Explainer-ECB to change how it supplies banks with vital liquidity By Reuters

FRANKFURT (Reuters) – The European Central Bank will announce on Wednesday the outcome of its Operational Framework Review, a technical but vital exercise that will set rules for how it provides liquidity to commercial banks in the coming years.

The following explains key aspects of the review and previews some of the likely decisions.

WHAT IS THE OPERATIONAL FRAMEWORK AND WHY CHANGE IT?

The ECB’s operational framework is the backbone of the financial system because it sets out how the central bank steers short-term money market rates and thus transmits its monetary policy to banks and ultimately the broader economy.

The ECB has been pushing cash into the system for over a decade with the aim this money will find its way into the real economy of the euro zone to generate growth and inflation.

This abundance of liquidity, a remnant of the bloc’s debt crisis and a period of anaemic inflation the ECB tackled by taking interest rates negative, is incompatible with the current economic reality of rapid price growth and high interest rates.

The ECB’s biggest problem is that this cash – there is 3.5 trillion euros of excess liquidity sloshing around the system – is costing billions of euros because lenders deposit the funds back at the ECB overnight, at an interest rate of 4%.

The other issue is that banks now rely predominantly on the ECB for liquidity, which has effectively killed the interbank market. Some policymakers now want to revive interbank lending, with the central bank to act as a back up.

HOW DOES THE ECB CURRENTLY OPERATE?

The ECB has provided cash over the past decade mostly via three channels.

It printed trillions of euros and used them to purchase government and corporate bonds from the market, a policy known as quantitative easing (QE). Most of these remain on its books and yield much less than the 4% it has to pay out on deposits.

It also gave banks multi-year loans via so-called Targeted Longer-Term Refinancing Operations or TLTROs, though these have been discontinued and most funds were repaid early.

The ECB also provides cash via regular tenders, including the weekly main refinancing operation, a facility that has seen little demand in recent years.

WHAT IS LIKELY TO CHANGE?

The ECB is expected to adopt a “demand-driven floor” system under which banks will have to tell the ECB how much they want to borrow instead of having funds thrown at them by the central bank via bond purchases.

This change to a demand-driven system will reduce the amount of liquidity the central bank must maintain and encourage banks to return to lending to each other.

The central bank will still effectively set the market “floor” – the lowest rate at which banks would lend to each other – via the rate it pays on bank deposits, currently 4%.

This will remain the prevailing rate for money markets while the interest rate banks must pay to borrow funds from the ECB at auction – currently 4.5% – will be the source of marginal funding for banks.

To avoid the big gap between the two rates lifting market rates from the “floor”, the ECB is likely to narrow the disparity, probably by lowering the main refinancing rate.

This rate adjustment is likely to come once the ECB starts cutting borrowing costs from record highs in the coming months.

The ECB is also likely to say that some of the liquidity it provides will be done via a “structural portfolio” of bonds and longer-term loans.

This means that at some point the bank would stop letting bonds it bought under QE expire and could restart some purchases to maintain a certain level of cash in the system.

It is unlikely to specify the optimal size of its balance sheet, however, and will instead keep its guidance vague.

One change some policymakers lobbied for, an increase in minimum reserves for commercial banks, is unlikely to happen.

Banks are required to keep some of their cash at the ECB at a zero percent rate and some, particularly Germany’s central bank, had wanted to increase this ratio so that more bank deposits go unremunerated, lowering its own interest bill.

HOW QUICKLY WILL THE ECB ADJUST TO A NEW FRAMEWORK?

Not much in the near term: whatever the ECB decides will take years to implement in full.

Bonds purchased during a decade of crises will expire over years, meaning excess liquidity will shrink only slowly. The banking sector as a whole will have more reserves than it needs until 2029, according to the ECB’s own estimates.

The ECB could speed up the process by selling the bonds but this would…