LONDON, Sept 13 (Reuters) - The European Central Bank doubled down on its negative rate policy on Thursday, meaning banks will now have to pay 0.5% interest simply for depositing much of their spare cash with it - an attempt to make them lend more to kickstart the economy.
While such a policy is widely considered valid only for economies in Europe and Japan with chronically low inflation and weak growth, the idea is attracting other supporters elsewhere - not least U.S. President Donald Trump, who has labelled U.S. central bankers "boneheads" for not resorting to it.
This is how a negative rate policy works alongside some of its potential pitfalls:
WHY HAVE SOME CENTRAL BANKS ADOPTED NEGATIVE RATES?
To battle the global financial crisis triggered by the collapse of Lehman Brothers in 2008, many central banks cut interest rates near zero. A decade later, interest rates remain low in most countries due to subdued economic growth.
With little room to cut rates further, some major central banks have resorted to unconventional policy measures, including a negative rate policy. The euro area, Switzerland, Denmark, Sweden and Japan have allowed rates to fall to slightly below zero.
HOW DOES IT WORK?
Under a negative rate policy, financial institutions are required to pay interest for parking excess reserves with the central bank. That is, any surplus cash beyond that which regulators say banks must keep on hand. That way, central banks penalise financial institutions for holding on to cash in the hope of prompting them to boost lending to businesses and consumers.
The ECB introduced negative rates in June 2014, lowering its deposit rate to -0.1% to stimulate the economy. Describing the euro zone economy as mired in a period of "protracted" weakness, ECB chief Mario Draghi announced on Thursday a 10-basis-point cut in the deposit rate to -0.5% from its previous -0.4%.
The Bank of Japan (BOJ) adopted negative rates in January 2016, mostly to prevent an unwelcome strenghtening of the yen from hurting an export-reliant economy. It charges 0.1% interest on a portion of excess reserves financial institutions park with the BOJ.
WHAT ARE THE PROS, CONS?
Aside from lowering borrowing costs, advocates of negative rates say they help weaken a country's currency by making it a less attractive investment than other currencies. A weaker currency gives a country's export a competitive advantage and boosts inflation by pushing up import costs. This is one of Trump's motivations for wanting negative rates on the dollar.