The European Central Bank outlined major changes to the way it works on Wednesday, aiming to scale down its presence in financial markets after 15 years of emergency measures.
During the financial crisis, the ECB took up a far more active role in European markets, creating money through quantitative easing and buying up assets and government debt.
It’s now looking to step back, but the first results of a wide-ranging review of its operational framework left important questions unanswered, highlighting how long and uncertain the path to a new ‘normality’ will be. The proposals it set out reflected the difficulties of devising a new set of rules that will be both effective and free from unwanted side-effects.
Crucially, the ECB gave no indication of how big it expects its balance sheet to be in future.
In what it characterized as a ‘hybrid’ new regime, the ECB said it will continue to anchor market rates with its deposit facility, a hallmark of its current ‘ample reserves’ regime. It will also, ultimately, hold a quasi-permanent, or ‘structural’ bond portfolio, a successor to the portfolios it has accumulated through years of quantitative easing.
But it also said it wants to restore a ‘central role’ to lending operations, both short-term and longer-term, which dominated under the ‘scarce reserves’ regime before 2008.
“The ECB is looking for more time to evaluate the pros and cons of different liquidity frameworks,” said Patrick Saner, head of macro strategy at Swiss Re.
Carsten Brzeski, global head of macro at ING, noted more bluntly that: “The juicy stuff remains very vague.”
There was no detail, for instance, over what the ECB would, or wouldn’t, hold in the future bond portfolio, something Brzeski said signaled ongoing disagreement over the scope for either sovereign or ‘green’ assets.
The bank made clear that the transition is going to be highly experimental, saying it would revise the parameters of the new rules by 2026 “or earlier, if necessary.”
“This is the typical European way to kick the can down the road,” Brzeski said.
Saner was more charitable, noting that: “Not pre-committing to a certain size of the asset portfolio makes sense,” not least because it is still far from clear how big the balance sheet will have to be in the long run. In any case, he added, the process of balance-sheet reduction still has far to run before banks run short of reserves.
Things are gradually changing, as the ECB whittles down its balance sheet. Its last big ‘TLTRO’ operations will be repaid in the coming months, and the ECB is no longer reinvesting all the bonds in its pandemic bond portfolio as they mature. From next year, it won’t reinvest anything.
But for the moment, banks have all the reserves they need, so the ECB faces a challenge in reviving the lending operations with which it used to guide policy.
In an effort to make such lending more attractive, the difference — or spread — between the deposit rate and the main refinancing rate (MRO) will be reduced to 0.15 percent as of September, from the current 0.5 percent. The rate on its emergency, or ‘marginal’ lending facility, will also be adjusted at the same time to ensure that it stays only 0.25 percentage points above the MRO rate. Banks will still be able to borrow all they want, as long as they have adequate collateral.
Narrowing the “corridor” between the deposit and main refinancing rates “will limit the potential scope for volatility in short-term money market rates,” as the ECB transitions to the new framework, the bank said. It stressed that this is a step distinct from easing monetary policy, a process that markets expect to start in June.
One detail that the ECB did supply was that it will not change its minimum reserve requirement as part of the review. That means that banks will still be paid for all but 1 percent of their deposits at the ECB. Eurozone banks had been eager to avoid any increase in the MRR, which would have eaten into their interest income.