It's safe to say that the Swiss National Bank's (SNB) announcement on Monday to lower the factor for the interest rate cap on sight deposits from 25 to 22, effective October 1, hasn't made significant waves. This is understandable, as it is primarily a technical adjustment in the implementation of monetary policy. However, the move could still impact interest income and, consequently, the core business of many banks.

What does the factor mean, and how does the SNB justify its decision? To better understand, a brief look back in history is helpful.

Minimum Reserve Requirement: A Tool of Monetary Policy

Before the 2008/2009 financial crisis, liquidity in the system was generally tight. Competent treasurers held only as much cash as necessary to remain solvent, as holding excess funds meant forgoing interest income. One criterion for a bank's liquidity management was the minimum reserve requirement.

At that time, the minimum reserve requirement was designed to ensure a baseline demand for central bank money, serving a monetary policy purpose. It stipulated that banks had to hold a certain percentage of their short-term liabilities in Swiss francs (e.g., customer deposits) as minimum reserves. These reserves included Swiss coins, banknotes, and, in practice, the most significant component—sight deposits held by banks at the SNB.

From Scarcity to Abundance of Liquidity

At that time, the SNB did not pay interest on these sight deposits, so it was not attractive for banks to hold more than necessary. The SNB provided liquidity to banks through the money market, where they also traded liquidity among themselves. Those with excess liquidity would lend it to those with a shortfall at an interest rate, balancing the system.

Since the financial crisis, liquidity has shifted from being scarce to abundantly available in the system due to SNB monetary policy. This shift is because the SNB financed its foreign currency purchases with newly created Swiss francs. For example, when the SNB buys euro-denominated bonds from a bank, it credits the corresponding Swiss franc amount to that bank’s account, increasing the total sight deposits.

Renaissance of the Minimum Reserve Instrument

Due to the liquidity surplus, the minimum reserve requirement has been massively exceeded since then, with Swiss banks' fulfillment rate reaching over 2000 percent in May of this year. This means that the instrument has completely lost its original monetary policy purpose of ensuring a minimum demand for central bank liquidity.

However, following the financial crisis, there was an unexpected renaissance of minimum reserves. From 2015 (after the removal of the minimum exchange rate of 1.20 Swiss francs per euro) until 2022, the SNB imposed a negative interest rate of –0.75 percent. This meant that banks had to pay for their high sight deposits. From 2015 to 2021, banks paid the SNB an annual amount ranging from just over 1 billion to slightly more than 2 billion Swiss francs.

From the Threshold Factor for Exemptions...

Banks were not required to pay interest on their entire deposit balances. Instead, the SNB provided them with an exemption threshold to limit the burden on the banking system (and thus on bank customers). This exemption was calculated based on the average of the (monthly reported) minimum reserve requirement over the past three years, multiplied by a factor.

When the SNB began its policy shift in 2022 to combat global inflation in Switzerland, it had to adjust its monetary policy implementation once again. Although interest rates had returned to positive territory, there was still substantial excess liquidity in the system. The SNB would have had to eliminate this excess by selling foreign currency assets on a large scale and quickly, which would have led to a massive appreciation of the Swiss franc and market turbulence—both of which were highly undesirable from a monetary policy perspective.

...to the Factor for the Limit

If excess liquidity cannot be eliminated, the SNB must at least contain it to enforce its (now positive) key interest rate in the money market. It does this by paying interest on banks' sight deposits and by withdrawing liquidity through its own debt securities (SNB Bills) and repo transactions (Reverse Repos).

Unlike the period of scarce liquidity and the interim of negative interest rates, banks now benefit from the implementation of monetary policy. The SNB transfers billions annually as interest on the still massive sight deposits.

Bank Subsidization Holds Political Risks

This «subsidization of banks» carries political risks, especially if the SNB, like in 2023, cannot distribute profits to the federal government and cantons, resulting in billions of lost revenue for them. Consequently, the SNB aims to minimize its burden from interest payments as much as possible.

Therefore, not all of a bank's sight deposits are paid interest at the current key rate of 1.25 percent. Only the portion below the so-called limit is eligible for this rate. The portion above this limit is compensated at a reduced rate of 0.75 percent. This limit is still calculated based on the minimum reserve requirement multiplied by a factor—now termed a «limit factor» rather than a «free allowance factor».

Measures to Reduce the SNB’s Interest Expense

In October 2023, the SNB announced it would lower the factor for the limit on interest-bearing sight deposits from 28 to 25 starting in December, and stop paying interest on sight deposits held to meet the minimum reserve requirement, aiming to reduce its interest expense. Additionally, in April of this year, it raised the (interest-free) minimum reserve requirement, expanding the definition and increasing the reserve ratio from 2.5 percent to 4 percent—the maximum allowed by the National Bank Act. This move was also intended to reduce the SNB’s interest costs.

In its latest statement, the SNB justifies the reduction as necessary to ensure a continued «effective implementation of monetary policy». With the increase in the minimum reserve requirement taking effect on July 1, the limits for banks will inevitably rise over the next three years. The SNB states, «The decision to lower the threshold factor counteracts this increase, thereby ensuring that the implementation of monetary policy remains effective and supporting an active money market».

Mitigating Unwanted Side Effects

UBS economists note in a commentary («European Economic Comment, SNB: Lowers the tiering threshold – implications») that banks' sight deposits currently total 435 billion Swiss francs, which is below the limit of 558 billion Swiss francs. However, this is a general figure; individual institutions might still have sight deposits exceeding their specific limits. Such a bank would have an incentive to offer its liquidity at better terms than the current 0.75 percent on the money market.

It is somewhat ironic that the SNB's recent reduction of the factor is intended to boost activity on the money market (which helps it enforce the policy interest rate) because one of its earlier measures, the increase in the minimum reserve, had the opposite effect. The National Bank seems to prioritize reducing its interest costs over other considerations.

Banking Sector's Interest Business Remains Challenging

At least in this regard, the recent reduction of the factor is unlikely to have undesirable side effects. It initially appears to relieve the SNB from interest costs. However, this adjustment alone does not alter the liquidity situation on the money market; the SNB may need to absorb more funds through SNB Bills and Reverse Repos at a lower factor to enforce the policy interest rate, which could incur additional costs.

Bottom line: The SNB will continue to aim at limiting its interest burden. For commercial banks, the flip side is that the previously lucrative interest business is unlikely to get any easier.

Monetary Policy Shift Leaves Clear Marks

In 2022, the SNB raised its key interest rate from –0.75 percent to 1 percent and further to 1.75 percent. This increase temporarily widened the interest margin, as banks adjusted rates for active business (mortgages and other loans) relatively quickly, while customer deposit rates lagged (it’s worth noting that the negative rates had not been fully passed on to savers either).

The monetary policy shift, marked by interest rate cuts in March and June of this year, is already evident in the semi-annual reports recently released by banks (and those yet to be presented). The interest margin has narrowed again, and customers have become more sensitive to rates.

Moreover, as mentioned, the reduction in interest rates and other measures have led to lower returns on sight deposits, with indications of further rate cuts possibly in September. The outlook for the banking sector’s interest business has significantly dimmed. This doesn’t mean banks will struggle, but the era of lucrative interest income is definitely over.