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The European Central Bank has announced one of the biggest overhauls of its relationship with the financial system in a decade, outlining plans to increase lending to commercial banks while shrinking its vast bond portfolio.
ECB Board Member Shifts agreed Wednesday’s virtual meeting highlighted how major central banks are rethinking how to provide liquidity to the financial system while reducing the size of their balance sheets.
The ECB, which has injected vast amounts of liquidity into the financial system over the past decade through large-scale bond purchases, has been debating for months what kind of “operating framework” to switch to now that its assets are shrinking.
Shrinking the ECB’s balance sheet means a steady drain of excess liquidity from the banking system. This risks lenders not having sufficient reserves at some point, which could lead to undesirable fluctuations in short-term borrowing costs or even a credit crunch.
To avoid this, the ECB has resorted to a combination of lending to commercial banks to stabilize overnight interest rates and building perpetual or “structural” bond portfolios to ensure that assets do not fall below a certain level. I’m planning to rely on you. .
The central bank announced on Wednesday that it would continue its weekly and three-month refinancing operations in their current form at slightly lower interest rates, “providing liquidity through a wide range of financial instruments.”
It also plans to launch “structural long-term credit operations and structured securities portfolios,” but these will only be introduced at a “later stage” after ECB balances reach a smaller size. However, the ECB has not defined its size.
It agreed to focus on green issues, adding that the new system “seeks to incorporate climate change-related considerations” into its design. This could be done by moving planned portfolios of structured bonds away from the biggest polluters, or by encouraging banks to fund more green loans.
The changes aim to ensure that the ECB “continues to provide an effective, flexible and stable source of liquidity to the banking system, thereby also supporting financial stability,” the commission said. .
This new regime ensures that the ECB keeps overnight interest rates within a narrow “corridor” between the deposit rates it pays on funds held in commercial financial institutions and the higher refinancing rates it pays on borrowings from the central bank. It means to aim.
The government will continue to guide its monetary policy stance through the standard deposit rate, which is currently set at 4%, and the refinancing rate, which is currently set at 4.5%.
The bank announced on Wednesday that the difference between these two key interest rates will narrow to 0.15 percentage points from September 18. The marginal lending facility rate for overnight lending will remain 0.25 percentage points above the refinancing rate.
By offering commercial banks loans at interest rates similar to those earned on deposits, the ECB hopes to overcome the stigma that deters some lenders from seeking loans from the central bank. .
The ECB’s new system will focus on allowing banks to borrow as much as they need, with the US Federal Reserve planning to maintain a large enough bond portfolio to maintain sufficient bank liquidity. It is a hybrid of the system used by the Bank of England. Through regular short-term financing operations.
Tomasz Wiladek, an economist at investor T. Rowe Price, said there were “several advantages to adopting this hybrid system”, which would allow the ECB to allocate liquidity to regions and institutions that need it most. “This gives us greater discretion over the size of liquidity,” he said. The asset side of the balance sheet.”
However, regulatory changes aimed at making the banking system safer after the financial crisis have increased the amount of ultra-safe assets that commercial banks are required to hold, making it difficult for banks to determine how much at any given time. It is difficult to accurately determine whether liquidity is required.
There is also still 3.5 trillion euros of excess liquidity in the euro zone banking system, far more than the 1.5 trillion euros some ECB officials estimate is needed. This means the new system is expected to take at least several years to become fully effective. The ECB said it would conduct a review in 2026.
Commercial banks are relieved that the ECB has maintained the minimum level of reserves (zero interest) required to be deposited with the ECB at 1%, despite recent calls for this from some Governing Council members. You’ll sigh. Ascend/rise.
