MNI INTERVIEW: ECB Should Be Cautious In Reducing Liquidity

The European Central Bank should avoid any hasty moves to reduce excessive banking system liquidity after its operational framework review reports back at the end of the year, its former Market Operations Chief Francesco Papadia told MNI.

Calls from Bank for International Settlements Monetary and Economics Head Claudio Borio for a rapid return to the corridor system in place before the global financial crisis are misplaced, Papadia said in an interview, pointing to difficulties faced by the Federal Reserve in running down reserves in 2019.

“Currently the prospect of reducing liquidity back to a balanced situation is far away. Five years is my wild guess, but my sense is it’s too early to start thinking about that and there is no urgency because one can’t say the current system has any big problems,” he said.

Prior to 2008, the rates on the ECB’s deposit facility and the marginal lending facility defined a floor and ceiling for overnight interbank lending, but the flood of liquidity in response to the global financial crisis flattened that differential. Eurozone excess liquidity currently stands at about EUR3.6 trillion.

FINANCIAL REGULATION

Borio has proposed that the ECB and the Eurosystem could issue securities to reabsorb liquidity and so avoid potentially disruptive sales of its massive government bond portfolio.

But the causes of the current demand for excess liquidity are complex and tied up with banks’ risk preferences and changes to financial system regulation, Papadia said.

“Liquidity regulations are part of that, but also banks’ decisions are part of that. They want to have bigger buffers, given what happened during the global financial crisis,” he said,

Moving too quickly to reduce central bank balance sheets would present serious dangers, said Papadia, pointing to the Fed’s experience.

“In September 2019, bank reserves were still historically high in the U.S., well above one trillion, even if they had come down significantly, and the liquidity situation looked comfortable, yet the system really risked seizing up and the Fed had to intervene decisively, showing that there is a lot of uncertainty about banks’ demand for liquidity,” he said.

The Federal Reserve is now “enthusiastic” about the current system, and very keen to avoid allowing reserves to fall below the point at which overnight rates shoot up abruptly, which Papadia described as a “kink” in the rates-reserves curve.

RATES KINK

“If you listen to the Fed, they want to make sure that they don’t go left of the kink. They don’t want to get into a situation where liquidity could start being insufficient, so they want to stay on the right but they don’t know where the kink is and so they say we want to stay right of the kink,” he said. (See MNI INTERVIEW: US Treasury Cash Rebuild To Force Early QT End)

“The ECB has been more mixed, but I don’t see anyone who says we can quickly go back to the corridor approach,” he said, though he noted that that the “kink” for the eurozone might be located at a still-very-distant level of EUR750 billion in excess liquidity.

While the ECB should not rush into anything, Papadia says it would still be useful to offer a sense of direction in their operational framework review.

“If you are very uncertain about liquidity demand, one possibility is to have a standing facility that banks can use at any time. It’s not about you giving them a lot of liquidity but allowing them to take liquidity from you as they need and at non-punitive rates,” he said.

“Standing facilities in the old system did not play a very important role, it was more market operations, but the central bank of Norway is using this system, and it could be an innovative part of the review.”