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On average banks pay about 2% less on bank accounts than they receive on riskless assets. When rates go to zero, this revenue goes to zero (without reducing costs). They don't cut customer rates below 0%. So they are right to dislike low rates, though maybe not right to lobby for premature central bank rate increases.

Max: I think that's roughly right. But one way that banks can implicitly adjust the interest rate they pay on chequing accounts is by varying service fees, in particular by varying fees according to the average or minimum balance in your account. (If they waive fees when you have a larger balance, it's like paying interest.) So I'm not sure if it's exactly right. But I don't see them implicitly paying negative interest this way, because that would be like cutting fees if you have *below* a minimum balance.

Interest is what we pay when our assets diverge from liabilities. It is he surplus needed to cover planning error. Interest over time is the rate of divergence between assets and liabilities. Positive rate.

OK, with that, we get bankruptcy. In bankruptcy the assets already have a large divergence from liabilities. The bankruptcy judge goes through a sequence of trades that cause assets to converge to liabilities. Negative rate.

Elsewhere, returning an item to the store, recalling automobiles to the factory.

“banks make profits off interest rate spreads, between borrowing and lending rates, and not on the level of interest rates”

Not quite, Nick.

Not too related to the main theme of your post - but visualize a bank balance sheet and think of the common equity (book) position down in the right hand corner of the balance sheet. That position has a zero interest cost for purposes of determining profit. So the total net interest margin of the bank includes not only the asset/liability spread portion (calculated on the basis of matching some chunk of interest earning assets to the remaining (non-common-equity) interest-paying liabilities), but that ‘slice’ of the balance sheet that includes an ‘interest rate mismatch’ between some chunk of interest earning assets and a (permanently) zero interest cost book equity position. This is a non-trivial contribution to the total net interest margin of the bank, and it means that the contribution of this portion does indeed benefit from a higher level of interest rates. The exact nature of that contribution in turn depends on how the treasury function manages the interest rate sensitivity of that part of the balance sheet (along with the rest of the balance sheet). This is all part of interest rate risk management for the bank as a whole.

Another type of zero bound to consider in banking.


JKH: I think I see your point. I had missed that. I think it's the same as the distinction between what we economists call "accounting profits" vs "economic profits". The difference is that economic profits consider the opportunity cost of the firm's own assets ("equity"). Like if I quit my job to start a business, I should include my foregone salary as a cost of that business when calculating profits. Not sure which definition of profit applies here (though, naturally, I'm biased).

(If I quit my job to start a business, and can't get my old job back if my business fails, then my foregone salary becomes a sunk cost, and no longer an opportunity cost, so the two concepts of profit line up again. Might be the case for banks.)

I think you’re referring to a separate issue Nick. Whatever you do with asset values in the calculation of profit – ‘economic’ or ‘accounting’ – the net interest margin must be a component of the fully calculated profit. You can choose to fluctuate asset values (and liability values for that matter), or not, in the calculation of profit. In fact, standard bank accounting includes both types of asset value accounting, depending on the nature of the asset business. (For example, trading positions are marked to market; residential mortgage positions are not.)

My point relates purely to the calculation of that net interest margin, which must always be a component of the fully calculated bank profit. And you can split the interest margin into two different sections of the balance sheet that originate it – the common equity position and the rest. There is no interest cost on the common equity position. So profits go up when the general level of rates goes up, other things equal.

"(If I quit my job to start a business, and can't get my old job back if my business fails, then my foregone salary becomes a sunk cost, and no longer an opportunity cost, so the two concepts of profit line up again. Might be the case for banks.)"
I think JKH's point WAS that the bank's equity capitalization is a sunk cost. In the extreme where a bank is fully equity capitalized and employs no leverage, changes in rates would flow directly to profits. To extent you substitute in (floating rate) liabilities for equity finance, the bank is less exposed to rates, but is still long.
The capital isn't truly sunk - a bank can always liquidate all or part of its portfolio to return capital to shareholders - but in the short-term it is clear that bank managers want to be able to earn higher returns on their equity capital base.
In medium to longer term, this shouldn't matter, as the interest rate spreads banks charge are set competitively, not fixed. In a lower-rate, lower-profitability environment, banks will be less willing to extend loans at previous customary spreads and demand higher spreads to justify their equity cost of capital. Example - 3:1 leverage, 4% funding rate, 2% spread - $1000 loan generates $30 in profits on $250 in equity, or 12% ROE. If funding rate falls to 2%, profits fall to $25, or a 10% ROE. But if the fall in rates is seen as permanent, and the 12% remains the cost of equity, then new loans will be done at a 2.5% spread to restore previous profitability.

" If robots can reproduce themselves at 10% per year then the robot rate of interest will be 10%. But if the price of robots is falling at 15% per year relative to consumption goods, the consumption rate of interest will be minus 5%. "

Just wondering if you personally relate this area at all to the General Theory Chapter 17.

I've spend some time on that chapter from time to time - seems super brilliant to me.

I have a question on 'And if our consumption basket includes a rising proportion of services that cannot easily be stored, even metaphorically,'.

I really liked your earlier description of investment: 'All forms of investment are just like storing apples, except that we first transform the apples into trees, and then back into apples. Or use the resources that could have produced apples for current consumption to produce something else to help us produce apples for future consumption." Why can't this be applied to the production of services ? Rather than producing haircuts in the present I can instead invest in human and physical capital to increase the productivity of haircuts in the future (more skilled hairdressers who can cut faster using electric, lazer-controlled scissors or whatever) and in this way transport haircuts into the future with "negative wastage". Are you saying that it is just an empirical fact that services have less potential for roundabout production methods than physical consumption goods or that there is something about services that makes this necessarily true ?

MF: We can also invest in non-haircut sector productivity so that we can transfer the economised resouces back to haircut. Which is a good part of what happened in manufacturing to service transition in the 20th century.

JKH: "Just wondering if you personally relate this area at all to the General Theory Chapter 17."

I hadn't thought of that connection until you mentioned it, but yes I think it's there.

MF: I agree with what you say there. Yes, by training future hairdressers we can invest in services. But the investment opportunities (plus possibility for big technological improvement) seem, empirically, to be rather limited. I don't think it's necessarily true about all services.

Great post, Nick. The last paragraph effectively sums up what Eric and I argue for UK policy: https://ftalphaville.ft.com/2017/11/23/2196091/guest-post-time-for-a-uk-sovereign-wealth-fund/ and https://www.philosophyofmoney.net/safe-asset-issuance-discovery-oil/

Tristan: Thanks! I'm still collecting my thoughts for my next post, following up on that last paragraph.

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