Here’s my humble attempt to explain the logic of “negative interest rates” over at Enhancing Capital. I’ve found some good stuff written on this topic already, but nothing that I thought was accessible to the average person. Hopefully this report helps to fill that gap.

One highlight I’d like to point out is that negative interest rates on reserves at the central bank aren’t necessarily a “game changer.” They do reverse the logic of interest on reserves (commercial banks pay interest to the central bank instead of the central bank paying interest to commercial banks), but they don’t mean that banks are all of a sudden going to try to get rid of all their reserves. This hasn’t been the experience of banks in the Eurozone, where negative rates already exist on some deposits at the ECB. It won’t be the experience of banks in the U.S. if the Federal Reserve takes similar measures. Finance is all about trade-offs—paying a small fee to hold reserves at the central bank could still be a more attractive option to commercial banks than making more loans to keep their negative interest-bearing reserve balances from growing. What matters is whether commercial banks can identify enough credit-worthy borrowers whose risk of default is low enough to promise a higher return than the negative interest rate charged by the central bank. If not, then banks might very well be content to pay interest to the central bank rather than make more loans.

Finally, I realize this report might seem mistimed. If anything, talk on the town regards when the Fed is going to tighten monetary policy, not loosen it. My explanation is three-fold:

1. I’m not convinced tightening is as imminent as many analysts are making it out to be, for reasons I’ve explained before.
2. It’s important for investors to understand the logic of negative interest rates before they happen, not after (no harm in being over-prepared!).
3. The ECB has already imposed negative interest rates, and the Bank of Japan has toyed with the idea. The policies at these banks, of course, have ramifications worldwide, and investors everywhere ought to understand what negative interest rates are.

Read the full report at EnhancingCapital.com.