Why negative interest rates are a bad idea, by Capital Economics Dear central bank of Santa, We, the banks, think we have been really good this year. We didn't pick on retail customers. We didn't tell on our Libor manipulating friends. We respected our regulator parents. And most importantly we didn't have a hissy fit that nearly brought down the global monetary system. Given all that, we think, we deserve some positive interest rates for at least another year. Thank you very much. Yours sincerely, The banks. That, of course, would be the inner child of the banking profession talking when it comes to the ideal Christmas present for the industry. Though the adult version is not too dissimilar. Here's the abridged version of the request from Capital Economics, outlining in effect why anything but positive rates are a bad idea for the banks this festive season (emphasis from Capital Economics): Given the dubious benefits and possible costs of cutting deposit rates below zero, we still see ECB interest rates remaining on hold for the foreseeable future. Note that if the ECB cut the deposit rate, it would almost certainly also reduce the rate that it pays banks for excess reserves in their current accounts (historically zero) or put a limit on such reserves. Otherwise, banks would simply leave money in their current accounts instead of paying to use the deposit facility and the gap between effective deposit and actual lending rates would narrow. The main aim of negative rates would be to boost lending to the wider economy. The move would not cause a mechanical drop in aggregate bank reserves with the ECB. After all, if one bank lent to a firm, the money would probably end up in that firm's commercial bank account and then back in that bank's account with the ECB. But negative deposit rates should encourage banks to find ways to make profits with their money (i.e. opportunities to lend) instead of just paying to leave it on deposit. But there are two big problems with this theory. First, even if banks in the euro-zone were very keen to lend, there is no guarantee that they could do so. The ECB's October Bank Lending Survey revealed that weak demand for loans was a bigger factor holding back lending than a lack of supply. Second, banks might well be prepared to pay for safe deposits with the ECB instead of making loans that they fear will never be repaid. Note that demand for safe assets such as German and Swiss short-term government bonds has already driven the yield on these assets into negative territory. Beyond having dubious positive effects, negative deposit rates might even be damaging. If banks were unable to lend more to boost their profits, they might look for other ways to offset the cost of depositing money with the ECB. This could mean an increase in lending rates for existing borrowers. Chart 2 shows that there is some evidence that this has happened in Denmark. Alternatively, commercial banks might start charging their largest customers (typically other banks) to place deposits with them as has occurred in Switzerland. This would put further strain on the region's troubled banking sector. On balance, while a further ECB rate cut is possible, this would not materially improve the economic outlook and might even make it worse. And either way, yields on safe assets like German two-year bonds are likely to remain negative for some time. There you have it, Santa. Now please give us what we want. Related links: The muddled consequences of negativity - FT Alphaville The strange world of negative interest rates - Coppola Comment Draghi's ready to get negative - FT Alphaville Some Danish negativity consequences - FT Alphaville Negative carry universe - FT Alphaville