for excess reserves to mitigate burdens on bank earnings, facilitate market transactions (by exploiting the uneven distribution of excess reserves among financial institutions), and discourage higher holdings of physical currency.”

“The European Central Bank is studying options to lower the charge that banks pay on some of their excess cash as a possible way to offset the side-effects of its ultra-easy policy, two sources told Reuters…The objective of the move would be to return some of more than 7 billion euros a year the ECB collects in interest from banks. Negative interest rates effectively mean banks pay the ECB to park their excess liquidity safely with it overnight. A so-called tiered deposit rate would mean banks are exempted in part from paying the ECB’s 0.40% annual charge on their excess reserves, boosting their profits as they struggle with an unexpected growth slowdown… A tiered rate…would signal that rates are going to stay low for a very long time” [Reuters, March 27, 2019]

“The pain for the banking sector has increased, as the amount of excess liquidity in the system has swelled. Amidst the ECB’s asset purchases and liquidity policies, excess liquidity has climbed from just above EUR 100bn in late 2014 to above EUR 1800bn currently [March 2019]. In a closed banking system, this excess liquidity will always return to the ECB in the form of excess reserves or the use of the ECB’s deposit facility.” [Nordea, March 15, 2019]

“The direct cost of a negative deposit rate on excess reserves is relatively small, even without tiering, but affects banks disproportionately due to significant differences in excess reserve holdings. Since the ECB charges interest only on excess liquidity, the charge is greater in those countries where banks hold large excess reserves.
In comparison, the indirect effect of negative interest rate policy via lower bank profitability from lending can be large…A 10 basis point rate cut would reduce lending margins by 5 basis points and result in an indirect cost of about EUR8.8 billion. Valuation gains from investments and trading income might, to some extent, mitigate these costs. However, the aggregate balance sheet of euro area banks suggests that lending is about 6-7 times more important than investments for profitability.” [Nordea, March 15, 2019]

Sources

Boutros, Michael and Jonathan Witmer (2017), “Monetary Policy Implementation in a Negative Rate Environment”.
Jobst, Andreas and Huidan Lin (2016), “Negative Interest Rate Policy (NIRP): Implications for Monetary Transmission and Bank Profitability in the Euro Area. “ IMF Working Paper, 16/172.
IMF 2017, “Negative interest rate policies – initial experiences and assessments”, IMF PolicyPaper, August 2017.
Nordea, “ECB Watch: Could tiering save bank profitability?”, Macro Themes 15 March 2019.
Reuters, “ECB studying tiered deposit rate to alleviate banks’ plight: sources.”, March 27, 2919.

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Ralph Sueppel is founder and director of SRSV, a project dedicated to socially responsible macro trading strategies. He has worked in economics and finance for over 25 years for investment banks, the European Central Bank and leading hedge funds. At present, he is head of research and quantitative strategies at Macrosynergy Partners.