Why people pay banks to hold their money

January 16, 2015

Switzerland’s sudden removal of the country’s currency cap yesterday sent a tremor through the world financial system and brought some foreign exchange vendors to their knees. The ramifications of the move are still shaking out, but one aspect of it brings further attention to the perplexing concept of negative interest rates.

As this Reuters graphic shows, a number of central banks are running interest rates as low as zero percent, but the Swiss Central Bank’s highest rate is -0.25 percent. The Swiss bank announced the move to -0.25 percent for some types of accounts in December, with an anticipated start date of Jan. 22, but yesterday’s announcement deepened the rate and accelerated the timetable.

The concept of negative interest rates isn’t as much a question of what as of why. On their face, negative interest rates are just what they sound like: paying to have money deposited in a bank. Whereas standard positive interest rates pay a percentage of the deposited amount, negative interest rates charge a percentage for the honor of housing cash. A 1 percent interest rate on $100 would pay $1; conversely, a -1 percent rate on $100 would charge $1.

But why would anyone want to do that? Isn’t someone better off just pulling money out of the bank and burying it in the back yard, so to speak? Not necessarily. Richard G. Anderson and Yang Liu of the St. Louis Fed explain:

Conventional wisdom is that interest rates earned on investments are never less than zero because investors could alternatively hold currency. Yet currency is not costless to hold: It is subject to theft and physical destruction, is expensive to safeguard in large amounts, is difficult to use for large and remote transactions, and, in large quantities, may be monitored by governments. Currency does not provide even a logical zero floor for market interest rates.

This reasoning pertains to individual investors, but the same concept applies upstream. Currencies are naturally somewhat volatile, and have become even more so recently, owing in no small part to the continuing collapse of the price of oil and the crisis in Russia.  Again, Anderson and Liu write: “In times of turmoil, investors accept zero or negative nominal yields as a fee for safety.” Because of the renowned stability and integrity of the Swiss banking system, investors and businesses regularly park money there in times of uncertainty, and this helps us understand the Swiss Central Bank’s motivation: they’re too popular.

Due to the accumulation of cash, the Swiss franc has become too strong against other currencies, which in turn serves to make Swiss exports more expensive, something that is ultimately not good for the Swiss economy. In a statement that came with December’s move, the SCB wrote, “Over the past few days, a number of factors have prompted increased demand for safe investments. The introduction of negative interest rates makes it less attractive to hold Swiss franc investments, and thereby supports the minimum exchange rate.”

Unfortunately for the Swiss, December’s rate cut announcement didn’t achieve the desired effect, so yesterday they took further action on behalf of their currency.  Time will tell how well this combination of tactics works. As Tomas Hirst wrote yesterday in Business Insider, “As long as there is a risk of further major shocks in the eurozone it will be extremely difficult to stem capital flows into perceived safe havens such as Switzerland — indeed they might well increase from here. After all, what is losing 0.75% on your Swiss franc savings compared with the erosion of your euro purchasing power as the latter weakens?”

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