The Mystery of Negative Interest Rates: Why People Keep Depositing and Lending Despite Losing Money

Central banks around the world, especially in Europe, have been experimenting with negative interest rates as a means to stimulate economic growth. But how can it make sense for individuals to deposit their money in banks or for banks to give out loans knowing they’re likely to lose money? Let’s explore the nuances of this economic phenomenon.

Why Would Anyone Deposit Money in Banks?

Despite the seemingly counterintuitive nature of negative interest rates, there are still compelling reasons why individuals opt to deposit their funds in bank accounts. The primary reason is the security and liquidity provided by banks. Unlike keeping cash in a mattress, which is vulnerable to theft, cash stored in a bank is insured and accessible.

Security: Banks offer a safe environment for your funds, with protections such as FDIC insurance in the United States. Even if the interest rate is negative, the security provided by the bank is invaluable. This insurance against theft and loss is a significant factor in choosing a bank over leaving cash at home.

Liquidity: Banks provide easy access to your funds through various means such as debit cards, checks, and online transfers. This liquidity is crucial for managing daily expenses and financial transactions.

Why Do Banks Give Out Loans When They’re Losing Money?

Banks are in the business of managing risk and providing value to their customers and shareholders. While negative interest rates complicate traditional banking models, banks can still make a profit by strategically managing their loan portfolio.

Wholesale Rates and Wholesale Costs: Banks can borrow money from other sources at a rate lower than the negative interest rate they have to offer. For instance, if a bank needs to lend out $1 million at a -1% rate, it can borrow that amount at a rate of -2% from another source. The bank still makes a profit by paying less on the borrowed funds than the interest rate paid to depositors.

Maximizing Profit Margins: Banks can also adjust the interest rates on their loans to cover the negative rate on deposits. If the bank offers a loan at a slightly higher interest rate, they can still come out ahead. For example, a bank could offer a mortgage of $1 million at a -0.5% interest rate and still make a profit due to the spread between the loan rate and the deposit rate.

The Role of Inflation in Negative Interest Rates

The concept of negative interest rates is often misunderstood. From a consumer’s perspective, interest rates are never truly negative; they’re just so low that they fall behind the pace of inflation. To understand this, let’s look at a practical example.

Example: Inflation and Interest Rates: When interest rates are positive and higher than inflation, depositing money in a bank grows your purchasing power. However, when interest rates are close to or below inflation rates, the real value of your deposit diminishes over time. For instance, if your interest rate is 2% and inflation is 5%, you are effectively losing 3% of your purchasing power every year.

Negative Interest Rates: If the interest rate falls below zero, the loss in purchasing power accelerates. In this scenario, negative interest rates can be seen as a reflection of high inflation rates, where the cost of holding cash exceeds the value it retains due to inflation.

For example, if you deposit $1,000 in a bank with an interest rate of -1%, in a year’s time, you would have just $990. If the inflation rate is 3%, the purchasing power of your $1,000 would have decreased to $970. Thus, from an absolute perspective, you see a loss of $20 in purchasing power.

Conclusion

The economic rationale behind negative interest rates is complex, involving a balance between managing inflation, stimulating economic growth, and maintaining the profitability of banks. For individuals, the key factors to consider are the security and liquidity of bank deposits, as well as the impact of inflation on the real value of your money. While the idea of losing money on deposits or loans might seem counterproductive, it is part of a broader economic strategy aimed at managing economic challenges and fostering growth.

Remember, the decision to deposit money in a bank or use other financial strategies depends on a careful assessment of the risks and returns, influenced by factors such as inflation rates and personal financial goals.