Despite the evident contradiction in further blogging, given my ‘why bother?’ post, I thought I would explain why I tweeted ‘er, no’ in response to a blog by Robert Peston [UK BBC Economics Editor] on issue of whether the zero bound to interest rates was really zero or not. The title is actually far too harsh, for Peston gets some way to the point, but not all of it.
So here’s why the BoE’s Monetary Policy Committee first decided that the bound would be 0.5%. A simplified bank makes a turn by offering a low deposit rate to get money off savers, and lending it out at a higher rate to borrowers. After the crisis broke, post Lehman’s, and central bank rates started to head South, the MPC figured that at some point cutting rates would eat into bank profits. That would happen because many loans were on tracker rates, meaning there was a pre-existing contract with the borrower to cut rates in line with Bank Rate. However, there was no pre-existing contract with depositors. And in fact as spreads [gap between deposit rate and lending rate] rose, there was nowhere for this rate to go. Given that storing large amounts of cash is costly, there would have been scope to charge depositors for their account holding services in the form of slightly negative rates, but this was calculated to be likely to be politically unpopular for the banks. So, with lending rates forced down by tracker contracts, and deposit rates unable to fall, bank profits would fall.
Robert Peston’s account has it differently, that ‘competition’ drives lending rates down, and deposit rates can’t fall. But the way the MPC saw it – and the way I see it too – was that ‘competition’ would, normally, demand a relatively stable risk-adjusted spread between lending and borrowing. It was just that pre-existing promises, combined with the floor to deposit rates, meant the spread would fall, shrank.
The reason the MPC have reassessed this risk is that bank balance sheets are much healthier than they were. Banks have rebuilt capital through retained profits, made by charging through the roof for new lending, despite the fines for bad behaviour. And their loan book now looks much more healthy as asset prices and therefore collateral values have recovered, and borrowers sources of repayment [jobs for household borrowers, customers for corporate borrowers] look more secure. Although I’m not sure of the facts on this, one might also hope that the proportions of borrowers on tracker loans had fallen, and so a further cut in rates would be less profit-eroding. And given rates have been low for so long, the heat on bank reputations has subsided a little, and the fact that some interest rates have gone negative, perhaps the floor for deposit rates has fallen a little too.
As I recall it was the smaller building societies that were most hampered by loan trackers. And I never accepted that the floor should have been there in the first place. These banks should have been kept afloat by other means if that was necessary, so that monetary and fiscal/financial policy were more clearly separate. [More of a question than a statement, but, couldn’t regulatory intervention have stopped the banks offering trackers to the extent that they did, so that this concern could have been removed, or made their supply contingent on Bank Rate being amply above the zero bound?] Plenty of finance is routed around the banking system, and the price of this, which also works off central bank rates, was kept unduly high. I also found it odd that the floor was only revisited last month. The situation of the banks improved dramatically from the depths of the crisis, especially over 2010-2012, and that would have been the time to acknowledge that this ‘plank’ of the 0.5% floor to rates had been removed.