Announcing a key interest rate is much easier than enforcing it. In order for interest rates to climb to the desired level, the Swiss National Bank has to take a number of detours.
Monetary policy, one might think, is a simple discipline. First, there are the central banks. These have the unique monopoly of being able to create money out of nothing. And as if this privilege weren’t outrageous enough, the central banks can also have a say in the price of money. They do this every few months in a sovereign act by setting the monetary policy rate.
The money market as the place of action
But this is where the simple ends. Because a key interest rate follows its own rules, especially in the case of the Swiss National Bank (SNB). Their key interest rate differs from the interest rates that normal commercial banks apply to their customers. When a bank raises interest rates on savings accounts, savers immediately get more money on deposit. If, on the other hand, the SNB raises the key interest rate, as it did last December to 1.0 percent, then initially little will happen.
Because the SNB key interest rate – and this is where it gets almost metaphysical – doesn’t actually exist. Or rather, it only exists as an abstract idea in the minds of the SNB technocrats. However, because monetary authorities ideally do not just run after any fantasies, but rather fulfill a specific mandate, the idea of a key interest rate must somehow be made tangible. And with monetary consequences for the financial system and the entire economy. It is therefore necessary to put the key interest rate into practice.
This implementation is anything but simple, especially after many years of almost limitless money printing. The place of implementation is the money market. This is the place where short-term funds are borrowed and borrowed. It is mainly used by banks. Because here, financial institutions that are short on cash in the short term can quickly borrow the liquidity they need. And here banks that have too much liquid funds can give their excess liquidity to other banks in return for interest.
The banks are swimming in money
The most important interest rate on this market in Switzerland is the Saron (Swiss Average Rate Overnight). It is considered to be the most meaningful interest rate when shifting liquidity back and forth in the short term. And because the Saron is the most important price tag in money exchanges between banks – also known as the interbank market – the SNB also attaches central importance to it. Therefore, when she announces her SNB interest rate, she is already thinking of the Saron. Because the aim of the SNB is to always bring this Saron close to the SNB key interest rate.
But the Saron cannot be moved by decree or by pressing a button, not even by the SNB. Rather, like any price, it is the result of supply and demand. In order to steer the Saron in the desired direction, the SNB itself must influence supply and demand on the interbank market. It must therefore intervene in the market and set incentives so that the Saron approaches the SNB key rate quickly and precisely. If you don’t succeed, the key interest rate will remain a mere wish – without any consequences for the economy, inflation or the economy.
For some years now, however, the SNB has had a bigger problem with this task. Because unlike before the financial crisis of 2007 and 2008, when banks were mostly short of liquidity, banks have been swimming in liquid funds for years. The central banks are to blame for this. After the outbreak of the financial crisis, these flooded the markets with vast amounts of money. As a result, the banks soon had significantly more liquidity than they could even use. Little has changed in this overhang to this day.
Tiered interest on credit balances
Why is the excess liquidity, which is reflected on the balance sheet in the form of banks’ high sight deposits at the SNB, a problem for the SNB? Because banks with a very plentiful supply of liquid funds have little reason to enter the interbank market and exchange money with each other. And where there is hardly any trade, the price – specifically: the Saron – can neither be reliably calculated nor steered in the desired direction. So the SNB has to find a way to encourage the banks to swap.
How does she do it? the SNB applies two measures. The first consists of a tiered interest rate on sight deposits held by the banks at the central bank. The SNB wants to give the banks an incentive to lend more money to each other. However, this only works if the credit balances have different interest rates. A limit is therefore defined for each bank. The balances that are below this limit are subject to higher interest (currently at the key interest rate of 1.0 percent) than the balances that are above (0.5 percent).
Why do you need tiered interest rates to bring life to the interbank market? Because all banks strive for the highest possible return on their funds. Those banks whose sight deposits exceed the limit will therefore be happy to lend their excess funds, which only earn interest at 0.5 percent, to banks that pay more than 0.5 percent for this money. Those banks whose limit has not yet been exhausted and who can therefore use additional liquidity are ready for such a deal, since the SNB pays an attractive interest rate of 1.0 percent on this money.
