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Economist Insights 21 May2

Economist Insights 21 May2

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Published by buyanalystlondon
Economist Insights 21 May2
Economist Insights 21 May2

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Published by: buyanalystlondon on May 21, 2013
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09/28/2013

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Economist Insights
 Money for something 
20 May 2013Asset managementMost of us think that when we deposit money in a bankaccount, we should be paid interest on that deposit – afterall, we are effectively lending our money to the bank. Intoday’s ultra-low interest rate environment, the interest weearn may be negligible but at least we are getting paid someinterest. Banks themselves have their own bank accountsat central banks, and the banks were used to being paidinterest on those deposits. In Europe the European CentralBank (ECB) stopped paying interest on reserves last July, andmay now make the banks pay for the privilege of depositingtheir excess cash at their central bank (a step Denmark hasalready taken).To understand why the ECB may do this, we need tounderstand how banks interact with their central bank (seechart 1). Suppose that Bank A needs liquidity so it decidesto borrow from the ECB. Suppose that Bank A also makes amortgage loan, which the borrower pays to the house seller.That seller then deposits that cash into their bank accountin Bank B. If Bank B does not lend out this money, it mustdeposit the cash at the central bank as excess reserves. The keypoint is that the money that Bank A borrowed ends up backat the ECB (via Bank B in this simple example, but there couldbe many more transactions in reality and the logic still holdsas the money is spent). So the banking system as a whole ispaying the repo rate to the ECB for the original borrowing andthen receiving the deposit rate on the same amount.The difference between the repo rate and the deposit rateis known as the rate ‘corridor’, which is effectively the costof central bank liquidity for the banks. In theory a bank willaccess that liquidity if it thinks that it can earn more intereston a loan it might make or a bond it might purchase (takinginto account the risk). With the ECB repo rate at 0.5% andthe deposit rate at 0%, the rate corridor is 0.5%. To increasethe rate corridor without hiking the repo rate (a bad ideawhen you are in your sixth consecutive quarter of recession),the ECB will need to push the deposit rate negative.Why would the ECB want to widen the rate corridor? The hopeis that by increasing the cost of holding liquidity banks wouldstart using that extra liquidity to make more loans in order toearn enough interest to cover their increased cost of liquidity.Banks could also buy government or corporate bonds, but
Joshua McCallum
Senior Fixed Income EconomistUBS Global Asset Management joshua.mccallum@ubs.com
Gianluca Moretti
Fixed Income EconomistUBS Global Asset Managementgianluca.moretti@ubs.com
Chart 1: Roundabout
Illustrative example of how bank borrowing from the central bank leadsto increase in excess reserves
   C   e   n   t   r   a    l   B   a   n    k
Bank ABank BHousebuyerHousesellerRepo rateBorrow cashDeposit excessreservesDeposit rateMortgage rateMortgage loanDeposit inbank accountSavings rateHousePaymentInterestCashAsset
Source: UBS Global Asset Management
The ECB stopped paying interest last July on deposits itholds for European banks, and it may soon turn its depositrate negative: making the banks pay for the privilege ofdepositing their excess cash. Money borrowed from thecentral bank effectively ends up back at the central bankafter passing through various transactions in between,so banks will always pay the borrowing rate and receive(or pay) the deposit rate. Widening the gap between thetwo rates could stimulate bank lending and therefore theeconomy. But there is also the risk that the banks do notbehave the way the ECB would like and reduce borrowing,move money out of the Eurozone or simply pass on thehigher costs to customers.

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