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FX COLUMN-ECB rate cut risks unintended consequences
July 10, 2012 / 8:47 AM / 5 years ago

FX COLUMN-ECB rate cut risks unintended consequences

--Neal Kimberley is an FX market analyst for Reuters. The opinions expressed are his own--

By Neal Kimberley

LONDON, July 10 (Reuters) - 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.


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 money.

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 stronger institutions.

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 ultra-accommodative.

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 credits. (Editing by Swaha Pattanaik)

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