By Francesco Canepa
FRANKFURT (Reuters) - The European Central Bank wants to wean banks off free cash but it will try to do so gently enough not to upset the financial system or lending, the result of its long-awaited Operational Framework Review showed on Wednesday.
During nearly a decade of too-low inflation, the central bank for the 20 countries that share the euro currency inundated banks with cash via massive bond purchases, with the aim of spurring them to lend and stimulate price growth.
That largely removed the need for banks to borrow from each other, and effectively pinned the overnight interest rate on the money market to the one the ECB pays on deposits.
But this exceptionally generous system is now proving costly for the ECB and national central banks, and needs adapting for a new era in which inflation and interest rates are higher and the liquidity pumped into the system is being drained.
Under the new framework unveiled on Wednesday, the ECB will give banks more incentive to lend to each other, while providing safety nets to limit the risk that lenders could run out of cash.
"The framework will ensure that our policy implementation remains effective, robust, flexible and efficient in the future as our balance sheet normalises," ECB President Christine Lagarde said in a statement.
The ECB said the new framework should make its balance sheet "financially sound" after it and the central banks of some euro zone countries suffered large losses as a result of its past largesse.
"A financially sound balance sheet supports central bank independence and allows the smooth conduct of monetary policy," it said in a statement.
The main features of the framework were exclusively reported by Reuters last month.
IN THE VICINITY OF 4%
The ECB said it will aim to keep the interbank rate "in the vicinity" of its deposit rate, currently 4%.
But rather than single-handedly pumping free cash into the system, it will rely more on banks lending to each other as the bonds it bought mature and excess liquidity leaves the system.
The banking sector as a whole will have more reserves than it needs until 2029, the ECB estimates, but analysts expect liquidity to become a constraint for some banks as soon as 2026.
Lenders will still be able to tap the ECB for as much cash as they like, secured with collateral, at its weekly Main Refinancing Operations and 90-day auctions.
In a bid to ease the financial penalty and the stigma for borrowers turning to the central bank, the rate on these auctions, currently 4.50%, will be lowered to reduce the spread between it and the ECB's deposit rate to 15 basis points.
The change will take effect on Sept. 18, when the ECB may have already lowered interest rates several times as inflation steadily declines.
The ECB also plans to launch longer-term loans and bond-buying operations - which will incorporate climate considerations - once it sees its balance sheet has started growing again as a result of banks' own borrowing.
"These operations will make a substantial contribution to covering the banking sector's structural liquidity needs arising from autonomous factors and minimum reserve requirements," the ECB said.
A likely implication is that future bond purchases will be focused on shorter-maturity bonds, rather than nearly all bonds on the market, like the ECB's stimulus programmes launched over a decade of crises.
Minimum reserve requirements were left at 1%, which is likely to be a relief for banks, which would have seen their profits and cash buffers shrink if the requirements had been raised as some policymakers wanted.
"Fundamentally the ECB is sticking to the system of high excess liquidity and will hold many bonds in the long term," Commerzbank (ETR:CBKG)'s chief economist Joerg Kraemer said.
"The ECB could have dared to bring in more normality 15 years after the end of the financial crisis."
The ECB plans to review the new system in two years or even earlier if needed, it said.