Negative interest rates have been in place in some jurisdictions overseas for several years, and after cutting the official cash rate to a historic low of 0.75, the Reserve Bank of Australia Governor has recently reflected on the outside possibility of rates below zero in Australia;
An inversion of the positive interest rate environment that the payments system was built and developed in could have unusual and unforeseen impacts on the economy at large, including for payments;
Among other things, this could include a relatively dramatic drop in the use of non-cash payment methods, unusual practices in the timing of payments, and disruption to the effective operation of the Standard Inter-Organisation Compensation (SIOC) rules.
Since June 2019, the Reserve Bank of Australia (RBA) has cut interest rates by 75 basis points. Australia's official cash rate is now sitting at the record low of 0.75 per cent.
Speaking to the House of Representatives Standing Committee on Economics recently, RBA governor Phillip Lowe said the central bank was now considering “unconventional” methods to kickstart spending and economic growth in Australia, including the outside possibility of the official interest rate going below zero. While this has been implemented in some overseas jurisdictions, (At time of writing: Japan -0.10%, Sweden -0.30%, European Central Bank -0.40%, Denmark -0.70%, Switzerland -0.80%) it would be a first for Australia.
Many economic commentators see negative interest rates as an extreme response to a stagnant economy, and in the case of Australia, a response that the RBA is only considering in light of the federal government’s apparent preference for delivering a budget surplus over fiscal stimulus to promote spending and growth.
Typically, interest rates are a percentage of a loan paid by a borrower to a lender on top of the principal to compensate money lenders for the ‘time value of money’. Under usual circumstances there is more demand from potential borrowers than there is money being made available by willing lenders, meaning that lenders are able to charge an amount of interest that reflects this supply and demand dynamic.
However, several factors have combined to invert the supply and demand dynamic between potential borrowers and lenders, including:
The ageing population having produced more potential lenders, including large pension funds. This is sometimes referred to as a ‘global savings glut’;
Fewer people being willing to borrow, in part because of the very high levels of household debt around the world and especially in Australia;
Geopolitical and global economic uncertainty, including the USA-China trade-war.
As the pool of borrowers gets smaller, the lenders offer to lend at lower and lower rates of interest to encourage them to borrow in the hope that the borrowers will invest their savings productively. As these interest rates get lower and money gets cheaper to borrow, it should theoretically lead to more spending. But when this doesn’t work, interest rates can enter negative territory in pursuit of the same goal.
When this happens, the basic principles outlined above are extended further and borrowers can actually be effectively paid to borrow.
Practically this occurs when instead of paying a rate of interest to commercial banks for the excess reserves (that being any surplus cash beyond that which regulators say banks must keep on hand - the reserve ratio in Australia was reduced to 0% in 1988, replaced with 1% non-callable deposits) that they leave with the central bank, the central bank decides to charge them a rate of interest. That way, central banks penalise commercial banks for holding on to cash in the hope of prompting them to boost lending to businesses and consumers. This interest rate is generally then passed on to the bank’s customers encourage them to borrow in turn.
Banks had been mostly restricting the application of negative interest rates to large institutional savers, as opposed to retail deposits. This is because, in theory, the alternative of withdrawing and holding cash is too attractive to everyday bank account holders with retail deposits in the face of a negative rate.
As opposed to such everyday bank account holders with retail deposits, large institutional investors, such as pension funds purchasing government bonds (about a quarter of government bonds globally are now at a negative interest rate), can be willing to accept this situation because:
It is impractical for them to store their money in other ways, such as building a vault and hiring security guards to protect the money; and
A guaranteed small loss is preferable to the risk of larger losses that could come from storing their wealth in other kinds of investments at higher rates which customers may not be able to meet in the long run.
However, the reluctance to apply negative interest rates to retail deposits appears to be changing.
At the end of September, Germany’s central bank surveyed 220 lenders, two weeks after the European Central Bank cut its deposit rate from -0.4 to a record low of -0.5 per cent. In response, 58% of the banks said they were levying negative rates on some corporate deposits and 23% said they were doing the same for retail depositors. Further, last month Germany’s biggest co-operative lender, Berliner Volksbank, announced that it would start applying a -0.5 per cent rate on any deposits above €100,000.
The negative interest rates could also soon be passed on to retail borrowers too. Denmark’s third-largest bank, Jyske Bank, announced in August that customers would now be able to take out a 10-year fixed-rate mortgage with an interest rate of -0.5%, meaning customers could theoretically pay back less than the amount they borrowed.
Heading towards negative interest rates is relatively unchartered territory, especially for Australia, and it is sure to have implications in many areas, including for the payments industry.
Reduction in the use of non-cash payment methods:
If negative interest rates do lead banks to raise fees on retail deposits, some depositors may respond by holding more cash.
David Humphrey argues that depositors would then have an incentive to hold more cash for both transactions and savings, because cash is not subject to a negative interest rate once it is withdrawn. If the increased cash is used for transactions, non-cash payments are likely to fall as a proportion of payment methods used.
