Global Daily – Has the ECB eliminated the lower bound?

by: Nick Kounis

ECB View: TLTRO rate has no theoretical lower bound but it is does not drive the 3m Euribor benchmark – Although the ECB’s asset purchases have made the headlines, a quiet revolution has taken place in the central bank’s monetary policy. On 12 March, the ECB reduced its TLTRO rate below its deposit rate for the first time. For counterparties that maintain their levels of credit provision, the lending rate on the TLTRO, over the period ending in June 2021, can be as low as 25bp below the average level of the deposit rate  (so as low as -0.75%). At the end of last month, the ECB went further. On 30 April, the interest rate over that period was brought down to 50bp below the average deposit rate (so to -1%). With the ECB having decided to detach the TLTRO lending rate from the deposit rate, there is now no theoretical floor to the TLTRO rate. So has the ECB effectively eliminated the lower bound?

Although the deeper cuts to the TLTRO rate are an effective way to ease bank lending conditions, we do not think that the ECB has eliminated the lower bound with this move. This is for two reasons. First of all, the key benchmark 3m Euribor rate is still linked to the deposit rate. Banks will unlikely lend to each other at a rate below the rate that they can deposit funds risk free at the ECB. Needless to say the Euribor rate is crucial. It is a key input for the pricing of bank loans and the valuing of financial assets on balance sheets. In financial markets it is the basis for issuance of securities with variable rates, options, forward contracts and swaps. The benchmark rate is an import driver of the risk-free curve and also the euro exchange rate and hence financial conditions in the eurozone. With regards to bank loan rates, it remains to be seen the extent to which the lower TLTRO rate drives down bank lending rates. Especially given that Euribor rates have jumped above the deposit rate over the last couple of months given dislocations in money markets.

A second reason why the TLTRO rate has not eliminated the lower bound problem relates to bank retail deposit rates. Overnight deposit rates for retail clients in the eurozone are generally close to zero and commercial banks are reluctant to bring them into negative territory for most clients. Indeed, over recent years, we have seen bank lending rates coming down (in line with the fall in Euribor rates), but banks could not bring retail deposit rates down to the same extent. This caused a margin squeeze for commercial banks. This dynamic means that there are limitations to further falls in bank lending rates in any case. It must be noted that lower funding costs (via the TLTRO) do help to alleviate the drag on net interest income, but not entirely. In many ways, the zero-lower bower bound on the vast majority of the deposits held by eurozone banks is what really creates the lower bound for the ECB’s main policy rates.

So the ECB’s new found willingness to cut the TLTRTO rate does not entirely eliminate its lower bound problem. However, that does not mean the policy is not worth pursuing. The lower TLTRO rate means bank lending rates will be lower than they would otherwise have been. Even if bank lending rates do not come down much due to TLTRO rate cuts, they will make bank lending more profitable and hence more attractive to banks. Indeed, the evidence from the ECB’s recent bank lending survey showed that the TLTRO has had an important impact in terms of easing lending conditions. Banks reported a net easing impact of TLTRO III on their terms and conditions, credit standards, and a positive net impact on their lending volumes. (Nick Kounis)