At first I had no idea what to think of this. I have sat and thought about and haven't read any commentary but composed an email to a financial friend walking through my thoughts. To my investor friends, if you have differing thoughts, please let me know. I am working through the concept and haven't worked through all the details yet.
First the article from the CNN (originally from the financial times) Below that is my email I sent which covers some thoughts.
For a world first, the announcement came with remarkably little fanfare.
But last month, the Swedish Riksbank entered uncharted territory when it became the world's first central bank to introduce negative interest rates on bank deposits.
Even at the deepest point of Japan's financial crisis, the country's central bank shied away from such a measure, which is designed to encourage commercial banks to boost lending.
But, as they contemplate their exit strategies after the extraordinary measures of the past two years, central bankers will be monitoring the Swedish experiment closely.
Mervyn King, the Bank of England governor, has hinted he may follow the Swedish example as the danger of a so-called liquidity trap, where cash remains stuck in the banking system and does not filter out to the wider economy, is an increasing concern for the UK.
Hoarding is exactly what happened in Japan earlier this decade when the Bank of Japan implemented quantitative easing between 2001 and 2006.
Japanese banks refused to lend, in spite of central bank stimulus, because of fears over the dire state of the economy.
There is much more to the article.
My initial take
I have literally been spinning in my chair for about 30 minutes thinking this through. At first I didn't know what to think but have worked through the various dynamics in my mind. To the extent you have a differing thoughts I would enjoy hearing them.
First what I don't know. I realized thinking through this there are several things I don't know about the process.
1) Is there a legal requirement that the commercial banks keep money at the central bank? I thought it was always voluntary. You have extra reserves and can earn a little bit keeping them at the central bank. To the extent you get charged to keep them there, why not just keep them as cash in a vault at your bank? Basically wouldn't it be very easy to get around it? The article actually addressed this at the end.
2) Isn't there are a certain amount of reserves required by law? Certainly the central banks wouldn't charge for this minimum?
What I do know or at least the way I am looking at the world.
1) Reserves do not directly impact solvency. They impact liquidity. Equity is a solvency issue. If you increase a reserve from an accounting perspective it changes the asset and liability side of the balance sheet. Equity and hence solvency does not change until reserves earn a profit. That profit adds to equity.
2) Liquidity can help starve off an insolvency event (even if you are still insolvent) because it dilutes the insolvent problem. This isn't completely accurate and being oversimplified here but as an example: I am insolvent by 1 billion dollars and have a 10 billion dollar balance sheet (10 billion in assets, 11 billion in liabilities and -1 billion in equity) (a banks balance sheet wouldn't show this even if this was actual reality because their marks are way off from reality). I have more risk of a liquidity run which would expose my insolvency than if I was 1 billion dollars insolvent but had a balance sheet because of a liquidity injection by a central bank that I used to build reserves that would now show as having 20 billion in assets and 21 billion in liabilities and -1 billion in equity. The huge build in reserves in no way helps the insolvency issue but does lower the possibility of a liquidity squeeze that would expose my insolvency (think Bear Stearns)
3) This thinking by the Bank of England and Bank of Sweden (also the Fed) continues to be completely and totally wrong. They still don't realize it is an insolvency issue.
4) Banks desire to make money. They are capitalistic creatures. To the extent they do not pursue higher yielding assets with their reserves is because they realize they are insolvent. BB&T markdowns of Colonials assets when BB&T took over Colonial shows just how insolvent the banking system is. In some cases the markdowns were twice what JP Morgan took on WAMU and Wells Fargo took on Wachovia which means these two companies are probably already underwater with these two FDIC helped acquisitions.
5) The few healthy banks that are out there (think Beal bank out of Dallas) who built huge reserves in 2004, 2005, 2006 (once again think Beal bank) are using their reserves as fast as they get them (once again think Beal bank). They couldn't be happier. They are very solvent and do what healthy solvent banks do when they get reserves. Lend and buy assets. Central bankers assume it is some fear issue. Maybe on a small scale but healthy solvent banks are buying assets and lending as fast as they can.
6) This is of course the downside of letting zombie banks live. We are doing what Japan did. There were banks failing 10 years after the initial implosion that should have failed in year 1 through 3. Japan solved the liquidity issue through flooding the banks with reserves but the banks were still insolvent and some weren't able to outrun this insolvency issues by earning there way out of it.
7) To the extent the central banks are actually able to charge for the reserves, (once again I think it is mostly voluntary how much of an actual banks reserves they can hold at the central bank) the long term results I think would be a disaster. Short term you could definitely create another liquidity jump (though I am not sure this is even likely) but instead of slowly building back solvency you are now depleting it because you are taking away from earnings which would flow to equity. To the extent the central banks actually do force these reserves out and the bank is actually insolvent (regardless of what the balance sheet says) instead of the dilution effect of the insolvency issue because of the liquidity injection you have instead leveraged up the insolvency issue. If you make good bets buying the right assets or lending to the right borrower you will get out of the insolvency problem quicker but to the extent you make wrong bets the insolvency issue becomes worse and is levered up in relation to the balance sheet. You are forcing the banking system to play Russian roulette. To the extent there is a positive feedback loop from the increase purchase of assets you may have increased the odds of more banks earning their way out of insolvency. To the extent there is some unforeseen event in the future you have just made the problem much much worse.
8) It is basically like doubling down in black jack. Something the banks shouldn't want to do, be compelled to do, or be required by law to do. It gets away from everything that banking is supposed to be.
9) To sum it up, I still think it speaks volumes to how clueless the central bankers still are.