Humphrey outlines the impact this could have in a US modelling exercise, finding that:
“What if US consumers withdrew $50 more than the average $118 they now do each time they went to the ATM in response to a higher fee on their bank deposit balance? If the entire extra $50 replaced electronic card transactions at the point-of-sale, card usage would fall by $290 billion. Since the value of card point-of-sale transactions is $3 trillion, the value of card point-of-sale transactions would fall by 10 per cent.”
Timing of payments
When interest rates are negative and payers face a fee on their deposit balance, an incentive also exists to engage in unusual economic behaviours geared to extracting the maximum value held by a unit of currency in the present.
McAndrews and Garbade explain that when short-term interest rates are high, as in the late 70s in the US (and in the early 1990s in Australia), people tended to delay making payments for as long as possible and collected payments as quickly as possible. If interest rates go negative, the opposite is likely to occur as people have more incentive to make payments quickly and to receive payments in forms that can be collected slowly.
They suggest a few examples of how incentives could exist for certain types of payments to be be expedited or deferred to slow to take advantage of processes that preserve value over time by sheltering it from the negative interest rates:
- Taxpayers could make larger than necessary quarterly tax pre-payments and collect the excess later when taxes are due, or over-pay expected monthly credit card charges for the same reason;
- Cashing of cheques could be delayed to a later time, because they would more reliably store their nominal value than a bank deposit;
- Workers would rather be paid in smaller more regular amounts, since their average deposit balance, and the fee it would incur over time, would be lower;
- It is also suggested that some type of special-purpose institution could arise that holds a transaction account balance fully and only backed by deposited cash, which would not attract the negative interest rate.
For a payments system that has been built and developed entirely in the context of positive interest rates, this could present some surprising challenges. McAndrews and Garbade suggest that:
“… we may see an epochal outburst of socially unproductive—even if individually beneficial—financial innovation. Financial service providers are likely to find their products and services being used in volumes and ways not previously anticipated, and regulators may find that private sector responses to negative interest rates have spawned new risks that are not fully priced by market participants.”
Another area where it is anticipated that negative interest rates would have an impact on payments is their effect on the Standard Inter-Organisation Compensation (SIOC) rules.
AusPayNet members developed the SIOC rules for calculating compensation between financial institutions relating to payments to their exchange settlement accounts held at the RBA. Compensation may be payable when a payment is made to those accounts on a day other than the day agreed, or is made in error to that account.
These rules came into force on 13 June 2001 and can be applied in any clearing and settlement system where participants settle with each other by adjusting their exchange settlement account balances held with the RBA.
They provide a calculation of compensation amount based on some or all of the following three factors:
- The lost revenue from overnight investment of missing funds;
- Any enrichment from a party holding funds that they should not; and
- The administrative costs incurred in addressing the erroneous payment.
However, part of the formula for calculating the amount of compensation includes the base cash rate set by the Reserve Bank of Australia. As the base rate moves towards unprecedented low rates (i.e. very low, zero or negative base rates) the SIOC calculation may produce outcomes with unintended consequences.
A specific circumstance that would give rise to such consequences would be any situation where a fixed percentage offset from the cash rate is used.
For example, the policy on the RBA’s settlement accounts is that any unplanned surplus funds earn interest at CRT (cash rate target) -0.25%, and any shortfall is charged interest at CRT plus 0.25% - and in the case of the SIOC rules, there is a fixed offset of 0.5% between the cash rate and the effective rate used for calculating compensation.
This fixed offset breaks down in a very low CRT scenario. For example, if the cash rate were to hit -0.25%, then banks would theoretically be able to borrow an unlimited amount of money from the RBA at 0% interest.
It could be argued that this scenario is not in the spirit of the rules. In light of this, it is likely that these rules would need to be adjusted should negative interest rates be introduced in Australia.
Other jurisdictions that already have negative interest rates have already had to make such adjustments to their equivalent of the SIOC rules, and their experience could be instructive for Australia.
However, in November Philip Lowe spoke further on the subject of ‘unconventional monetary policy’, and emphasised that despite his statement to the House of Representatives Standing Committee on Economics, that negative interest rates in Australia are ‘extraordinarily unlikely’:
“We are not in the same situation that has been faced in Europe and Japan. Our growth prospects are stronger, our banking system is in much better shape, our demographic profile is better and we have not had a period of deflation. So we are in a much stronger position.”
He also canvassed the international experience with negative interest rates, and reflected that to his mind, it is not clear that it had been a success.
“While negative rates have put downward pressure on exchange rates and long-term bond yields, they have come with other effects too. It has become increasingly apparent that negative rates create strains in parts of the banking system that can impair the ability of some banks to provide credit. Negative interest rates also create problems for pension funds that need to fund long-term liabilities. In addition, there is evidence that they can encourage households to save more and spend less, especially when people are concerned about the possibility of lower income in retirement. A move to negative interest rates can also damage confidence in the general economic outlook and make people more cautious. Given these considerations, it is not surprising that some analysts now talk about the ‘reversal interest rate’ – that is, the interest rate at which lower rates become contractionary, rather than expansionary.”
While the RBA is continuing to take the possibility of a reversal rate seriously, it is confident that conventional monetary policy is still working in Australia. Though in uncertain economic times, planning for a range on contingencies, including the possibility of negative interest rates, would be wise.