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De-jargoned | Negative deposit rate

LiveMint logoLiveMint 09-06-2014 Vivina Vishwanathan

Last week, in an unusual move, the European Central Bank (ECB) cut deposit rates below zero to minus 0.10%. ECB is the world’s first big central bank to use a negative rate. The ECB negative interest rate will be applicable for 18 countries that use the euro currency. Prior to this, Denmark and Sweden have also used negative deposit rates.

What is it?

Whenever you keep money in a bank, you earn an interest on it based on a deposit rate decided by the bank. What if banks start charging a certain percentage of the amount you keep with it? That is what negative interest rate does. European banks have been parking extra cash with ECB. This negative rate is applicable for that extra cash, and technically, not for retail depositors. When a central bank offers a negative interest rate, it is asking banks to pay to park that money with the central bank, which is a disincentive for banks.

An interest rate of (-0.10%) means when European banks now keep extra money with ECB, they will have to pay for it. Prior to this, banks were keeping cash with ECB at 0%. This change will come into effect from 11 June.

Why negative rate

ECB cut key interest rate to bring it below zero on the basis of deflation fears. One of the key objectives of commercial banks is to lend money. However, European banks have been hoarding cash with ECB as safekeeping instead of lending. The idea of a negative interest rate is to make parking of money with the central bank expensive, thereby pushing banks to lend money to businesses and consumers. In a way, it is to encourage banks to take risk.

What will be the impact?

There are different theories about what could be the impact of such a move. One likelihood could be banks passing on the cost to the consumers on the money that retail users keep as savings with banks. This could lead consumers to pull out money from banks because they have to incur a cost for parking their own money or they could end up spending the money as they have no incentive in saving.

Another possibility could be that banks may bear the burden of negative interest rate, which will ultimately eat into their profitability. There is yet another theory that there could be a possibility of cash outflows into the emerging markets.

It is, however, still too early to say whether the negative rates will have the intended effect of banks lending the money instead of saving it with ECB.

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