The European Union, Denmark, Switzerland and Japan all have negative central bank interest rates. This means you are charged for deposits held by the central banks in these area/countries.
Chartered/Commercial Banks
The economies of these places with negative central bank rates are based on the fractional reserve system. This means commercial banks operating there need to maintain a specified minimum reserve deposit with the central bank.
The commercial banks earn interest revenue on the money that has been deposited with them for safekeeping. To obtain deposits they pay the depositor a fee (interest on the amount deposited). The bank charges a higher fee (interest) on the money they lend and the difference is their profit.
In the past funds lodged with the central banks as reserves also earned the commercial bank interest, this could be added to loan revenue and less what they paid depositors equaled profit.
In the areas with negative central bank rates the formula is reversed – it is now loan revenue less reserve holding cost less deposit costs.
On the surface, one would expect the commercial banks reserve holding costs to be factored into their deposit rates (i.e. lower deposit rates) so profit remained at least static. This has not happened yet, explicitly anyway, although I won’t be holding my breath.
Why do I Care?
Both Canada and the US central banks have been publicly exploring the potential use of negative interest rates to increase spending in the economy. It is a very real possibility.
What else happens?
Government bonds start to be issued with negative rates (this is already occurring in Switzerland, Denmark and the EU). If low risk government bonds is a preferred investment vehicle you may rethink that approach and spend the money, invest in economic activity (the equity market) or put cash under your mattress (this being the lowest risk way of protecting your capital).
Hows this working out?
Japan just implemented negative rates last week but the other areas have been trying it out for more than a year with so far little positive change in their economies.
What do proponents like about this idea?
Simply put, negative interest rates discourage saving. If you are not saving you are spending. Spending causes the economy to grow. Of course this is not absolute logical as you might not save with a bank but you might hold bank notes (cash) which won’t help the economy.
Or you might spend on things that fail – a start-up investment for example. This does not help the economy and will make you sad.
In Summary
You may soon be punished for saving (whether for retirement or other purposes) or forced to higher risk investments. All for an idea that has not worked, and in my humble opinion – won’t.