Q&A: what are negative interest rates?

European Central Bank has cut the interest rate banks receive when they deposit money with the ECB

The ECB has cut its headline interest rate to a new record low of 0.15%, and also imposed negative interest rates of -0.1% on eurozone banks – to encourage them to lend to small firms rather than to hoard cash.

How do negative interest rates work?

Instead of earning interest on money left with the ECB, banks are charged by the central bank to park their cash with it. The ECB cut its deposit rate to -0.1% on Thursday and the hope is that this will encourage the banks to stop hoarding money, and instead lend more to each other, to consumers, and to businesses, in turn boosting the broader economy.

Will it work?

No one knows. In theory it sounds attractive but it has never been attempted by the eurozone and could have unpredictable and unintended consequences. Those consequences include the possibility that banks will pass on to customers the costs they incur for depositing money with the ECB.

A broad risk is that a negative return on parking funds with the central bank might encourage banks to invest in riskier assets to secure a return, potentially driving new asset bubbles and more pain further down the line.

As part of this bid to find alternative investments, banks are likely to increase their purchases of government bonds. However, this has potentially serious consequences if banks are holding bonds to such an extent that government borrowing costs are artificially low. If a financial shock occurs, the banks and governments could find themselves so intertwined and interdependent that they drag each other - and the economy - down.

Has it happened before?

Sweden and Denmark have introduced negative deposit rates on a temporary basis in recent years. In Denmark, the aim was to cap an unwanted rise in its currency, which was pushed higher when foreign money flooded into the country as investors looked for safe havens outside the crisis-ridden eurozone. The move to negative deposit rates did not cause financial meltdown, with the Danish central bank issuing plenty of advance warning. Nor did it lead to a noticeable change in the interest rates charged by banks for bank loans. But then again negative deposit rates have never been tried by an economy on the scale of the eurozone, and the fear is that the Danish example will have little read-through for the 18-member bloc.

What would it mean for me?

Very little in terms of the detail of the policy and any impact on retail banking rates. However, if it provided the desired boost to the eurozone economy and put it on the path to a sustainable recovery, that would be good news for the UK economy too. On the flipside, if there were some nasty unintended consequences, including a shock to the eurozone banking system, Britain's economic recovery could potentially be undermined.