Negative Interest Rates Threaten the Financial System
Markets may need to be rebuilt on a new set of assumptions, but we don’t know what those should be or how they would work.
Jim Bianco is the President and founder of Bianco Research, a provider of data-driven insights into the global economy and financial markets. He may have a stake in the areas he writes about.
Former Federal Reserve Chairman Alan Greenspan recently said he wouldn’t be surprised if yields on U.S. bonds turned negative and if they do, it wouldn’t be “that big a of a deal.” That seems to be a sentiment widely held in central banking circles these days, but it’s wrong. Negative interest rates represent a threat to the financial system.
To understand why, let’s start with the existing fractional reserve banking system, which is more than a century old. For every dollar that goes into a bank, some set amount (usually about 10%) must go into a reserve account to be overseen by the central bank. The rest is either lent out or used to buy securities.
In other words, the fractional reserve banking system is leveraged to interest rates. This works when rates are positive. Loans are made and securities bought because they will generate income for the bank. In a negative rate environment, the bank must pay to hold loans and securities. In other words, banks would be punished for providing credit, which is the lifeblood of an economy. As German bankers recently explained to the European Central Bank:
We already have a devastating interest rate situation today, the end of which is unforeseeable,” Peter Schneider, who represents public-sector savings banks in the southern German state of Baden-Wuerttemberg, said on Wednesday. “If the ECB aggravates this course, that would hit not only the entire financial sector hard, but especially savers.
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