ECB seeks to cut bank subsidies as rate hikes leave it hanging, sources say

By Francesco Canepa, Frank Siebelt and Balazs Koranyi

FRANKFURT -The European Central Bank is exploring ways to cut a subsidy to banks that could cost it tens of billions of euros in interest, four sources told Reuters, prompting a backlash from lenders.

To fight galloping inflation, the ECB raised the rate it pays on the 4.6 trillion euros ($4.5 trillion) in banks’ reserves that exceed requirements by -0.5% to 0.75% in less than two months.

This leaves the ECB on the hook for tens of billions of euros in annual interest on these reserves and threatens to burn a hole in the capital of the central banks of the countries where most of these reserves are located, the Netherlands and Belgium already putting warning of impending losses.

He also puts the ECB in the politically uncomfortable position of subsidizing the banks at a time when the public is grappling with high inflation.

Banks, in particular, can make a guaranteed profit on the three-year loans they have taken out with the ECB because the average interest they pay on these targeted longer-term refinancing operations (TLTRO) is less than what they can earn by depositing that same cash at the central bank.

For these reasons ECB staff are exploring ways to pay less, such as not paying interest on cash banks have borrowed from the central bank itself, sources familiar with the matter told Reuters.

The ECB could also modify the terms of TLTRO loans, although it could potentially harm the credibility of future programs and lead to legal challenges, the sources added.

Other proposals include remunerating excess reserves only below or above a threshold or abolishing interest on required reserves – those that banks must maintain at the level ECB and currently earning 1.25% per year, the sources said.

A spokesperson for the ECB declined to comment.

The sector body of the European Banking Federation defended the current, favorable TLTRO conditions, which were set by the ECB at the height of the coronavirus outbreak.

“The TLTRO program and its conditions were put in place as European banks took risks to keep the economy afloat during the covid pandemic,” he said in a statement.

But ECB Policymakers feel justified in taking action if necessary to preserve capital, the sources said, noting that lenders have benefited from ultra-cheap loans in the past.

Policy makers only briefly discussed this topic at their meeting on 8 September and are expected to come back to it at a retreat in Cyprus on 5 October or at their policy meeting on 27 October – when the ECB is ready to raise rates again.

The Swiss National Bank said on Thursday it would only pay interest on reserves “up to a certain threshold” and French Central Bank Governor Francois Villeroy de Galhau also championed a similar plan.

A problem for the ECB is that different options would affect member countries in different ways.

Italian banks, for example, borrowed more from ECB that they have deposited there in excess reserves, whereas the reverse is true for most other countries and in particular for Germany, France and the Netherlands.

Dutch bank ING seen “disruptive effects on the Italian money markets” if the ECB stopped remunerating part of the money borrowed by Italian banks TLTRO.

Another problem is that the ECB must justify any decision on monetary policy grounds, rather than preserving its own profits or avoiding political embarrassment.

“The most relevant question in this respect, rather than our income statement, is the financial strength of central bank balance sheets through their levels of capitalized reserves,” Villeroy de Galhau of the Banque de France said in a recent speech.

($1 = 1.0251 euros)