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ECB: Risks of a negative interest rate

The European Central Bank has taken some radical steps and entered, as commentators have pointed out, uncharted waters. While policy makers genuinely believe that their actions will help revive Europe, there are significant risks to the banking sector, and therefore to the economy.

Europe’s track record in financial matters has not been stellar. The concept of a common European currency, which was debated for years, was flawed in its implementation. While innumerable people spent countless person-years designing it and defining norms for countries entering the union, they left largely unaddressed the aspect of countries leaving it – a fundamental design flaw. Countries are bound to have their ups and downs. An exit clause was essential.

One hopes that ECB’s drastic slashing of interest rates (including one of them turning negative), does not have unintended consequences. Negative interest rate essentially means that a bank has to pay the borrower to borrow – a difficult idea to visualise.

One cannot draw comfort in what economists say either, as there will always some support for all kinds of policies, however risky they may be. One just has to look at what economists said a year or two before the financial meltdown in the US.

Viewing this new situation from a bank’s viewpoint, one is left wondering how banks would remain profitable when spreads are so miniscule. How does a well-run bank meet its costs, fulfil the expectations of policy makers, and meet shareholder expectations? The first knee-jerk reaction would be to cut costs.

Cutting costs brings tremendous pressure on the fundamental operational aspects of a bank, including credit appraisal and asset evaluation. And with compressed spreads, banks will have to lend more than before to merely to stay afloat. This means that more work will need to be done in less time, and with lower budgets – a perfect recipe for asset quality deterioration .

And with miniscule spreads, it will not take very many defaults to sink a bank.

Let us hope that this come to pass. We can ill afford another financial crisis, this time on the other side of the Atlantic.

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