With the Bank of England recently serving notice to its commercial banking sector that negative interest rates could soon be on its way, many analysts have recently gone on record stating that it’s likely only a matter of time before the Bank of Canada is forced down that path as well. Of course, the Bank of Canada has already gone on record stating that its current positive rate of 0.25% constitutes its self-imposed lower bound, so going negative would certainly represent a significant departure from the BoC’s previous communications. As the Bank of Canada has never explicitly taken negative rates off the table, an elusive recovery may be all the reason it needs to take rates negative in the name of further economic stimulus.
As a reminder, prior to COVID-19, the Bank of Canada would control short term interest rates using a “corridor system” in which their target for the trend-setting overnight rate was set half-way between the “Deposit Rate” and the “Bank Rate”. The Deposit rate is the rate at which the BoC pays interest to commercial banks on their settlement balances (ie. reserves), while the Bank Rate is the rate at which the BoC charges to lend settlement balances to commercial banks. For example, if the BoC wanted to target an overnight rate of 1.5%, they would set the Deposit Rate to 1.25% and the Bank Rate to 1.75%. In this scenario, commercial banks with a surplus of reserves were happy to lend to other commercial banks at a rate higher than what they were currently earning at the BoC (the Deposit Rate of 1.25%), and borrowing banks preferred to pay this rate as long as it was below the BoC’s lending rate of 1.75%. By setting the Deposit Rate and the Bank Rate to be 0.5% apart from one another, the BoC could effectively keep the overnight lending rate within a tight “corridor” bound by the Deposit Rate on the bottom and the Bank Rate on the top.
Of course, with the massive monetary response undertaken to combat the effects of COVID-19, the Bank of Canada’s foray into large scale asset purchases resulted in a large influx of new settlement balances onto the balance sheets of Canadian chartered banks. With this huge injection of new settlement balances, the BoC could no longer rely on their old corridor system to control the overnight rate, as the large increase in bank reserves exerted massive downward pressure on interest rates. The only thing preventing interest rates from falling to zero was the fact that commercial banks were able to earn the Deposit Rate by simply holding their reserves at the BoC, and therefore had little incentive to lend out settlement balances at anything lower. As such, the Deposit became the new de-facto policy rate.
Given how the BoC sets interest rates via the interest it pays commercial banks on settlement balances, we can see that any attempt by the BoC to implement negative interest rates would be done by charging banks a negative interest rate on reserves. As previously mentioned, the commercial banks currently hold a large quantity of reserves, and setting the Deposit Rate negative would penalize them heavily for simply holding these balances at the BoC. A negative interest rate would be highly uncomfortable for private banks, and they would logically do whatever they could do to dishoard these reserves. Thus, by first inundating commercial banks with large quantities of settlement balances, and then setting interest rates on these settlement balances negative, the Bank of Canada would effectively be creating a monetary “hot potato”.
Remember, all settlement balances must be held collectively by all commercial banks at all times. If Bank A sends settlement balances to Bank B to avoid a negative Deposit Rate, the aggregate level of reserves remains unchanged. All that has happened is Bank B will now be penalized relatively more following the transaction since it now holds more reserves. Bank B of course will not want to hold these settlement balances any more than Bank A, and will try to send them off to Bank C, and around and around we go. This, of course, is the whole idea. By making it painful for private banks to hold settlement balances, negative rates are intended to stimulate banks into extending loans in the following manner.
Suppose that Bank A wishes to dishoard some of its settlement balances. Previously Bank A had no desire to loan, say, $10,000 to Jason, but now decides that in order to get rid of its settlement balances, it makes sense to do so. By extending a loan to Jason, Bank A creates a deposit in Jason’s account at Bank A, which is a liability of Bank A. Bank A has also created itself an asset, which is the money that Jason now owes Bank A at some point in the future. Suppose that Jason now decides to spend his newfound money, paying Amelia $10,000 which she then deposits in her account at Bank B. This $10,000 deposit at Bank B is a liability of Bank B, in the sense that Bank B now owes Amelia $10,000 on demand. But Bank B does not simply take on a new liability for nothing. It also needs an asset to balance the transaction. Thus, Bank A, which has now lost Jason’s $10,000 liability, also transfers $10,000 of its reserve assets to Bank B to complete the transaction.
Thus, Bank A has now lost the $10,000 liability that it had originally created as a deposit for Jason. It has also lost $10,000 of reserves that it sent to Bank B, while managing to retain the $10,000 asset in the form of the loan that Jason still owes Bank A. Bank B, on the other hand, winds up with a new $10,000 liability, but it also winds up with a new $10,000 reserve asset which was sent over by Bank A to settle payment. As a result of the loan, Bank A has converted a $10,000 reserve asset (which was being charged a negative interest rate) into a $10,000 loan asset, and Bank B is now saddled with the new $10,000 of reserves being charged negative interest rates by the BoC. Bank B, of course, has no desire to hold excess settlement balances either, so it too will create more loans of its own as settlement balances are passed around and around from bank to bank like a proverbial hot potato.
Of course, this all sounds good and well in theory, but as studies out of Europe have shown, theory and practice aren’t always the same thing. For example, why should Bank A lend Jason $10,000 when they had previously thought it imprudent to do so? If Jason was a credit risk at positive interest rates, does negative interest rates really cause loan growth to increase rapidly as private banks take on riskier loans merely to dishoard their excessive settlement balances? Or rather, do commercial banks attempt to get rid of their excess reserves in other ways such as purchasing positive yielding assets with their negatively yielding settlement balances. As the studies of European banks suggest, this is exactly what they’re doing1.
Instead of originating a riskier new loan to get rid of their excess reserves, evidence suggests that Bank A would more than likely bid on a higher yielding bills or bonds which it would pay for with settlement balances. So Bank A spends its settlement balances on a Government of Canada bond, replacing a negative yielding asset with a positive one, and all is well. Of course, the settlement balances then eventually wind up on the books of Bank B, who no sooner wants a negative yielding asset than Bank A did. Bank B then bids on GoC bonds in the same manner as Bank A, which has the effect of further driving up bond prices and driving down bond yields. These “hot potato” settlement balances get passed around and around, bidding up debt prices until GoC bond yields eventually converge towards the Deposit rate.
All of this leads to an interesting conclusion. We know that the Bank of Canada is nearing its capacity to absorb GoC bonds through its QE program, with a self-imposed limit of 50% of outstanding government debt. The BoC has sucked up a huge amount of bonds off bank balance sheets and replaced them with settlement balances which currently pay a trivial amount. Now, the Deposit Rate is currently sitting at 0.25%, which might not seem like a whole lot until you take a look at 30-day T-Bills paying 0.06%. Under these conditions, earning 0.25% risk free probably doesn’t seem half bad to the private banking sector. If the Bank of Canada wants to stimulate domestic demand for its bond market and give itself a way out, given the flood of settlement balances now sitting on the balance sheets of commercial banks, one would have to think that taking rates negative would certainly be one way to stimulate that demand. The Bank of Canada has already distributed the monetary potatoes. All they’d really need to do is turn up the heat.