Why The Fed is Testing Banks for Negative Interest Rates

As interest rates around the world fall to new lows, the Federal Reserve announced that it will include the possibility of negative interest rates in the United States when it stress tests the country's largest financial institutions later in 2016.

Could negative interest rates be coming to American shores? Will the nation's banks pass these tests with flying colors, or are negative rates a real risk to the American banking system? In this segment of Industry Focus: Financials, The Motley Fool's Gaby Lapera discuss why the Federal Reserve is throwing negative rates into its stress tests for 2016.

A transcript follows the video.

This podcast was recorded on March 7, 2016. 

Gaby Lapera: The big news recently is that the Fed is stress testing for negative interest rates. This doesn't necessarily mean that these are going to happen, but it's a scenario that they're seeing what would happen. Right?

Jordan Wathen: Right. They're basically saying it could be a reality here, and that's the concern is, let's say a recession comes. And typically, a recession comes, what you do, at least for monetary policy, is you start cutting rates. Well, we're already close to 0% or at 0%. So the only place to go from there is negative. And obviously, there's a big concern now, the biggest banks are only bigger. And so, what would this do to their income statements and balance sheets if rates actually go negative? It's one of those things where they're just trying to be responsible and get ahead of the problem, should it become one.

Lapera: Right. So, if we get to the point where this is occurring, there are a lot of other problems happening. This isn't going to come out of the blue. Janet Yellen isn't going to wake up one day and be like, "You know what? Today, we're going to have negative interest rates." That's not going to happen. We're going to see it coming.

Wathen: Right, things have already gone terribly wrong. Especially for the banks, because, the point at which we have negative interest rates, they would already be paying a positive yield, likely, on deposits, and investing into securities at negative interest rates. So they're already losing money. This is so ... this is like problem #5 that you encounter. This isn't like, oh, you just wake up one day, and interest rates are suddenly negative. This is, things have really gone badly.

Lapera: Yeah, and it's kind of doubtful right now anyway. The job market is pretty strong. The Bureau of Labor Statistics released its job report. The labor market is pretty strong, unemployment is hovering around ideal levels. Some people say we're going into another recession right now. I don't know, it's kind of hard to tell.

Wathen: That's the thing too, you have to put everything into perspective. One of the things that's kind of difficult to consider is, things seem to be fairly rosy in the United States, and we've never had things to be this rosy in the United States and rates to be this low, it's kind of weird. But interest rates are kind of a global issue. So, if rates are super low in Japan, they're not going to be very high in the United States, because investors are going to say, "Well, forget Japan, I'll take my money to the United States." Right?

Lapera: Right. The other interesting thing about negative interest rates is that they're not even sure if it's legal to have negative interest rates in the United States. Like, according to the Federal Reserve Act, which kind of established the Federal Reserve Board's authority, they're not sure if they can declare negative interest rates anyway. But it's just kind of one of those things that they're like, "Eh, I guess we should test for it, just in case it turns out it is legal."

Wathen: That's fascinating. I hadn't even encountered that, I hadn't even pondered the fact that it might not be legal. That's a whole 'nother slew of issues, great. So, now you throw politicians in the mix, too, fantastic. (laughs) 

Lapera: (laughs) Yeah, because that always goes great with fiscal policy. So, what would this mean for consumers, if a negative interest rate environment did happen in the United States? Which, as we've established, is not hugely likely. I'm not going to say 100% unlikely, because as we'll get to, forecasting is hard. But, what would consumers want to do?

Wathen: It's hard to say. We're dealing totally in theoretical territory here, so, all bets are off. But, at least so far, if we use foreign countries as an example, I don't think that if we have negative interest rates here in the United States, that consumers will have to deal with the negative interest rate on their bank account. So, although this will be an issue for banks, will be an issue for a lot of huge corporations -- Apple, they have $100 billion or whatever overseas, they have to deal with the effects of this. But for individuals, I don't think that it will come to an issue where you have to tolerate the idea of having $10,000 in your bank account today and next year only having $9,900 because of a -1% interest rate. I don't think that is within the realm of possibility. At least, I hope not. (laughs) 

Lapera: Yeah, and if it is, we're probably both fired anyway. So, we'll get what's coming to us. (laughs) 

Wathen: Yeah, all bets off. I'll have bigger problems to deal with, everyone will have bigger problems to deal with than that. And, another thing, too, that you have to think about is that banks are fairly resilient. That's kind of a joke.

Lapera: (laughs) 

Wathen: But, they are fairly resilient in a sense of that, say a Wells Fargo, they make 50% of their income from interest rates. But they also make 50% of it from fees and stuff like that. So, there's some give and take.

Lapera: Right.