Deflation and Negative Interest Rates (Part 2)

A new study suggests that negative rates actually reduce bank lending.

We recently focused on the debt-deflationary effects of negative interest rates. Now, we highlight a new study from the University of Bath, England which suggests that, rather than stimulate bank lending, negative interest rates actually reduce it.

The paper’s researchers used a dataset comprising 7,359 banks from 33 OECD member countries over 2012–16 and found that that bank margins and profits fell in those countries pursuing a negative interest rate policy compared to countries that did not adopt the policy. Specifically, loan growth was found to be damaged by the squeeze on bank margins that negative interest rates produce.

One of the authors, Dr Ru Xie, is quoted on scienceblog.com, stating, “This is a good example of unintended consequences. Our study shows negative interest rate policy has backfired, particularly in an environment where banks are already struggling with profitability, slow economic recovery, historically high levels of non-performing loans, and a post banking-crisis deleveraging phase.”

He goes on to say, “If bank margins are compressed due to low long term yields, and if there is limited loan growth, then bank profits will fall accordingly. The decline in profits can erode bank capital bases and hitherto further limit credit growth, thus stifling any positive impact on domestic demand from negative interest rate policy monetary transmission effects.”

Recently, the head of the Financial Supervisory Authority in Denmark warned that negative interest rates are pushing the European banking sector to a tipping point, where banks must either radically change their business model or accept that they will have to shrink. Evidence is coming in thick and fast that negative interest rates are deflationary.

For years now, our Elliott wave analysis of the European banking sector, has been suggesting that the downtrend which started in 2007 is not over. In that sense, the fact that the millstone of negative interest rates is hampering banks’ business models could have been forecast. Our chart shows that the downtrend is far from over and, in fact, could be entering its most dramatic declining wave. Will this be when the penny drops that negative interest rates are deflationary?