Economics question - Central bank policy

CFA General
#1

Hi All - So i just finished the level II exam. I’ve got the Mundell-Fleming model fresh in my head and all that. What I’m not understanding at all is the ECB’s recent decision to make the deposit rate negative.

That means that banks which announce net deposits in excess of their reserve requirements are “fined” or charged interest instead of earning interest. I feel like I need more information on how this works. My understanding was that banks collect deposits and simultaneously make loans. If they net in deficit of their reserve requirements they (typically) pay interest on the deficit whereas they would earn interest on the surplus. However, it was my understanding that they had to effectively declare the surplus as a deposit in order to earn that interest. What I’m saying is, if a bank has a surplus of deposits, do they not have the option to keep that in cash (money market) or invest it in other financial instruments instead of declaring it a deposit to the ECB? Would a bank that loans funds to the point of being short their reserve requirement be able to earn interest on that deficit? Wouldn’t the ECB be better served keeping the deposit rate at 0 and lowering the reserve requirement?

Maybe I don’t understand the banking microstructure. My understanding was that if I’m a bank and I have €1,000,000 in deposits and the reserve is 10%, I am obligated to keep €100,000 at the central bank to cover my withdrawals. If I’m under that reserve requirement then I must borrow from other banks and pay interest at the margin lending facility rate (MRO, or the discount rate in the states). If I’ve got excess cash reserves then I earn interest based on the Euro Overnight Index Average (EONIA, also known as the federal funds rate in the states).

BUT, it was my understanding that the bank’s had the option to deposit their excess reserves into the central bank. In other words, the banks had the option to simply earn no interest on that excess liquidity and just keep it on their books as cash. In the case of an option between no interest versus a small interest, small interest wins. But in the case of no interest versus negative interest, no interest wins.

So how does the ECB’s decision to make the deposit rate negative make any sense??? Wouldn’t banks simply declare up to their reserve requirements and opt out of depositing additional liquidity, holding the remaining excess in cash.

#2

This is much simpler than you are imagining. Central banks serve to influence short-run outcomes on the economy through monetary policy. By effectively charging banks to hold surplus reserves, this incentivizes banks to loan out at the margin, or at the very least invest in approved assets that transmit those proceeds to debtors elsewhere in the economy (bond issuers).

Holding cash does not help stimulate the Eurozone economy. The ECB wants to mobilize all available surplus to that end. In ordinary times, measures such as what is happening now would not occur – it would look more like the textbook – but these are not ordinary times. The late 00’s and early '10’s will be remembered as a time where central banks took extraordinary measures to change monetary policy outcomes, effectively rewriting the books on how these things are handled.

When Monsieur Greenspan talked to the specialists after the '87 crash, it was very storied – here, this guy effectively added “moral suasion” to the typical three measures the Fed had at its disposal to influence the economy – reserve ratio requirements, discount window and open market operations. Since 2008, world central banks have added at least 4 or 5 separate categories of tricks to their arsenal.