Consequences of the ECB Tiering Mechanism (3 min read)
The ECB meeting proved to be tumultuous as feared by many participants. In particular it would appear that the details of the tiering mechanism, meant to mitigate the side effects of negative deposit facility rate (DFR) on banks, could not only disappoint but could also have some unintended consequences.
The ECB Decision
The ECB cut its DFR by 10bp and strengthened its forward guidance significantly. In order to offset the side effect of the negative DFR it announced a tiering mechanism by which a part of each bank’s excess reserves would be remunerated at zero instead of the DFR. The share of each bank’s excess reserves to be remunerated at zero would be a multiple of its required reserves (6x to begin with but could be adjusted in the future). The implications of such a design are manifold.
Mitigating Factors Might Not Be Enough in Aggregate
First, excess reserves currently stand at around EUR 1.8tn while the total exemption stands at around EUR 800bn. The mitigating measures apply to less than 50% of current excess reserves. The re-start of QE will increase excess reserves at a faster pace than the exemption amount while the strengthening of forward guidance suggest that the negative DFR could persist for much longer than had been anticipated earlier. The sum of these factors imply that the mitigation measure might be a little disappointing at first glance.
Tiering Design not Targeted at Banks Bearing the Cost
Second, excess reserves in the Eurozone are not distributed uniformly with the bulk of excess reserves concentrated in banks in Germany, France and Benelux countries. However, the exemption amounts in the tiering system are linked to required reserves which means that the mitigating measure is not directed towards banks bearing the brunt of the direct costs of the negative DFR. Therefore, the actual effectiveness of the mitigating measure is less than that suggested by the aggregate numbers discussed above. This would imply that the ECB’s ability to cut rates much further is questionable.
Tiering Design Might Result in Rebalancing of HQLA Portfolios
Third, banks which have exemption amounts greater than the amount of excess reserves might look to rebalance their HQLA portfolios. They could look to reduce their holdings of short-term government bonds and other overnight loans (including lending in repo markets) which are negative yielding to take full advantage of their exemption capacity at the ECB. This pressure on short-term safe assets is likely to be further compounded by the ECB decision to allow purchases of corporate bonds in the QE programme below the DFR which would reduce the segmentation between short-dated corporate bonds and government bonds.This rebalancing should begin with the most negative yielding assets such banks own.
Disappointing and Unintended Consequences
○ The design of the tiering mechanism will not alleviate the pressure of negative DFR on the banks suffering the most
○ The ECB is unlikely to be able to cut rates much further
○ Short-term safe assets which trade at the most negative yields and are held by banks with exemption capacity exceeding their excess reserves will come under selling pressure
Despite the ECB rate cut the design of the tiering mechanism is most probably bearish for the front-end of the euro rates market particularly for the most deeply negative yielding government bonds (assuming they are held by banks with spare exemption capacity). This is confirmed by yesterday’s market reaction with 1y1y Eonia selling off ~8bp and 2y Schatz and 5y Bobl yields leading the sell-off in the euro rates complex (+12bp and +11bp respectively). It should also be bearish for volatility on euro front end rates as the downside distribution is likely to be more capped than imagined previously (EUR 3M2Y vol was ~4bpv lower).
Abhishek is a fixed income strategist with 12 years of experience in the developed markets rates space. His particular area of expertise is the Eurozone rates market and has worked on both the sell-side and the buy-side.
He can be contacted here.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)