At today’s zero or near-zero interest rates in the euro area, a small loosening of monetary policy risks stalling the banking system and the economy.
Rock bottom interest rates have clearly hurt net interest margins. Whilst bank can respond by cutting deposit rates, once the policy rate hits zero, this profit-protection strategy hits a wall. A negative deposit rate would risk an exodus of out of bank deposits into cash or cash-substitutes. A deposit flight could create a liquidity crisis, forcing banks to shrink their balance sheets. Alternatively, banks could charge a higher rate to borrowers, but this would tighten credit conditions. Therefore, banks are left to take a hit to their already thin net lending margins. This also tightens credit conditions because pressure on profitability and share prices increase the cost of equity, making it harder to raise capital. Given that an insufficient capital buffer is a major constraint to euro area bank lending, this would be a de facto tightening of credit conditions.
Bottom Line: The paradox is that at the zero bound, the smallest additional monetary loosening – via interest rate cuts or QE – risks stalling euro area bank credit creation. It thereby risks stalling economic growth.