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Former Federal Reserve Chairman Alan Greenspan recently said he wouldn't be surprised if yields on U.S. bonds turned negative and if they do, it wouldn't be "that big a of a deal." That seems to be a sentiment widely held in central banking circles these days, but it's wrong. Negative interest rates represent a threat to the financial system.
To understand why, let's start with the existing fractional reserve banking system, which is more than a century old. For every dollar that goes into a bank, some set amount (usually about 10%) must go into a reserve account to be overseen by the central bank. The rest is either lent out or used to buy securities.
In other words, the fractional reserve banking system is leveraged to interest rates. This works when rates are positive. Loans are made and securities bought because they will generate income for the bank.
In a negative rate environment, the bank must pay to hold loans and securities. In other words, banks would be punished for providing credit, which is the lifeblood of an economy.
As German bankers recently explained to the European Central Bank: "We already have a devastating interest rate situation today, the end of which is unforeseeable," Peter Schneider, who represents public-sector savings banks in the southern German state of Baden-Wuerttemberg, said on Wednesday.
If the ECB aggravates this course, that would hit not only the entire financial sector hard, but especially savers. And to make matters worse, the German government is considering outlawing negative deposit rates.
In a negative rate world, forcing rates on short-dated debt to zero would keep the yield curve permanently inverted. The fractional reserve banking system cannot operate properly in this environment.
Valuation models are another area of finance that need to be tweaked in a negative rate environment. Nobel prizes have been awarded to economists that developed concepts such as the efficient frontier, the Capital Asset Pricing Model and the Black-Scholes option pricing model.
But when a negative value is assumed for the risk-free rate in these types of models, fair value results shoot off toward infinity. With trillions of securities and derivatives dependent on these models, valuation is critical.
