Read the WSJ article carefully, and answer the following questions based on what you have learned about dividend policy. Please use your words, explain intuitively.

Article #1: Negative Interest Rates

How does the central bank influence interest rates?

Where do excess reserves come from and how do banks use their excess reserves?

What do central banks want to accomplish by imposing a negative deposit rate?

What is the impact of negative rates on economy?

Everything You Need to Know About Negative Rates

The Bank of Japan, the European Central Bank and several smaller European authorities have ventured into the once-uncharted territory of negative interest rates. But what are negative rates, and how do they come about?

The Bank of Japan, the European Central Bank and several smaller European authorities have ventured into the once-uncharted territory of negative interest rates. But what are negative rates, and how do they come about? Here are some questions and answers.

How do central banks work?

All are a bit different, but as a rule the central bank is the bank for a countrys (or monetary unions) banks. Commercial banks have accounts with the central bank, just as households and businesses have accounts with commercial banks. A commercial banks account at the central bank is part of what makes it a bank: It allows it to go about the daily business of moving money.

What is a negative interest rate?

Its like a normal interest rate, except the lender pays the borrower.

Back to central banks

The most basic rate in a financial economy is the rate one commercial bank will pay another for the simplest, shortest loan: a loan of electronic cash overnight. Since commercial banks use the central bank as their bank, such a loan moves money from one banks central-bank account to anothers. The funds in these accounts are called reserves.

So how does the central bank influence that rate, called the overnight rate, or the Fed-funds rate in the U.S.?

First, it can directly set some boundaries.

The central bank can lend to commercial banks, simply by creating new reserves. Perhaps the commercial bank that is borrowing is doing so because it needs the reserves to make a transfer to another bankin which case the new reserves would be moved to the central-bank account of that second bank.

The central bank can charge interest on the loan it made to the first bank, and it can pay interest on the deposit it is taking from the second bank. Those rates provide a ceiling and floor on the overnight rate: One bank wouldnt borrow reserves from another bank if it could get the same loan cheaper from the central bank. Likewise, one bank wouldnt lend reserves to another if it could get a better rate simply by leaving them on deposit.

Historically, central banks have kept broad space between the floor and the ceiling, and have manipulated the overnight rate by stepping in to the market for reserves. But that technique is less powerful in the era of quantitative easing, and central banks are now directly making use of the boundaries (or at least of the floor.)

What rate is now negative in Japan and the eurozone?

The deposit ratethe floor. Instead of getting paid for depositing with the central bank, the commercial bank now pays the central bank when it does.

Does this mean interest rates are negative?

Some, but by no means all. The ECBs chief interest rate is its main refinancing ratea rate paid by banks when they borrow from the ECB for longer terms than overnight. That rate is 0%. The Bank of England uses a deposit rate as its principal rate. (It is positive, at 0.25%.) To most people, interest rates means the rates paid on things like mortgages or car loans or credit cards. With rare exceptions, those rates are still positive.

How does a central bank actually impose a negative rate on deposit accounts?

It makes the electronic balances in those accounts shrink.

What does a commercial bank do when deposit rates are negative?

In theory, it should want to get rid of its extra reserves, because those have to go in a central-bank deposit account and will be shrunk. (Most central-bank regimes provide a way to avoid at least some of the negative-rate penalty: Banks are only charged for reserve balances above a certain amount, for example. But holding additional reserves carries a cost when rates are negative.)

Cant commercial banks lend excess reserves to customers?

No. Reserves can only be held by institutions that have reserve accountsgenerally other banks and possibly the government. Its a closed loop. (Well, almost closed: Electronic reserves can be exchanged for bank notes.) Banks lend and borrow reserves among themselves. They can also buy stuff, like bonds, with their reserves, but such transactions just move reserves around among banks.

Why would a bank need to borrow reserves from another bank?

For starters, the bank might need to meet a minimum threshold for reserves set by the central bank or regulators.

But banks also need reserves to handle electronic transactions across the banking system. A customers deposit at a bank is just a loan to the bank. The funds arent kept in a vault. So a transfer of electronic money from a customer of Bank A to a customer of Bank B is a transfer of Bank As debt to Bank B. And Bank B needs to be compensated by Bank A for taking on the obligation. That compensation comes in reserves: Bank A transfers reserves to Bank B.

Where did the excess reserves come from in the first place?

