Interview with Christoph Rieger, Head of Rates and Credit Research at Commerzbank

ECB monetary policy stands at a crossroads. After more than a decade in which the central bank pursued a policy best characterized as ‘abundant reserves’, it is now working to steer market participants into a new era of ‘ample reserves’.

This push comes after a relatively short period of monetary tightening between 2022 and 2023. As the central bank balance sheet is in the process of normalizing after almost a decade of quantitative easing, the ECB needs to adjust its approach of lending against collateral. The ECB is not alone among central banks in this regard, with the Bank of England pursuing a similar policy as its balance sheet transitions to a new steady state. 

Realizing the ambition to run a leaner balance sheet while staying firmly in control of short-term interest rates, however, is challenging. During the period of abundant reserves, the ECB’s Main Refinancing Rate (MRO) became irrelevant as banks had more than enough reserves and thus no need to borrow from the ECB in its regular refinancing operations. As a consequence, the importance of MRO as a reference rate for the wider market also fell. The marginal return on cash was set by the ECB deposit rate, which in turn became the relevant reference rate for market participants.

Despite reserves falling during the period of monetary tightening, they have not yet arrived at a level which stimulates borrowing from the ECB, despite the reduction in the spread between deposit and MRO rate from 50bp to 15bp. It may be that, with most banks still sitting on healthy reserves, there is a stigma around borrowing from the ECB. Eurozone banks currently hold €11.6bn of funding at the MRO rate, which is equivalent to only 0.03% of their liabilities.

Instructive lessons could be taken from the Bank of England, which is slightly further along the path towards an ample reserves paradigm. The Old Lady is also lending against collateral at attractive terms. As a result, it has seen increasing demand for its short-term repo operations (STR) since February, which hit a record £44.5bn in September.

At the same time, gilt repo spreads have gradually cheapened, suggesting that tactical arbitrage amid no stigma seems to be driving STR. With UK banks actively borrowing reserves at the Bank Rate against Gilt collateral, this is keeping repo spread widening in check. 

The BoE is struggling to drum up interest in its longer-term refinancing operations, however. This has already led officials to mull how to recalibrate its Indexed Long-Term Repo facility, which provides reserves for a six-month period.

In the meantime, it should be noted that private repo market activities have picked up since ECB excess liquidity began to drain from the system more than a year ago. At Eurex, GC Pooling repo in particular has ramped up. 

The door to HQLA

The fact is though, that while bank reserves remain at historically high levels, bank demand for central bank reserves will remain structurally restricted. However, banks’ need for short-term funding is not the only factor driving use of these facilities.

Regulatory requirements to hold high quality collateral still offer another incentive for banks to engage with central bank borrowing programs. As banks seek to improve their liquidity coverage ratios, some market participants could consider ECB facilities as a route for improving the quality of their collateral at an attractive cost.

That aside, it is likely to be at least another year, assuming current market conditions largely persist, until banks begin to tap central bank refinancing operations in order to maintain their desired levels of liquidity.