ECB gets rid of subsidy on bank loans to mop up cash

By Francesco Canepa and Yoruk Bahceli

FRANKFURT (Reuters) – The European Central Bank on Thursday got rid of a subsidy on over 2 trillion euros of loans to banks to encourage them to repay early, a move designed to mop up excess cash but which was criticised by the banking industry.

The ECB has come under pressure to change the terms of its Targeted Longer-term Refinancing Operations (TLTRO) because the generous rate offered at the height of the COVID-19 pandemic now allowed banks to make a guaranteed profit at the ECB’s expense.

As well as being costly for the ECB, this source of cheap cash was getting in the way of its fight to lower inflation, which is running at close to 10% in the euro zone.

For these reasons, the ECB said banks would have to start paying going rates on their TLTRO credit, rather than the average rate over the whole duration of the loans.

From Nov. 23, banks which meet lending targets tied to the loans will pay the average deposit facility rate, which the ECB hiked to 1.5% on Thursday, prevailing over the remaining period of their loans.

Those failing to meet the targets will pay the average of the higher main refinancing operations rate, which was raised to 2%, an ECB spokesperson said.

The ECB will also offer banks additional voluntary early repayment dates, the first one on Nov. 23.

The terms were changed so “there is no deterrent to the transmission of our monetary policy and that banks will actually transmit the lending rates, which by necessity of our monetary policy stance, are higher and have to be higher,” ECB President Christine Lagarde told a press conference.

Euro zone banks are sitting on 2.1 trillion euros ($2.1 trillion) worth of TLTRO loans extended at ultra-low or even negative interest rates at a time when the ECB’s main worry was persistently low inflation.

But the rate the ECB pays commercial banks is now back in positive territory and is likely to rise further.

Without a change to the terms, banks could make a guaranteed profit of 30-35 billion euros simply by parking their TLTRO cash at the ECB, according to IESEG School of Management estimates based on the rate on deposits peaking somewhere between 2.5% and 4.5%.

In a similar vein, the ECB decided to remunerate banks’ minimum reserves at its deposit rate instead of at the main refinancing operations rate.

CREDIBILITY

Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, said in a Twitter post the decision to change the terms of the loans in this way was “the most radical, and the worst of all options.”

Analysts have warned changing the terms of loans already outstanding could deter banks from tapping similar loans in future downturns.

The BVR association of Germany’s cooperative banks said in a statement the changes “raise questions about the reliability of the ECB”.

Euro zone banking stocks briefly fell following the decision but then turned positive, led by Italian lenders, as the TLTRO changes didn’t look as bad as initially feared.

The announcement was also seen as pushing back the date when the ECB starts trimming its 3.3 trillion-euro bond pile it accumulated in the last eight years when inflation was too low.

This winding down is called ‘quantitative tightening’ in market parlance, or QT.

“As a consequence of the action of the ECB to accelerate the voluntary reimbursement of the TLTRO 3, QT measures to decrease the size of the balance sheet of the Eurosystem are less urgent,” Eric Dor, a professor at the IESEG business school said.

TRANSMISSION

Lagarde said that even considering litigation risk, the bank believed this was the best decision in order to transmit its policy.

Michiel Hoogeveen, a member of the European Parliament’s economic committee that oversees the ECB, said the central bank “runs (the) risk to lose some of its credibility” but motivated the decision “in a reasonable and logical way”.

The amount of liquidity sloshing in the system has meant that the rates at which banks lend to each other in the money markets are also still below the ECB’s policy rate, so recent rate hikes have not been fully passed on to the banking sector.

The TLTRO cash also creates additional demand for low-risk securities, limiting the rise in rates on repurchase agreements and short-dated government bond yields.

The spread between interest rate swaps and the two-year German bond yield fell to the lowest since August in a sign that traders see the move as helping ease the shortage of government bonds used as collateral in the euro area. Lagarde said that also factored into the ECB’s decision.

($1 = 0.9997 euros)

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