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 The idea of negative rates - essentially making banks pay for having
their funds held overnight - is to push banks into lending the
money, hence boosting the economy.
But if banks just hold on to what they have, or deposit overnight
elsewhere, it would push up money market rates, effectively
tightening rather than easing money flow.
So the ECB will also need to find a new incentive to lend.
The ECB has clearly flagged a cut in its deposit rate into negative
territory for its June 5 meeting - a move that would see it in the
first such policy step by a major central bank.
"If they would use their liquidity not with us but for other means,
it would be good for the economy. And that is precisely what we
would like to see," ECB Vice-President Vitor Constancio told Reuters
Insider television in an interview this week.
The exact impact of a cut in the deposit rate - now at zero - would
depend on the design of the move and any accompanying measures. But
it would be hard for banks to avoid incurring a charge for at least
some money held at the ECB after the expected move.
Instead of increasing their lending to businesses, banks could
respond by moving money from the ECB to non-euro zone central banks,
putting it in a vault, passing on the cost to their customers, or
holding less cash on their balance sheets.
To avoid such scenarios and get banks to lend more money, the ECB
will therefore need to wave a lending carrot that will deter banks
from simply taking the money and buying safe assets like sovereign
bonds.
A targeted long-term funding operation, or LTRO, for banks -
essentially giving them cheap access to money to lend - is most
likely.
Constancio said that if the ECB did decided to go that way it would
be "targeted", meaning that it would have some strings so that the
money was not just tucked away.
Reuters reported earlier this month that the ECB is preparing a
package of measures for its June 5 policy meeting, including cuts in
all its interest rates and targeted measures aimed at boosting
lending to small- and mid-sized firms (SMEs).
COST TO BANKS
The devil is in the detail of the plan, which is still in the works.
The extent of the impact depends on the size of the expected deposit
rate cut and how the ECB adjusts its rules on holding money at the
central bank.
The ECB requires euro zone banks to keep minimum reserves in a
current account at the central bank. It does not pay banks holding
any funds above the minimum in this account, so banks have
traditionally held such excess funds on the deposit account, where
in the past they earned interest.
With the ECB's deposit rate now at zero, banks earn no interest on
cash above the minimum reserve held at the ECB in either the current
or deposit accounts.
With a negative deposit rate, the ECB would need to cap holdings on
the current account or pay a negative rate on excess reserves in
that account as well.
How this hits banks is one key to its success or failure.
Banks hold excess reserves at the ECB as a cushion to avoid funding
crunches. Retaining a decent cushion will cost them should the
deposit rate turn negative.
Commerzbank <CBKG.DE> spokesman Martin Kurz said banks' options for
dealing with the cost included lowering the interest rates they pay
customers and changing their terms and conditions. That could mean
higher account charges.
The Danish central bank's experience of a negative rate from July
2012 to April of this year saw Danske Bank - the country's biggest -
adjust some of its interest rates and fees for customers but it said
this was not enough to recoup the cost.
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Goldman Sachs said in a May 22 report that despite the fact that
inflation-adjusted interest rates had been negative for some time,
an ECB cut into negative territory could still provoke negative
reactions.
It said there could be tax and accounting considerations and "bank
treasurers may be adverse to seeing negative income flows arising
from excess holdings of central bank liquidity".
The head of money markets at one euro zone bank said psychological
factors could play if the deposit rate turned negative, adding that
banks would struggle to pass on negative rates to depositor
customers.
OTHER OPTIONS
Rather than hold money at the ECB banks could store cash in a vault,
but this is expensive and only becomes a realistic option with a
deeply negative deposit rate.
If ECB rates and the interbank market are both unappealing, banks
could in theory deposit at least some of their funds with non-euro
zone central banks, provided they did so via one of that central
bank's recognised counterparties.
The Bank of England and the Danish central bank both confirmed this
was possible. But one treasurer who faced that situation said in
practice, international banks were unlikely to start doing this in
droves.
For one thing, banks would face a currency risk, he said, adding
that they also could have to hold more capital against deposits at a
non euro zone bank than at the ECB, because the deposits would
attract a different risk weighting.
Another option would be for banks to reduce their excess liquidity
at the ECB to minimise the cost they would incur from a negative
deposit rate, but in doing so giving themselves less of a cushion
should they hit a funding crunch.
"A risk is that rather than lending out money, banks simply repay it
to the ECB and reduce their borrowing from the ECB to the absolute
minimum," said Berenberg bank economist Christian Schulz. "The
danger then is that banks don't have enough excess liquidity and the
system becomes more vulnerable."
With reduced excess liquidity, the ECB would risk volatility in
overnight money market rates as cash-strapped banks bid them up
towards the ECB's main refinancing rate before tapping the central
bank for cash and sending market rates back down again.
Hence the idea of a new, targeted LTRO.
"If you put the two things together (lower rates and a new very Long
Term Refinancing Operation with a fixed rate), it may have an effect
on lending to the economy," said Francesco Papadia, a former ECB
director general for market operations.
"If it doesn't work, the ECB can say 'okay, let's have a look at the
next tool in our box."
(Additional reporting by John O'Donnell in Frankfurt, David Milliken
in London and Ole Mikkelsen and Teis Jensen in Copenhagen Editing by
Jeremy Gaunt)
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