How do banks make money with negative interest rates?

In an environment of negative interest rates, banks adapt their operations and financial strategies to continue generating revenue, although profitability can be significantly challenged.

Traditionally, banks earn money by acting as intermediaries: they take deposits from savers and lend that money to borrowers. Their profit comes from the spread – the difference between the interest rate they charge on loans and the typically lower interest rate they pay on deposits. When central banks implement negative interest rates, especially on excess reserves held by commercial banks, this traditional profit model is put under immense pressure. Banks are often hesitant to pass negative rates onto retail depositors, which means their cost of funding (deposits) might remain at zero or slightly positive, while their lending rates are pushed downwards, compressing their profit margins.

Challenges to Bank Profitability Under Negative Rates

Negative interest rates directly impact a bank's core business model:

• Compressed Net Interest Margins (NIM): The most direct impact is the reduction in the difference between interest earned on assets (like loans) and interest paid on liabilities (like deposits). If banks cannot charge negative rates to depositors but are charged negative rates by the central bank on excess reserves, their NIM shrinks.
• Reduced Incentive to Lend: While negative rates aim to stimulate lending, if the return on loans is too low, banks may become more cautious, potentially stifling the very growth central banks seek.
• Pressure on Deposit Retention: Passing negative rates to retail depositors risks customers withdrawing funds, further impacting liquidity.

Strategies Banks Employ to Maintain Profitability

Despite these challenges, banks employ several strategies to adapt and generate income:

1. Passing on Negative Rates (Selectively):

   • Banks may charge negative interest rates to large corporate clients, institutional investors, or high-net-worth individuals for significant deposits. This helps offset the costs imposed by central banks on excess reserves.
   • Retail depositors are generally shielded from negative rates due to competitive pressures and the risk of deposit outflows.

2. Increasing Lending Volume:

   • To compensate for lower margins per loan, banks may seek to increase the overall volume of loans. This often involves relaxing lending standards slightly or targeting less saturated markets, though it also increases risk.
   • Focus on higher-yield loan segments, if competitive conditions allow.

3. Diversifying Revenue Streams:

   • Fee-Based Services: Banks increasingly rely on income from non-interest sources, such as:
     • Wealth management and advisory services.
     • Investment banking activities (mergers and acquisitions, underwriting).
     • Transaction fees (e.g., payment processing, foreign exchange).
     • Insurance product sales.
   • Digital Offerings: Charging for premium digital banking features or specialized services.

4. Cost Reduction and Digital Transformation:

   • Operational Efficiency: Banks invest heavily in technology to automate processes, reduce manual labor, and streamline back-office functions.
   • Branch Network Optimization: Reducing the number of physical branches and shifting towards digital customer interactions cuts overhead costs.
   • Workforce Adjustments: Rightsizing staff and optimizing human resources to improve productivity.

5. Optimizing Balance Sheet and Investment Strategies:

   • Banks may adjust their asset allocation, reducing holdings of low-yielding government bonds and seeking alternative investments, potentially with higher returns but also higher risk.
   • Utilizing hedging strategies (e.g., interest rate swaps) to protect against adverse rate movements.

6. Focus on Specific Market Niches:

   • Some banks may specialize in areas where they can command better margins, such as specific types of commercial lending, niche consumer loans, or structured finance.

The table below summarizes common strategies:

For a more in-depth understanding of how central banks implement such policies and their effects, resources like the Bank for International Settlements (BIS) or the European Central Bank (ECB) offer comprehensive analyses.

In conclusion, while negative interest rates pose significant challenges to the traditional banking model, banks adapt by innovating their services, diversifying revenue sources, implementing stringent cost controls, and selectively adjusting their pricing strategies to maintain profitability.