ECB assesses options to limit banks’ gains from crisis lending

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(Bloomberg) – The European Central Bank is looking for ways to prevent lenders from taking unfair advantage by raising interest rates to combat record inflation.

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The problem concerns about 2.1 trillion euros ($2 trillion) in ultra-cheap loans, called TLTROs, which were issued at the height of the pandemic to maintain credit and avoid deflation.

Although the initiative was successful, it has since become a thorn in the side of policymakers, as banks can park loan proceeds at the ECB and earn interest that exceeds their costs.

This is becoming increasingly lucrative as rates that were below zero as recently as July have moved to 0.75% and are expected to double on Thursday. This could prompt the ECB to act at its meeting this week.

Such risk-free profits for banks look bad at a time when Europe’s energy crisis is sending household heating bills skyrocketing and prompting some companies to cut production. But there are also political implications: the stable source of income discourages early repayments that would help officials fight inflation. Eurozone central banks could also post losses.

Estimates of how much lenders currently benefit vary. Morgan Stanley economists estimate they could benefit from an additional stimulus of nearly 28 billion euros.

President Christine Lagarde said last month that parts of the ECB’s compensation arrangements need to be reviewed and will be reviewed “in due course”. Since then, officials have narrowed the debate over excess cash held at the ECB to three options.

Stricter loan conditions

Tightening the terms of TLTRO loans has become the preferred option.

Banks currently face interest equivalent to the average deposit rate over the term of the loan. The ECB could make this more expensive.

Changing contracts retroactively could cause legal problems and jeopardize the adoption of any future TLTRO offers. But officials believe these hurdles are surmountable because the deal behind the deals has disappeared.

Indeed, business credit is growing at almost 9% a year, the fastest pace since 2009. This threatens to fuel inflation which, at just under 10%, is already five times the medium target. ECB term.

With an early repayment deadline just days before the December meeting of the ECB’s Governing Council, officials could push for a solution this week. Officials have signaled that waiting for the bulk of the loans – around 1.3 trillion euros – to expire in June 2023 is not an option.

“Reverse hierarchy”

Another way to reduce payments to banks would be to subject certain deposits to a lower interest rate or even no interest.

Known as reverse tiering, it would be the opposite of a strategy the ECB used to ease pressure on banks after introducing negative rates in 2014. But the approach could also have “unintended consequences for the market “, according to economists at BNP Paribas.

These include pushing the rate that financial institutions charge each other to lend without overnight collateral even lower than the deposit rate, as cash is withdrawn from ECB accounts and placed elsewhere. Excessive differences between these two rates can hamper the transmission of monetary policy to the economy as a whole.

There could also be renewed stress in the short-term loan market. The influx of money from ECB accounts could worsen a situation in which too much liquidity chases away too little of the collateral needed for other financial operations.

Officials expressed concerns about developments in the money market. Chief economist Philip Lane said the ECB would remain “attentive to the spread between different money market rates as well as collateral scarcity issues”.

Reserve management

The ECB could increase the level of reserve requirements it requires lenders to hold and reduce the interest it pays on them.

Banks currently have to keep 1% of certain liabilities, mainly customer deposits, at the ECB and receive interest equivalent to the main refinancing rate – 1.25% currently.

Although changing this arrangement also poses no legal problems, it is also the least effective of the ECB’s options. Doubling reserve requirements – they were 2% until early 2012 – would cover less than 16% of outstanding TLTRO loans.

–With the help of Libby Cherry.

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