As of 11 June 2014, the interest rate on the Eurosystem Deposit Facility is -0.10%. This negative rate applies to all banks’ holdings of euros in excess of the minimum reserve requirements, as well as to cash balances above a certain threshold that Eurozone governments hold in the Eurosystem (this is cash obtained through taxes or bonds issued and not yet spent), as well as to all deposits held by non-Eurosystem central banks.

What does it mean that the ECB sets a negative interest rate?

In the same way as an interest paid by the ECB to holders of euros is a net addition to holders’ income, an interest paid by the banks to the ECB for holding euros is equivalent to a tax on holders of euros.

What is the purpose of this tax?

The ECB made it clear it has a dual goal:

a) Stabilize the interbank (EONIA) rate around zero;

b) Further reduce market segmentation in the Eurozone banking sector, where some banks prefer to hold reserves rather than lending them to other banks. Notice that this attitude by banks makes the amount of excess reserves needed for the smooth operation of the payment system way bigger.

Will banks now try to get rid of their excess liquidity to avoid paying the rate?

The banking system cannot reduce its accounts at the ECB unless:

a) Banks repay prior loans (all reserves that banks hold are borrowed);

b) The ECB takes the initiative of carrying “liquidity absorbing operations” such as reverse repos.

All banks can do is to offer a (negative) rate to other banks for holding reserves. In other words, a bank that is expected to make a payment to another bank might be offered the option to continue holding the reserves and be paid an interest for this.

Dose this mean that EONIA can go negative?

Yes, if market segmentation gets further reduced, and if bank liquidity remains higher than required, then banks may set a negative interbank rate, equal or very close to -0.1%.

Will the negative rate on banks’ “excess liquidity” increase bank loans?

Taxing bank’s balance sheets with a negative interest rate does not make the volume of lending any bigger. The lending volume depends on the bank’s desired leverage (bank capital ratio requirements, the quality of potential borrowers, expected profit from lending). Unless such factors change, the negative rate has no effect (and perhaps even a negative effect) on bank lending.