What net effective ECR could look like in the U.S. before the end of 2020
A negative interest rate policy (NIRP) – requiring financial institutions to pay a fee for leaving funds with a central bank – was initially implemented by the European Central Bank (ECB) in June 2014 to stimulate the economy. The move assumed that commercial banks would increase corporate lending rather than pay the fee to keep their cash balances with the central bank. In January 2016, the Bank of Japan adopted a similar policy to lower the Yen’s value and protect exports.
Theoretically, a cut in central bank rates below zero should have a similar effect as a cut in rates above zero. However, depending on the economic environment, the action can also signal a weak economy, potential deflation (inflated asset prices), and a weakening of a country’s financial institutions. A long-term NIRP is not sustainable and eliminates a nation’s competitive currency advantage if it becomes widespread.
U.S. adoption of a negative interest rate policy
Despite the mixed results of other countries’ experiences with NIRP, the likelihood that the United States will adopt a negative interest rate policy in the near term is high. Pressures from the dramatic drop in gross domestic product (GDP) accompanying the COVID-19 pandemic, political needs for a surging economy, and the historic levels of cash on corporate books suggest a formal Fed announcement of the change before the end of 2020.
However, when it comes to cash management, the devil is in the detail. Even without any formal announcements from the Fed, we are already seeing large American banks use various strategies to charge balances while still displaying a positive earnings credit rate (ECR).
Impact of negative interest rate policy on member banks and corporations
Member banks typically pass on the actions taken by the Federal Reserve to their bank customers. In a negative rate scenario, member banks pay interest on funds left with the Reserve. To lower their costs, member banks may react by increasing lending activities. While the desired result of the policy, the willingness to make new loans is directly aligned with the borrowers’ quality or creditworthiness. Many potential borrowers have suffered severe losses from COVID-19 and the measures taken to combat the pandemic, reducing their appeal as borrowers.
Banks will likely recoup their costs by transferring them to customers. Currently, the fed funds rate is still positive (0-0.25%); however, we are already starting to see three main trends from banks that may go completely undetected:
- Charging additional balance-based fees
Most of our clients already receive a near-zero ECR on their collected balances. When netted with the deposit assessment fees that banks are charging on their ledger balances, companies with significant float will most likely be in a net negative position and receive a negative effective ECR. But in a recent RFP, the banks clearly indicated that they might start charging additional balance-related fees. While still stating a positive ECR, the reality is that most companies will soon be in a negative interest rate environment, if not already.
- Increasing bank fees
Another very deceiving way banks may recoup their cost on deposits is by simply increasing clients’ bank fees. Since ECR makes balances and bank fees interdependent, increasing your bank fees while maintaining the same ECR would reduce the value of your balances. This is the most deceiving strategy because while still displaying a positive ECR, banks would actually be indirectly charging your balances through your bank fees.
- Limiting deposits
If you were monitoring and strategizing balance allocations among your banks based on the competitiveness of their ECRs pre-COVID-19, you might need to reconsider your strategy. Some banks that have not yet generalized additional balance-based charges have announced more scrutiny on their client’s balance allocation strategies. Any deposit made through regular cash management activity at the bank is “safe” for now, but massive reallocation of balances from another bank could be subject to penalty.
Impact of NIRP on companies with large cash reserves
Concerned about increasing international trade and political tensions, U.S. companies began negotiating new debt and drawing down existing loans to increase cash reserves in mid-2019. The pandemic accelerated their efforts to increase liquidity. Ironically, those most adept in building reserves are most affected by a negative interest rate policy.
A change in monetary policy will particularly affect those companies with naturally high cash reserves, specifically in regulated industries with fiduciary responsibilities or companies with conservative investment policies unwilling or incapable of adjusting to the new charges.
Faced with reduced investment opportunities and lower return on capital, treasury departments are under much more scrutiny from leadership to either find alternative investment solutions or reduce their balance by improving working capital and cash forecasting.
Prepare for a negative interest rate policy
American businesses will struggle the next few years to remain profitable. Having large cash reserves, i.e., excessive liquidity, will be a competitive disadvantage in a period of negative interest rates. But what all of these companies have in common – regardless of industry, leadership, or regulation – is that they all pay bank fees and they all use their balances to offset these fees, to some extent. In this rate environment, renegotiating your bank fees is the first and most effective way to immediately reduce the burden that NIRP may place on your balance.