The major risk, of course, is that because of the fractional-reserve banking system, if enough depositors withdraw their funds the bank collapses. If a bank maintains a reserve of 10% and depositors withdraw a total of 10% of their deposits, the bank will have no money left to satisfy withdrawals, pay checks drawn on the bank’s accounts, etc., and will have to cease operating. In fact, even less than 10% of deposits being withdrawn can start to lead to problems with payments. If that were to happen the bank would have to start coming to the discount window for help. If it had to rely on discount window lending enough times, regulators might look to shut the bank down preemptively. If a big enough bank goes down, or if enough banks find themselves in such a situation, panic might set in and result in a bank run, with depositors rushing to withdraw their money while they still can. Witness the situation in Cyprus a few years ago.
That is the risk that the move toward negative interest rate entails, but one which no central bank is willing to admit. It must be sitting at the back of policymakers’ minds, but they probably think that if they don’t discuss the possibility of a total collapse of the banking system then it won’t ever happen. We are in uncharted waters right now, with central bankers who have failed over and over again yet who still possess an unshakable confidence in their own knowledge, expertise, and abilities, the “pretence of knowledge” which Hayek so eloquently explained. A banking system collapse is closer now than at any time previously, and probably closer than anyone suspects, which is why negative interest rates are so dangerous. All it takes is just one more rate cut, one more move into further negative territory to push enough people off the edge, to get them to withdraw their deposits, which will result in a severe banking panic. Central banks are playing with fire when they institute negative interest rates and we’re all at risk of getting burned.
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