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ECB adjusts strategy to encourage bank self-reliance and maintain financial stability

ECB, finance, financial news

The European Central Bank (ECB) is cautiously transitioning away from its long-standing policy of providing banks with free cash, a strategy that was implemented during a period of persistently low inflation. This move is part of the ECB's recent Operational Framework Review, reflecting a shift in the economic environment. The aim is to reduce banks' reliance on this easy cash without destabilizing the financial system or hindering lending practices.

For almost a decade, the ECB, which manages the monetary policy for the 20 countries using the euro, engaged in extensive bond-buying programs. This influx of cash into banks was designed to encourage them to lend more, thus stimulating economic growth and price increases.

This approach significantly reduced the need for banks to borrow from each other, with the added effect of stabilizing the overnight interest rate in the money market, closely aligning it with the ECB's deposit rate.

The ECB's ultra-generous financial strategy, while effective in its time, has become a financial burden. As the economic landscape evolves, with rising inflation and interest rates, the ECB recognizes the need to adapt its policies.

This adaptation is crucial not only for the central bank but also for national banks within the eurozone, as the current mode of operation is proving to be unsustainable in the changing economic climate.

The ECB's newly revealed framework aims to encourage interbank lending. It introduces measures to ensure that banks have enough incentive to lend to each other, while also establishing safety mechanisms to prevent potential cash shortages.

Christine Lagarde, the President of the ECB, has stressed the importance of this new framework, highlighting its role in maintaining the effectiveness, robustness, flexibility, and efficiency of policy implementation as the ECB's balance sheet undergoes normalization.

The revised strategy is intended to fortify the ECB's balance sheet, ensuring its financial health. This is critical, especially given that the ECB and several national central banks in the eurozone have incurred significant losses due to past policies. A financially stable balance sheet is essential for maintaining the independence of central banks and for the smooth execution of monetary policies.

This framework includes maintaining the interbank rate near the ECB's deposit rate, which currently stands at 4%. This approach differs from the previous method of directly injecting cash into the banking system.

Now, the focus shifts to fostering a self-sustaining system where banks are more reliant on each other for liquidity, especially as the bonds purchased by the ECB mature and excess liquidity starts to diminish.

The banking sector is projected to have more reserves than necessary until 2029. However, liquidity may become a limiting factor for some banks by 2026. The ECB will continue to offer banks the opportunity to borrow unlimited amounts of cash, using collateral, through its Main Refinancing Operations and 90-day auctions.

In an effort to ease the financial burden on banks borrowing from the central bank, the ECB plans to reduce the auction rate (currently at 4.50%) to narrow the difference with its deposit rate to just 15 basis points.

This change, expected to be implemented on September 18, coincides with potential ECB interest rate reductions as inflation is anticipated to decline steadily.

The ECB is also considering launching long-term lending programs and bond-buying initiatives that take into account climate-related factors. These measures would be activated once the ECB observes an increase in its balance sheet resulting from banks' borrowing activities.

These operations are designed to meet the banking sector's long-term liquidity needs, which arise from both autonomous factors and the requirement to maintain minimum reserves.

Future bond purchases by the ECB may focus more on bonds with shorter maturities, in contrast to its previous stimulus programs that targeted nearly all market bonds during various crises over the past decade.

The decision to keep the minimum reserve requirement at 1% provides some relief for banks, which would have faced challenges if this requirement had been increased, as some policymakers had suggested.

Commerzbank’s chief economist, Joerg Kraemer, observes that the ECB continues to support a system characterized by excess liquidity and long-term bond holdings. He notes that the ECB could have taken this opportunity to bring more normality to the financial system, especially considering that it's been 15 years since the financial crisis.

The ECB has planned a review of this new system within two years or earlier if necessary, allowing for adjustments based on the evolving economic landscape and the effectiveness of the implemented changes. Source: Reuters.



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