The ZLB and the impending race into Swiss CHF1000 bank notes

Two things worth noting:

1. As many of you know by now, the Swiss National Bank (SNB), Switzerland's central bank, just reduced the rate that banks earn on deposits held at the SNB by half a percentage point to -0.75% (from -0.25%). The SNB had only recently instituted a negative deposit rate, having reduced it to -0.25% from 0% this December. The SNB will also be targeting a 3-month LIBOR rate of -1.25% to -0.25%, down from the previous range of -0.75% to +0.25%


2. The SNB issues the world's largest paper bearer note denomination, the hefty CHF 1000 note (pictured above). It's worth around US$1143.

The first is significant because as yet, no central bank has ever brought rates this deep into negative territory. The ECB's current deposit rate is set at -0.2% while Denmark's central bank, the Danmarks Nationalbank (DNB), applied a negative deposit rate of -0.2% on deposits that banks placed with the DNB in 2012. Neither of these top the SNB's ultra-low -0.75% rate.

The second point is significant because neither the ECB nor the DNB issue a note that approaches the real value of the CHF 1000.

Why is the conjunction of these two observations important? In short, we get to observe in real time how tightly the so-called zero-lower bound (ZLB) binds. When a central bank reduces the rate it pays on central bank deposits below 0%, arbitrage dictates that all other short term interest rates will follow along, including rates on government t-bills and insured bank deposits. However, one asset interferes with this adjustment: cash. Cash carries an implicit yield of 0%. If deposits or t-bills are being penalized at a rate of 0.25% per year, there are significant incentives for everyone to convert these assets into zero-yielding paper equivalents in order to avoid the 0.25% penalty. Not only will commercial banks all convert their deposits at the central bank to cash, but the public will clear out their bank accounts in order to hold paper. The upshot is that interest rates can't fall below 0% lest the  entire country turn into a 100% cash economy.

In practice, the 0% bound isn't a tight one since paper currency incurs storage and transportation costs whereas electronic deposits don't. What this means is that a depositor will grudgingly accept a slightly negative deposit rate in order to avoid having to bear the inconveniences of ungainly cash. So the zero lower bound actually lies a bit lower than 0%, let's say -0.4%. However, reduce rates far enough below that and the dash to cash beings.

This is where the CHF 1,000 note comes into the picture. The larger the denomination of paper currency issued by a central bank, the lower the storage and transportation costs. Take CHF 1,000,000 worth of CHF 20 notes. That's 50,000 paper notes. The costs incurred in counting, double counting, checking for counterfeits, packaging, loading into an armoured car, unloading into a vault, paying storage costs on that vault, and finally insuring the hoard will be quite high. Now imagine CHF 1,000,000 worth of CHF 1000 notes. That amount to just 1,000 slim paper notes, a fiftieth of the amount. Handling and storage costs come out to much less. The point being that thanks to the CHF 1,000 note, the zero lower bound binds a bit more tightly in Switzerland than anywhere else in the world.

What I'd expect over the next few months is a mad dash out of deposits into these colourful bits of paper. Luckily, the SNB provides data on its note denominations, which I've charted below going back to 1990.

The value of CHF 1000 denomination notes in circulation. Source: SNB

You can see that in general, the value of CHF 1,000 notes outstanding has grown quite quickly since 1990 and now comprises around 61% of the entire value of the Swiss note circulation. While that tally retreated a bit in 2014, it should start to grow at an above-trend rate in 2015 now that negative rates are in effect. The actual process will go something like this; the Swiss public will ask to convert their bank deposits into CHF 1000 notes, the banks being obliged to provide these notes by going to the SNB and converting their SNB deposits into cash.

If this process doesn't occur, the implication is that the costs of holding 1000 notes are even higher than 0.75% a year, thus giving the SNB even more breathing room to reduce rates.

I'd expect ongoing conversion into 1000 notes to impose a significant burden on the SNB, threatening both the banking system's deposit base and the effectiveness of monetary policy. There are a number of fixes that the Swiss might consider to offset this burden. First, the SNB can bump interest rates back up in order to stem the mania for 1000 notes, hardly an alternative if it is trying to get inflation back up to  its target. Alternatively, the Bank may decide to call in and demonetize the CHF 1000 notes, forcing everyone to accept five CHF 200 notes in its place (an idea discussed here). Since the 200 incurs more carrying costs than the 1000, the conversion into cash will be forestalled and the lower bound will have effectively been loosened downwards. Lastly, the Swiss might consider adopting a crawling peg between cash and deposits, as advocated by Miles Kimball.

The next and last option is the most interesting. When the public asks the banks for CHF 1000s, and the banks ask the SNB for 1000s, the SNB can just say no. In doing so, the SNB will have frozen the quantity of 1000s in circulation.

What will happen next will amount to an instance of Gresham's law. Since a CHF 1000 note is better than five CHF 200 notes due to its lower carrying costs, and 200s can no longer be converted on demand into 1000s thanks to the SNB's freeze, the 1000 should trade in the market at a premium to its face value, say CHF 1012 or 1013. However, legal tender laws typically stipulate that a note cannot discharge debts at more than its face value, thereby resulting in the forced undervalution of the 1000 note in trade. As a result, the Swiss public and its banks will hoard their 1000s rather than spending them, preferring instead to make payments and settle debts with lower denominations notes. Thus we get a modern version of Gresham's law, whereby 'good' CHF 1000 notes are driven out of circulation by 'bad' lower-denomination CHF notes. Think of it as an unofficial demonetization of the 1000.

Ultimately, I think that this last solution is the easiest and lowest cost alternative for the Swiss to fix their impending problem of mass paper storage at the negative interest rates. It's a temporary fix, however. A permanent solution will require outright demonetization of large denomination notes, or something like Miles Kimball's plan.