How Might Negative Interest Rate Policies Affect Banks?

Last December, the Federal Reserve, the U.S.’s central bank, raised its benchmark interest rate for the first time in nearly a decade.

But lately, there have been a host of central banks from other countries – such as Japan and a number of European nations – that have begun introducing negative interest rate policies.

Though a negative interest rate is not an issue in Singapore at the moment, investors may still want to understand what it actually is and how it might impact the businesses of local banks such as DBS Group Holdings Ltd (SGX: D05), Oversea-Chinese Banking Corp Limited (SGX: O39) and United Overseas Bank Ltd (SGX: U11).

So, what exactly is a negative interest rate policy?

A negative interest rate means that banks are paying a country’s central bank to hold their reserves, rather than earning interest on those reserves. If negative interest rates were applied to customer deposits at banks, it would mean that depositors are paying the banks to park cash in bank accounts, rather than earning interest on the deposits. To put it simply, depositors would need to pay interest to keep their money in a bank.

Now, how might negative interest rates affect the business of banks? I see two potential challenges that banks may face as a result of a negative interest rate policy.

1) Lower profitability

Though modern banks have diversified into different business activities such as trading in securities, the provision of corporate finance advisory services and more, the majority of the income of many banks still come from traditional lending activities that characterises the business of banking.

Though simplified, the traditional lending activity essentially involves a bank taking money from depositors and lending the money to borrowers. A bank pays interest to its depositors and also collects interest from its borrowers; the difference between what’s paid to depositors and received from borrowers is known as the interest spread. The higher the interest spread, the higher a bank’s profit can be.

In the case of a central bank implementing negative interest rates, banks will “pay” interest to the central bank for the reserves deposited with it. Unless these payments are recovered later from depositors, which is difficult given that depositors would likely withdraw their money if the interest on deposits become too low or negative, banks will be responsible for the interest charge they pay to central banks. This in turn, will reduce the interest spread and thus the profit of the banks.

2) Higher risk of irresponsible lending

With deposit rates sitting at negative levels with central banks, a bank is likely to be forced to lend money to customers to reduce the amount of cash sitting dormant with central banks.

To increase lending under normal circumstances, a bank will relax its lending criteria and/or reduce its interest rate. Regardless of the option(s) chosen, the likely result is an increase in credit risk to the bank. This in turn leads to more risk for the bank’s shareholders.

A Fool’s conclusion

Though the prospect of negative interest rates appearing in Singapore does not seem to be an immediate risk, it is still real. It is also worth considering when making investment decisions in banking stocks.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Lawrence Nga doesn’t own shares in any companies mentioned.