Draw liquidity from the system
This trade is already lifting the Saron somewhat higher, as intended by the SNB. However, to ensure that the rate actually comes close to the SNB key rate, the central bank is taking a second measure: it is absorbing liquidity. It therefore reduces sight deposits and thus the supply on the money market. This is necessary because there should not be too much liquidity lying around above the limit. Because if large amounts of low-interest funds are available, the interest on the money market is more likely to be at the lower end of the graduated interest rate than at the upper end; i.e. at 0.5 percent instead of the targeted key interest rate of 1.0 percent.
But how do you get money out of the system? The simple answer: the SNB is in debt. So she acts as if she urgently needs money and knocks on the door of the commercial banks. That may sound absurd, because the SNB can create any amount of money itself and does not have to apply for a loan from the commercial banks. But that doesn’t add anything to the matter. The only thing that matters here is that the SNB needs a trick to get the banks to transfer part of their liquidity to the SNB. And for this, the banks need a financial incentive.
This incentive is provided by two types of debt securities that the SNB offers to the banks at an attractive interest rate that roughly corresponds to the base rate: so-called repo transactions and SNB bills. The repos have a short term and are offered to the banks on a daily basis. The SNB Bills, on the other hand, are bonds with a term of up to one year and are freely tradable on the market. However, these differences are not so important. The only significant thing is that the SNB can lure excess liquidity out of the banks in this way.
billions in implementation costs
In addition, these two instruments ensure that, thanks to the SNB, the banks can always expect minimal interest on their money close to the base rate, be it via sight deposits in the SNB balance sheet, via repo transactions or by means of SNB bills. In view of this safe minimum interest rate of currently around 1 percent, no bank will probably be willing to offer a loan below this interest rate to a company or a household, for example. So at least 1 percent will also be required for mortgages or company loans. The SNB guiding principle thus finds its way into the real economy.
The SNB will therefore have to move a lot of money until the key interest rate is implemented. The SNB leaves it open how much that is. However, the amounts can be guessed at. This is how the sight deposits of the banks are currently around 540 billion Swiss francs. Because the SNB has siphoned off a great deal of excess liquidity since the return to a positive key interest rate, i.e. since September, the vast majority of these deposits are likely to earn interest at 1 percent and only a small part at 0.5 percent. Roughly estimated, the interest payments to the banks would be between 4 and 5 billion Swiss francs.
In addition, there are the repos and SNB bills offered to the banks at the key interest rate, which – as already mentioned – are used to draw excess liquidity out of the financial system. The SNB has known these instruments for a very long time. For more than ten years, however, they have hardly been used. With the return to positive key interest rates, this has changed abruptly. The portfolio of repo transactions and SNB bills was already there at the end of November at an impressive CHF 151 billion, with just under CHF 63 billion in repos and around CHF 88 billion in SNB bills.
Are the banks subsidized?
This greatly simplified presentation of the fine mechanics of monetary policy makes it clear that when the SNB announces a key interest rate, it is only at the beginning of its work. Announcing an interest rate is far easier than actually enforcing it on the market. In this task, the SNB is dependent on the cooperation of the banks. However, they do not help voluntarily. In order for the cooperation to succeed, the banks must be given a financial incentive, be it attractive interest on their sight deposits or the opportunity to purchase debt securities – which also carry lucrative interest.
These complex transactions are difficult to communicate. In recent months, some observers have been outraged that the SNB is “subsidizing” the banks with payments worth billions, while the federal government and the cantons will probably have to forego a profit distribution due to the miserable year on the stock exchanges. But that is a shortened view of things. So the interest payments to the banks are not a subsidy. Rather, they are the price that the central bank has to pay so that their key interest rate does not remain a pipe dream, but arrives in the economy and has the desired effect there.