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To avoid rate cut backfiring, banks will need incentive from ECB

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[May 30, 2014]  By Paul Carrel and Laura Noonan

FRANKFURT/LONDON (Reuters) - The European Central Bank is gearing up to charge banks for depositing with it, something that will require careful manoeuvring if it is not to create the opposite result from that intended.

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).


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.


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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