MNI INTERVIEW: ECB QT To Squeeze Bank Liquidity Levels- EBA

Eurozone regulators will need to look closely at the implications of the still-unknown of extent of quantitative tightening for the region’s banks, which will see their liquidity coverage ratios come down as a result, a senior European Banking Authority official told MNI.

The potential long-term effects of running down balance sheets increased during years of quantitative easing are a “hot topic” among bank economists, EBA Head of Economics Olli Castren said in an interview.

“When the central bank does start to drain liquidity, the liquidity coverage ratio is going to come down. Then, of course, it’s important to see how that affects the banks' behaviour,” Castren said, though he noted that EBA-supervised banks’ LCRs normally averaged 160% or higher, well over the 100% minimum under Basel III. “Whether it's even a medium-term issue really very much depends on what the central banks are actually trying to do.”

While quantitative tightening by the ECB and the Federal Reserve is starting with balance sheets at very high levels, there is considerable uncertainty over how it will proceed, he said. (See MNI POLICY: ECB's Reinvestment Wind-Down Equates To 25bp Hike)

LACK OF GUIDANCE

“There isn't really any clear guidance from the central bank side [as to] where or how far are they planning to go,” he said. “Everyone has more or less started a process, but nobody has so far indicated what will be the new steady state size of the central bank balance sheet.”

While not top of the supervisory agenda, both European and U.S. authorities have started to research the issue, he said.

Despite the “remarkable” pace of interest rate rises, eurozone credit quality has so far held up well, though Castren agreed with the ECB’s assessment that the financial environment remains fragile, with the passthrough of higher interest rates still to show up fully on loan books.

“Standard models will tell you that default rates will start picking up about one year to two years from the beginning of the interest rate cycle, so we're not really quite yet there,” he said. “The final stage of the process [is that] you will typically start to see the credit quality of the banks' loan books start deteriorating; you start getting non-performing loans because the economy is starting to slow down and credit losses are starting to increase.” (See MNI INTERVIEW: German Recession On The Cards - ZEW's Wambach)

Rising interest rates have also brought higher net interest margins for banks, but these have been much slower to pass on the benefits to depositors, noted Castren, though he said this would change as lenders compete for funding.

PRESSURE POINTS

Overall, eurozone banks will enter any economic slowdown from a position of strength, he said. But while any eurozone repeat of the deposit outflows seen at Silicon Valley Bank is unlikely given much higher proportions of guaranteed deposits, the EBA is still on the lookout for vulnerable institutions, including those with greater exposure to non-bank financial intermediaries. (See MNI INTERVIEW: ECB Risks Financial Instability-Italian Banker)

“The size and the speed of the interest rate shock has been remarkable, and we need to be very careful, very vigilant all the time, to see whether there are some pressure points, weak spots that might be uncovered, as happened in the United States,” Castren said.

“You never know if there is something else out there when the interest rate cycle continues to advance. We do know that inflation is still high and central banks are still telling us that there's more [tightening] to come." (See MNI SOURCES: ECB To Hold Rates At Peak Into 2024)