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EXPLAINER-How do negative interest rates work?

LONDON, Feb 4 (Reuters) - Investors scaled back their bets that the Bank of England will bring in negative interest rates anytime soon after the central bank said lenders would need at least six months to prepare for such a move.

The BoE said it did not want send a signal that it intended to set a negative rate but regulators should start getting banks like HSBC, Lloyds and Barclays ready for the possibility that the policy is implemented in the future.

The European Central Bank, the Bank of Japan and others have already taken rates negative, although U.S. central bankers have been more hesitant.

This is how a negative rate policy works alongside some of its potential pitfalls:

WHY HAVE SOME CENTRAL BANKS ADOPTED NEGATIVE RATES?

During the global financial crisis of 2008-09, many central banks cut interest rates close to zero.

With their economies still struggling in the years that followed, policymakers in the euro zone, Switzerland, Denmark, Sweden and Japan allowed rates to fall to slightly below 0%.

The coronavirus pandemic has now put pressure on central banks to pump even more stimulus into their economies.

The U.S. Federal Reserve, which had managed to push up borrowing costs in recent years, cut rates back to just above zero but several policymakers have expressed resistance to going further.

The BoE cut its key rate to a record low of 0.1% in March 2020 and has doubled its bond purchase target since the start of the pandemic to support the economy.

However, most economists polled by Reuters think it is unlikely to cut rates below zero this year, largely because the fast rollout of Britain’s vaccination programme has raised the prospect of an economic recovery.

There have also been divisions over negative rates within the Monetary Policy Committee, with the internal members, headed by Governor Andrew Bailey, stressing risks and uncertainties, while the external members have sounded more open to the idea.

HOW DOES IT WORK?

Under a negative rate policy, banks and other financial institutions are required to pay interest for parking excess cash -- beyond what regulators say they must keep on hand for safety reasons -- securely with the central bank.

Avoiding the charges is an incentive for banks to use their money to lend more to businesses and consumers, helping growth.

The ECB introduced negative rates in 2014. Its deposit rate is currently -0.5%.

The Bank of Japan went negative in 2016, mostly to prevent a strengthening yen from hurting its export-heavy economy. The BOJ uses aggressive asset purchases to guide short-term rates to -0.1% and the long-term rate to about zero.

In December, however, it said it planned to examine more effective ways to achieve its inflation target amid growing concern among policymakers over the diminishing return and rising cost of prolonged easing.

WHAT ARE THE PROS AND CONS?

Negative central bank rates lower borrowing costs for businesses and households.

Advocates say they also help weaken a country’s currency by making it a less attractive investment than other currencies. That can give exporters a competitive advantage but boosts inflation by pushing up import costs.

But negative rates also narrow the margin that financial institutions earn from lending -- something BoE officials have previously said could prove counter-productive, hurting banks and reducing the flows of credit to the economy.

The ECB and the BOJ have sought to reward banks that use their credit lines, recognising the need for incentives to boost lending rather than just punishing them for parking their money.

BoE Governor Bailey said in January that rates close to and below zero changed the “whole calculus of how the banking system works.”

Lenders in Britain make most of their profits from the difference between the rates they charge for their lending and what they pay for deposits, and bankers said negative rates could force them to introduce more retail banking fees.

HSBC said in October that rock-bottom and sub-zero rates in countries where it operates meant it had to consider more charges.

British lenders would probably charge large corporate depositors first and consumers as a last resort.

In Switzerland, big banks initially did not pass negative rates on to private and smaller corporate clients. But five years on, nearly all Swiss banks have passed on some charges to corporate and individual customers with large cash balances.

Higher banking fees could also limit how low negative rates could go -- depositors can avoid being charged negative rates or fees on their deposits by choosing to store banknotes instead. (Reporting by William Schomberg in London, Leika Kihara in Tokyo and Balazs Koranyi in Frankfurt; Editing by Toby Chopra)

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