The central bank created them. In normal times (and it has been a long time since weve seen normal times,) banks collectively more or less hold just the reserves they need, and they borrow and lend reserves among themselves. The ECBs deposit facility, the one now subject to negative rates, had practically nothing in it until late 2008.

In these abnormal times, central banks have created huge volumes of extra reserves amid their emergency action: During the eurozone crisis, banks were too scared to lend to each other, so the ECB allowed needy banks to borrow cheap money in huge volumes directly from the central bank. And when a commercial bank borrows from the central bank, the central bank credits the commercial banks account: more reserves are created.

The Federal Reserve, the Bank of Japan, the ECB and the Bank of England have undertaken bond-buying quantitative-easing programs since the financial crisis. Each time the central bank buys a bond, it credits the reserve account of the bank whose customer was the seller. Yet more reserves.

Central banks created the extra reserves for which they are charging banks?

Yes. Thats why negative rates are often seen as a tax on banks.

So what does a negative deposit rate at the central bank accomplish?

It pushes down short-term rates on other types of lending. In theory, that is supposed to provide an economic boost. And, also in theory, it weakens the countrys currency.

How exactly does it make other lending cheaper?

Banks keep their excess reserves in a central bank deposit account. There are a lot of excess reserves, so there are a lot of banks trying to get rid of them by lending them to other banks. That competition pushes the overnight rate down, until its close to the deposit rate.

Those overnight rates drag down other rates: the rate one bank will pay another for a one-month loan, for instance, and a three-month loan and a one-year loan and so on. And those rates influence business and consumer rates, such as mortgages.

Negative rates also spur banks and other investors to buy things that are very much like moneyshort-term debt of ultrasafe governments.

Rates for financing in the capital marketsthat is, the interest rate a company gets if it sells bonds to investorsare linked to the yields on government debt. All other things being equal, they go down when government-debt yields go down.

How does it weaken the currency?

Low rates should make euro investors try to move to places where interest rates are higher, such as the U.S. When they do so, they sell euros and buy dollars. (The same principle applies with positive rates.)

This can cause a cycle of rate-cutting.

The Swiss National Bank, for instance, wants to keep the Swiss franc from strengthening against the euro. So when the ECB goes negative, the SNB must go more negative.

Does it actually help the economy?

Its hard to say. There havent been sharp turnarounds in the countries that have tried negative rates.

It remains to be seen whether stronger benefits come at more-negative rates. And its impossible to know whether things might have been much worse had the countries not tried negative rates.

Isnt this bad for banks?

It is. Banks do lots of things, but the very core of banking is lending money at higher rates than you pay to depositors: Lending at 6% and paying depositors 2% is a nice business. But banks are now lending at extremely low rates, yet they have a hard time pushing the rates they pay depositors much below zero.

Why?

Depositors, especially smaller ones, can hold cash instead of facing negative rates. Cash is like a deposit with an interest rate of 0%. It doesnt shrink: 10,000 in cash will be 10,000 tomorrow. Might want to buy a safe.

Commercial banks get the cash they give to their customers from the central bank: The central bank gives them bank notes and reduces their reserve balances. (Thats how reserves escape the closed loop.)

Thats good for banks, thendont they want to get rid of excess reserves?

To a degree. But banks dont want customers to yank their deposits en masse. It would be better for banks if they could find a way to keep customers but charge them negative rates.

For central banks, it defeats the purpose of negative rates: If customers suddenly pulled huge amounts of deposits, commercial banks might start needing reservesand that demand would push the interbank lending rate up, exactly the opposite of what central banks are trying to do.

How negative could negative deposit rates get?

No one knows. At a modestly negative deposit rate, cash probably isnt worth the hassle: You need vaults and guards, and its difficult to use in large transactions. But at some point, that calculation changes.

What about the Fed? Can it go negative?

Possibly. Fed Chairwoman Janet Yellen has suggested as much. There are some wrinkles. Heres one: The Feds version of a deposit rate, called interest on excess reserves, is now at 0.5%. But there are some government-linked institutions with accounts at the Fed, such as the Federal Home Loan Banks, that arent eligible to receive that interest paymentthey get 0%. So those institutions have an incentive to lend reserves at less than 0.5%. And they do. As a consequence, the federal-funds ratethe overnight rate in the U.S.is a bit below the floor established by the deposit rate.

If the deposit rate went negative, those institutions wouldnt have an incentive to lend. The drop in supply might press the overnight rate upagainst the grain of what the Fed would be trying to do.

Colin Barr contributed to this article.

Write to Charles Forelle