2&C=IS5&C=2DF&Filter=N6 To put it bluntly, the ECB will want to steer the amount of carry trades undertaken by the Italian banking system. Not too
much (which could be seen as ‘giving the Italians a free pass), and not too little, which would put undue pressure on Italy.
The BOE-like framework has the added benefit that the ECB can continue to focus on (aggressively) shrinking its
balance sheet via Quantitative Tightening while keeping its money market framework simple with one single
overnight rate. Of course, money markets rates will still increase relatively more in member states where reserves
are relatively low compared to member states where reserves are relatively high. As it should be, it must be
emphasized. But the ECB would limit such divergences by aligning the MRO rate with the deposit rate. More
importantly, the ECB would prevent a shock-like increase in money market rates and broader interest rates in
member states where the MRO becomes the leading interest rate when the MRO still stands 50bps above the
Time is short for the ECB to overhaul its operational framework. By June, the relative level of reserves in the
Italian banking system will have returned to its pre-pandemic level, while it will remain elevated in the other big
member states. By March 2024, when the next big TLTRO tranche matures, Italian banks will be short of reserves.
If one expects no sizeable net capital inflow into Italy, and banks not being able to cover the expected reserve
shortfall with private borrowing, then the Italian banks will have to turn to more costly ECB funding at the MRO
rate (which will be 50bps over the deposit rate). The ECB will consider that situation to be unwarranted
fragmentation of its monetary policy. Hence, expect the ECB to align the MRO rate with the deposit rate in the
second half of the year. That’s our base case scenario.
Of course, there is a communication problem with aligning the MRO rate with the deposit rate if the ECB isn’t able
to do so as part of rate hikes over the course of two monetary policy meetings. Put differently, if the ECB can’t
increase the deposit rate relative to the MRO rate so that the two are equal, it will have to simply cut the MRO
rate. The ECB could find it difficult to convince the market and the public of the merit of cutting the MRO rate
while at the same time promising to keep interest rates high for long(er) to fight stubborn inflation. Aligning the
two interest rates could easily be seen as the start of the easing cycle, or the ECB ‘going soft’ on Italy (again).
A workaround would be an apt communication strategy, rename the MRO rate or simply put in place a new
standing lending facility with the interest rate equal to the deposit rate. Of course, the ECB would needlessly
complicate its operational framework, a framework that has served it well since its inception.
If the obstacles to aligning the MRO rate with the deposit rate prove to be insurmountable, the deposit rate will
remain the leading interest rate in the bulk of the member states, while in Italy – and perhaps others – the MRO
rate will be the leading interest rate. Or: a floor system for most, and a corridor system for some. If that would be
the case, it would be best if the ECB managed to sneak in a corridor-narrowing interest rate increase in the
monetary policy meetings in the third quarter (or perhaps even fourth quarter). That would soften the blow for
Italy and other member states with relatively low bank reserves.
As an alternative to the BOE-like system of aligning the central bank deposit rate with the central bank lending
rate, we have seen trial balloons that all come down to the following: let the ECB pay more for central bank
reserves as to tighten money market conditions in the high-reserve member states in particular. At the March
2023 Money Market Contact group meeting, trial balloons pertaining the usual suspects were floated: ECB
certificates and/or a standing facility for nonbanks. Regarding the former, think of the weekly deposit tenders
that the ECB held from 2010 to 2014 that paid 50bps over the deposit rate. So, equal to the MRO rate. If that’s
the case, ESTR would settle below the 1-week interest rate/MRO rate, with the spread dependent on the size of
the new facility and the amount of reserves in the banking system. The bigger the size of the 1-week facility (or
the greater the amount of ECB certificates outstanding, and the lower the amount of reserves in the banking
system, the tighter the spread between ESTR and the MRO rate/1-week rate.
ECB 1-week certificates or a 1-week deposit facility are less likely than the MRO rate/deposit rate alignment.
For starters, the ECB will be forking over even greater amounts of interest payments on excess reserves to the
banking system. That’s a problem as many – if not most – national central banks are suffering heavy losses on
their bond portfolios that yield far less than what they pay on bank reserves. Furthermore, the notion of ECB certificates will set off alarm bells ringing in core countries as they will be seen as euro bills in disguise. Better call it weekly deposit tenders then.
Thirdly, a 1-week facility will likely exacerbate the problem of low reserves in Italy, with the damage increasing
the greater the size of the facility. Italy would become unnecessary and unwarranted collateral damage in
mopping up reserves in the core.
Fourthly, the ECB will need to estimate ex ante what the level of reserve scarcity is. Then, the central bank will
need to fine-tune the size of the facility to prevent a blow-out of money market rates or a money market seize up
like the 2019 US repo market carnage, or the most recent turmoil surrounding SVB and other smaller banks.
Fifthly, why would the ECB come up with a 1-week facility when TLTRO-created reserves will all but disappear
in the next twelve months, and when Quantitative Tightening has just begun? Better wait and see. Finally, the
ECB will needlessly complicate its operational framework while a simple and elegant solution is available: the
aforementioned alignment of the MRO rate with the deposit rate.
On a final note, we see odds of a standing facility for nonbanks as very remote. For starters, the ECB is already
working on the panopticon that is the ‘digital’ euro, which will give nonbank financials quasi access to the ECB,
but on a marginal scale though. Furthermore, the problem of excess wholesale deposits acting as a drag on banks’
balance sheet and profitability has started to ease. The chart below shows the ratio between all wholesale
liabilities to total/assets liabilities. The ratio peaked in December 2021 and has been on a marked decline ever
since. QT will accelerate the decline as the nonbank private sector will hold an increasing amount of (government)
debt securities, thus easing the pressure on bank balance sheets.
AFS GROUP AMSTERDAM
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