Lower reversal limit of the European Central Bank deposit rate and sustainability of traditional banking business model

Abstract

PurposeThe purpose of this paper is to present an empirical analysis of the European Central Bank (ECB) deposit rate dynamics during 2014–2020, attempting to answer how deep could be cut further this rate without causing persistent yield curve inversions (YCI), i.e. lower yields for longer terms. It addresses the sustainability of the traditional banking and shows that inverted yield curves would require changing the banking-as-usual model to the government-guaranteed long-term-borrowing coupled with short-term-lending. This research poses the question of whether the banking sector should become a public utility.Design/methodology/approachThe future scenarios of negative interest rate (NIR) behavior are modeled seeking to increase the understanding of NIR environment. Using an event-study design, empirical analyses of the ECB deposit rate cuts on the Euro Over-Night Index Average rates is performed at different maturities.FindingsThis study finds that, starting from the lower limit of 80 basis points below zero, the ECB deposit rate is likely to result in complete YCIs.Social implicationsThis paper evidences that moving rates into a more negative territory is likely to be completely counterproductive for banking industry, implying that banking at such conditions would become heavily dependent on governmental support. The results shed light on the interdependence of the banking business, financial monetary policy and welfare of the society, providing policymakers with empirically defined milestones for policy implementations.Originality/valueThis paper clarifies the impact of the ECB deposit rate on the overall shape of yield curves. The novelty of this research resides in investigation of YCI by simulating NIR dynamics.