Some thoughts on negative deposit rates at the ECB

By Marc Chandler

Since the ECB’s decision not to pay interest on reserves, when it brought the deposit rate to zero last July, banks have shifted their funds out of the deposit facility and into current balance.  At the same time, they moved funds out of the ECB altogether.

On May 8th, banks further trimmed their overnight deposits at the ECB and at 120 bln euros is the least amount since November 2011.  Banks increased their current account holdings to 46 bln euro to 347 bln, which is the most since mid-April.  We see rise of the current account holdings as a reflection of banks preparing for their reserve maintenance period.

ECB President Draghi suggested last week that the central bank was taking a fresh look at the deposit rate.   There does not appear to be any economist that thinks it is a good idea.  The reasons vary, but the two main reasons are that it would likely prove ineffective in boosting lending and would be potentially disruptive to the money markets and financial institutions. 

Classic economics teaches a lower price should, all else being equal, increase demand.  It seems that the financial and economic crisis is such that the low price of funds has not increased the demand, for the most part, leaving aside US C&I loans.  Contracting economies, generally high levels of unemployment, and weak aggregate demand have crushed the animal spirits.

The implications of a negative deposit rate go well beyond the 120 bln of overnight deposits at the ECB.  A negative deposit rate would likely downward pressure on other short-term rates and exacerbate the capital preservation efforts.  It would threaten profitability of a range of activities.  No major central bank in the last quarter of century  has done so and after a closer study we expect  the ECB not to be the impose a negative deposit rate. 

Draghi indicated that the ECB was looking for ways to support lending to small and medium sized businesses, which, given the economic structure, is particularly important for Spain and Italy.  Draghi seemed to link this to discussions with national government to reanimate the ABS market, which the US did much earlier in the crisis, with reasonable success. 

That the ECB would buy these, as some news reports suggest is being considered, seems a bit more of a stretch.   Some structures are acceptable as collateral already and adjusting the haircut applied or liberalizing what is acceptable as collateral seems a more likely route for an institution that has been so reluctant to use its balance sheet. 

Some German voices have already expressed concern about the ECB becoming a bad bank (where its balance sheet and collateral is effectively warehousing toxic below investment grade assets).  Similarly, it is inconceivable that the ECB buys the non-performing loans from Spanish or Italian banks as some press reports have suggested.

Meanwhile, rarely has the UK Telegraph or the blogosphere paid so much attention to what former Finance Minister (1998-1999) and leftist opposition leader Oskar Lafontaine says.  However, his recent call for the dissolution of monetary union has dovetailed with the observers’ agenda.  The slippage in recent polls of for Merkel’s CDU has more to do with the recent high profile tax evasion than the rise of the new anti-EMU party, which may not even be represented in parliament after the September elections.

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