(Bloomberg) -- The European Central Bank’s likely decision this week to deliver a second reduction in borrowing costs will come with a rather technical twist this time round.
While officials are widely expected to cut their key deposit rate on Thursday by a quarter-point — a standard size used by global peers to adjust policy — two other rates that put a price on the money banks can get from the Frankfurt-based institution will fall by a much less conventional 60 basis points.
The move is intended to grease the wheels of the financial system as policymakers unwind large-scale bond holdings and long-term loans. By adjusting the gap between the deposit and lending rates, they aim to ensure the ECB keeps control over market conditions as its balance sheet shrinks.
What’s the setup right now?
The deposit rate is currently at 3.75%. The main refinancing rate at which banks can borrow money for a week or three months is a half-point higher at 4.25%, while the marginal lending rate — an emergency overnight facility — is at 4.5%.
The asymmetric spreads between the three gauges are a legacy of the ECB’s era of negative borrowing costs. To fight deflation and stimulate the economy, policymakers cut the deposit rate deeply below zero, while they couldn’t do the same to the other two.
What’s going to change?
The ECB is about to shrink the gap between the deposit rate and the main refinancing rate — from 50 basis points to 15. The spread between the latter and the marginal lending rate will remain unchanged at 25 basis points.
If the outcome matches what observers widely expect, rates will fall to 3.5%, 3.65% and 3.9%, respectively. As usual, rate changes will apply on the Wednesday following the official decision.
Is what’s about to happen additional policy easing?
No. Market borrowing costs track shifts in the ECB’s deposit rate.
Changes to the other two rates that go beyond 25 basis points are considered technical adjustments necessary to respond to changes in the financial system and monetary policy in recent years. They’re the result of a 15-months-long review of the institution’s operational framework, and were announced back in March.
Bank borrowing from the ECB has been low in recent years, so the implications of this move on overall financing conditions will be small. The current take-up in weekly offerings is around €2 billion, while outstanding three-month loans total around €10 billion.
Why is the ECB changing the spread between its rates?
Ever since the ECB started large-scale bond purchases in 2015 and liquidity has been available in excess, overnight market rates have tracked the deposit rate.
But for a while now, policymakers haven’t reinvested the proceeds of all maturing bonds. Long-term loans are expiring as well, so the balance sheet has been shrinking quite rapidly.
That process will continue as officials press ahead with unwinding crisis-era stimulus. There will come a time when liquidity is no longer available in abundance and banks — in the absence of fresh asset purchases — will need to start borrowing again. Market volatility is a very likely side effect.
Policymakers’ main goal is to keep such gyrations to a minimum. Narrowing the spread between the rates at which banks can borrow from and park money at the ECB also narrows the gap between which overnight market rates will likely move. No bank will accept less than the deposit rate, or pay more for funds than the main refinancing rate, in interactions with its peers.
Is this the final word on how policy will be run in the future?
Probably not. Before the ECB announced the upcoming changes, officials had a big debate about whether they wanted to continue to operate in a system where banks have more liquidity than they technically need — or whether they want to return to the tight-money regime from before the Great Financial Crisis, where funds were painstakingly managed.
Opinions diverged sharply, with officials from the region’s south more in favor with the former. Others seemingly preferred the latter option of strictly rationed liquidity.
Leaving a final answer for another time, they decided to preserve for now the current system where excess liquidity keeps market rates close to the deposit rate. As the balance sheet shrinks in future, banks will have more responsibility to decide how much liquidity they need to operate.
Are banks likely to change their behavior?
Borrowing from the ECB will get comparatively cheaper, a potential incentive for banks to participate in regular lending operations.
A narrower gap also means a lower cost of erring on the side of caution — when asking for slightly more money than strictly needed, and depositing leftovers back at the central bank.
At the same time, there’s room for banks to interact with each other to save a bit of interest when borrowing and lending funds.
What do markets think the effect will be?
The near-term market impact is likely to be limited, partly because the change was flagged earlier this year. On top of that, excess liquidity remains high at more than €3 trillion (versus about €1.7 trillion pre-pandemic) which is crimping the need for alternative sources of funding.
When the fight for liquidity hots up, the key market to watch will be repo, where banks can pledge ultra-safe collateral in return for cash from their peers. The one-day repo rate for liquidity collateralized by a pool of German bonds is currently just under 3.75% — where the deposit rate currently stands — according to RepoFunds Rates Benchmark data from CME Group.
--With assistance from James Hirai.
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