--Neal Kimberley is an FX market analyst for Reuters. The
opinions expressed are his own--
By Neal Kimberley
LONDON, July 10 Euro zone money market desks are
feeling the unintended consequences of the European Central Bank
(ECB) cutting its deposit rate to zero.
The ECB's deposit rate usually acts as the floor for money
market rates and represents a safe haven where banks can park
money with the central bank to avoid counterparty risk - the
risk that a private borrower might prove unable to repay a loan.
By cutting this rate to zero, the ECB's intention was to
encourage banks to lend euro-denominated funds to their peers
given they can earn a higher interest rate, currently about 0.3
percent in the interbank market, by doing this.
While the theory is sound, that is not quite how things are
working in practice.
As short-term money market interest rates fall closer to the
ECB's zero deposit rate, lenders are earning close to zero for
placing deposits with banks for maturities out to three months.
They will see little reason to expose themselves to
counterparty risk for this long for very little return and there
is anecdotal evidence that some are already reducing the
maturity of loans they make to banks.
Traders said some loans to some banks that matured on Friday
were rolled over for a shorter period than the original deposit.
In some cases, maturing one-week deposits were just rolled over
the weekend so that they could be re-assessed on Monday.
WHAT'S IN IT FOR ME?
It is natural for those who have money to lend to seek to
maximise their return.
This usually involves placing deposits for periods that
offer the best yield while compensating the lender for the
counterparty risk to which he is exposed.
But when interest rates are being squeezed closer to a zero
bound, there is little to be gained from placing money for a
longer period while bearing the risk that the borrower could,
under the worst-case scenario, go bust before paying back the
In this environment, return of capital becomes an even more
important factor than return on capital and the time frame over
which bank-to-bank loans are made becomes shorter.
Of course, depositors and borrowers know that faster
maturing deposits incur more administrative costs as deals have
to be rolled over again and again.
But operational risk is limited given roll overs do not
involve any exchange of principal.
In a near-zero yield environment, some corporate treasurers
are already thinking that slightly higher administrative costs
are a small price to pay to manage counterparty risk as
effectively as possible.
None of this will come as a surprise to traders who remember
the consequences of Japan's zero interest rate policy (ZIRP).
During ZIRP, shorter-tenor deposits became the norm for many
Japanese banks and, over time, this led to a realignment of
Japan's interbank deposit base.
With returns negligible for a long period, money in Japan
gravitated further and further away from weaker names toward
Loan losses were not the only reason why a multitude of
"City banks" in Tokyo in the late 1980s became three "Megacity
banks" in the twenty-first century.
There was also the slow erosion of weaker banks' deposit
base undermining the viability of their business models.
Japanese bank lending contracted between 1997-2006, even
though the Bank of Japan's monetary policy was
The risk of the ECB deposit rate move is that a similar
phenomenon occurs in the euro money markets over time as
depositors use banks' credit default swaps as a measure of those
banks' "riskiness" and place their money accordingly.
Rather than encouraging lending, the ECB deposit rate cut
could therefore make euro zone banks even more cautious about
lending for any length of time and to any but the strongest
(Editing by Swaha Pattanaik)