Deposit rate

What Is Deposit Rate?

A deposit rate is the interest rate paid by a financial institution on funds deposited by its customers or by a central bank on reserves held by commercial banks. In the context of central banking, the deposit rate is a key tool within monetary policy, representing the interest rate at which commercial banks can make overnight deposits with the central bank. This rate significantly influences the overall interest rates in an economy, affecting lending and borrowing costs for other financial institutions and, ultimately, consumers and businesses.

History and Origin

Historically, deposit rates offered by retail banks were a straightforward incentive for individuals and businesses to save money. However, the concept of a central bank's deposit rate as a direct policy tool gained prominence with the evolution of modern central banking. In the United States, for example, the Federal Reserve began paying interest on reserve balances (IORB) held by depository institutions with the passage of the Financial Services Regulatory Relief Act of 2006, with authority advanced to October 1, 2008, by the Emergency Economic Stabilization Act of 2008. This marked a significant shift, as previously, banks earned no interest on these reserves.¹¹, ¹² This change allowed the Federal Reserve to exert finer control over the federal funds rate and manage bank liquidity more effectively.¹⁰

In the Eurozone, the European Central Bank (ECB) utilizes its deposit facility rate as one of its three key policy rates to steer the overnight money market interest rates.⁹ A notable development in central bank deposit rates was the adoption of negative rates by several central banks, starting with Sweden's Riksbank in July 2009, followed by the European Central Bank in June 2014.⁸ This unconventional measure was largely a response to persistent low inflation and weak economic growth following the 2008 global financial crisis, aiming to encourage lending and discourage hoarding of cash by commercial banks.⁷

Key Takeaways

• A deposit rate is the interest paid on deposited funds, particularly by central banks to commercial banks for holding reserves.
• It serves as a key instrument for central banks to implement monetary policy and influence short-term interest rates.
• Central bank deposit rates impact commercial bank lending behavior and, consequently, the broader economy.
• Negative deposit rates have been used by some central banks to stimulate economic activity during periods of low inflation or deflation.

Interpreting the Deposit Rate

The deposit rate, particularly when set by a central bank, provides a strong signal about the central bank's monetary policy stance. A higher deposit rate encourages banks to hold more funds at the central bank, which can reduce the amount of money available for lending in the broader economy, thereby tightening monetary conditions. Conversely, a lower deposit rate incentivizes banks to lend out their excess reserves, increasing liquidity in the financial system and stimulating economic activity. The level of the deposit rate also influences the interest rates that commercial banks offer to their own customers for deposits, impacting saving incentives and consumer spending. It forms a floor for interbank lending rates, as banks would not lend to each other at a rate lower than what they could earn by depositing funds at the central bank. Understanding the deposit rate helps in assessing the current state of financial stability and the central bank's outlook on inflation and growth.

Hypothetical Example

Consider a hypothetical scenario in the Eurozone. The European Central Bank (ECB) announces that it is lowering its deposit facility rate from 0.00% to -0.50%. Before this change, a commercial bank, Bank A, holds €100 million in excess reserves at the ECB and earns no interest. After the rate cut, Bank A would effectively pay €500,000 per year (0.50% of €100 million) to hold these reserves at the central bank.

This negative deposit rate creates a strong incentive for Bank A to reduce its holdings at the ECB and instead seek out lending opportunities or invest in assets that offer a positive return, even if small. Bank A might decide to increase its lending to businesses and consumers, potentially lowering the lending rates it offers to attract more borrowers. It could also consider investing in government bonds or other financial instruments. The aim of such a move by the ECB would be to inject more liquidity into the economy, encourage investment, and stimulate economic activity to combat low inflation or deflationary pressures.

Practical Applications

The deposit rate is a core instrument used by central banks to manage the supply of money and credit in an economy. Its practical applications are widespread:

• Monetary Policy Implementation: Central banks adjust the deposit rate to influence short-term interest rates in the interbank market. By raising the rate, they can encourage banks to hold more reserves, thereby tightening financial conditions. Conversely, lowering it makes holding reserves less attractive, promoting lending and economic activity.
• ⁶Controlling Inflation and Deflation: When a central bank aims to curb high inflation, it might increase the deposit rate, making it more expensive for banks to hold reserves and thus encouraging higher lending rates and reduced credit expansion. In periods of potential deflation, lowering the deposit rate can stimulate lending and investment.
• ⁵Managing Bank Liquidity: The deposit rate impacts how much excess liquidity commercial banks are willing to hold. It affects banks' decisions regarding holding reserves versus deploying them in the economy through loans or investments.

For example, the European Central Bank uses its deposit facility rate as a primary tool to manage overnight money market rates and influence broader financial conditions in the Eurozone.

L⁴imitations and Criticisms

While a powerful tool, the deposit rate, especially in negative territory, has limitations and faces criticisms:

• Zero Lower Bound (or Effective Lower Bound): Traditionally, the "zero lower bound" was considered the limit for interest rates, as holding physical cash would yield a zero return, making negative rates seem implausible. However, some central banks have demonstrated that rates can go below zero. There is, however, an "effective lower bound" beyond which further cuts could disrupt financial markets, as banks might struggle to pass negative rates onto depositors, particularly small ones.
• ², ³Impact on Bank Profitability: Prolonged periods of negative deposit rates can compress banks' net interest margins, potentially harming their profitability. Banks might be reluctant to lend or might increase other fees to compensate for the cost of holding reserves, which can undermine the policy's effectiveness.
• ¹Discouraging Saving: For retail depositors, negative deposit rates, or even very low positive rates, can reduce the incentive to save, potentially pushing funds into riskier assets or encouraging excessive consumption, neither of which may be desirable for long-term financial stability.
• Unintended Consequences: Extremely low or negative deposit rates can distort financial markets, impacting the yield curve and the pricing of various financial products. There is also a risk of encouraging excessive risk-taking by investors seeking higher returns in a low-yield environment.

Deposit Rate vs. Marginal Lending Rate

The deposit rate and the marginal lending rate are both key policy rates set by central banks, but they serve opposite functions.

Both rates, along with the main refinancing operations rate (for central banks like the ECB), form a corridor within which short-term money market rates, such as the federal funds rate, typically fluctuate.

FAQs

What is the primary purpose of a central bank's deposit rate?

The primary purpose of a central bank's deposit rate is to influence short-term interest rates in the interbank market and manage the overall liquidity in the financial system. By adjusting this rate, the central bank aims to encourage or discourage commercial banks from holding excess reserves, thereby affecting lending and credit creation in the economy.

How does the deposit rate affect commercial banks?

The deposit rate directly affects the profitability of commercial banks' excess reserves. If the rate is positive, banks earn interest on their deposits with the central bank. If it's negative, banks pay a fee for holding those deposits. This influences banks' decisions on how much to lend or invest, impacting their balance sheets and the availability of credit in the economy.

Can a deposit rate be negative?

Yes, a deposit rate can be negative. Some central banks, such as the European Central Bank and the Bank of Japan, have set negative deposit rates to encourage commercial banks to lend out their money rather than keeping it deposited at the central bank. This is typically done to combat low inflation and stimulate economic growth.

Is the deposit rate the same as the interest rate on savings accounts?

No, the deposit rate set by a central bank is not the same as the interest rate on retail savings accounts. The central bank's deposit rate applies to deposits made by commercial banks with the central bank. While it influences the rates that commercial banks offer to their customers for savings accounts, the retail rates are also determined by factors like market competition, a bank's funding costs, and its lending demand.