At the conclusion of European Central Bank’s (ECB) September meeting, President Christine Lagarde stated that the three key policy rates “were now sufficiently restrictive, to ensure the gradual return of inflation, back to its 2% target, over the medium term”. A subsequent hold of rates at these levels followed in October, firming the view, that the ECB is now likely, to be at the peak of its current tightening cycle.
Accordingly, market attention has veered towards other policy options that are at the disposal of the ECB’s Governing Council (GC). One such option, the remuneration of Minimum Reserve Requirements (MRR), has recently come under particular focus. While not widely understood, adjustments to this rate could have significant implications for short term interest rates and liquidity demand.
What is the MRR?
There are a number of factors that influence a credit institution’s decision to hold reserves at a central bank. One of the primary reasons is to provide a liquidity buffer during times of market stress. The ECB year is broken down into 10 reserve periods (RP); at the start of each RP, credit institutions are required to calculate their reserve base (RB). This is comprised of particular deposits that they receive and certain debt securities that they issue including: overnight deposits, term deposits with a maturity or notice period of less than two years, and debt securities with a maturity of less than two years.
The RB is taken from the available data two months prior to the month when the next reserve period starts. For example, the latest RP commenced on 1 November, therefore data from September is used to calculate the latest RB. Each credit institution is then required to hold 1% of the RB at the ECB, as an average, over the entire six week RP to meet its MRR. Note with only 10 month-ends each year used to calculate the RB, two month-ends should not be impacted.
What was the MRR remuneration level and what is it now?
Prior to the start of September’s RP, the ECB paid banks at the ECB deposit rate (then 3.75%). However, despite the deposit rate being increased to 4.00% in September, the remuneration on MRR was cut to 0.00%. This came as no surprise to banks as the decision was announced at July’s ECB meeting. It is in fact the second reduction in the remuneration level within the past 12 months, as in October 2022 the MRR rate was reduced from the level of the ECB’s main refinancing operations (MRO), down to the deposit rate (DR) (as at 1 November 2023 MRO = 4.50%, DR = 4.00%).
Why does the ECB need the change?
On 27 July, the ECB stated that the reduction in MRR remuneration “will preserve the effectiveness of monetary policy….ensuring the full pass through of the Governing Council’s interest rate decisions to money markets”, while at the same “reducing the overall amount of interest that needs to be paid on reserves”.
Despite being reported as a secondary importance to the ECB, we believe the cost savings will be significant. Based on the most recent data, with a requirement to hold 1% of the RB, the current level of aggregated MRR stood at €165bn. A reduction from 4% to 0% will save the ECB, interest payments totalling €6.6bn on an annual basis.
How much above 1% could the ECB require banks to maintain?
Written within its own legal framework, the ECB implemented a maximum RB base of 10%. Prior to 2012, the RB was set at 2% and several market commentators believe the ECB could increase the current figure to 4.00% at some point during 2024. Based on the above aggregated MRR, a rise of this magnitude will increase the cost savings to the ECB to €19.8bn per annum. Taking the MMR to its maximum of 10% (€1.650bn) would result in cost savings totalling €59.4bn per annum.
Increasing the MRR from the perspective of credit institutions
Clearly any reduction in the amount of interest received from the ECB will hit banks’ net interest margins. However, as the MRR is mandatory, banks may look for alternative means to offset the loss of interest from this policy change. Options include:
- Reducing the volume of short-term deposits taken over month end dates, which will have a downward impact on euro short-term rates. September’s month end saw a 2.6 basis point reduction in overnight euro short-term rates, the largest decrease witnessed since December 2020. It could also lead to a reduction in market liquidity and increase in market volatility.
- Reducing the volume of debt securities issued with a sub two year maturity. The ECB has previously reported tightening bank lending standards (BLS) during 2023 and attributed this to the pass through of interest rate hikes. A further reduction in BLS would dampen demand further, with the benefit of decreasing eurozone inflation.
- Banks could decrease their own remuneration paid to clients holding cash on balance sheet. In addition, overnight deposit rates paid to money market funds could also be lower.
- Banks and short term money market investors could invest in alternative instruments, such as repo transactions and short term government Treasury bills, reducing the yields of both.
Where does the ECB go from here?
Christine Lagarde’s reluctance to expand on the MRR during the press conference that followed October’s policy meeting likely stems from the GC’s desire to not fuel speculation within money markets before the ECB can fully assess the impact of any proposed changes.
Doing nothing will inflict higher costs on itself but by going too far, it risks destabilising one of its key transmission mechanisms, not to mention raising concerns from market regulators.
In addition, if credit institutions restrict their operations to such a significant degree, money markets could very well experience year end funding constraints 10 times a year, compared to once a year at present, with potentially significantly implications for short term liquidity volumes and volatility.
Source for all data is J.P. Morgan Asset Management, as at 13 November 2023, unless otherwise stated.