MNI SOURCES: ECB Seen Changing TLTRO Terms

The European Central Bank’s Executive Board will present the Governing Council with a proposal to retroactively modify conditions on cheap TLTRO loans to banks and expects it to be approved this Thursday, sources told MNI.

Higher interest rates have made it profitable for banks to plough money received from Targeted Longer-Term Refinancing Operations into deposits at the ECB, raising the prospect of substantial losses for some Eurosystem national banks. (See MNI SOURCES: ECB's Focus Shifts To Interest On Reserves)

While some Governing Council members are wary of the risk of making retroactive changes to loan contracts, considering that such a move might also damage the ECB’s credibility and that it would be easier to limit the proportion of a bank’s reserves that can receive the Deposit Rate, Executive Board officials are confident that legal concerns can be allayed. The changes being prepared by ECB economists will enact forward-looking changes to TLTRO terms, one source said.

A majority of national central bank bosses are expected to agree that such a move would be proportionate and within the ECB’s mandate, with legal support coming from a previous European Court of Justice ruling in favour of ECB bond-buying.

“I would expect an announcement related to TLTRO at the next meeting,” one Eurosystem official said.

The proposal may be raised as a separate item rather than being embedded in policy options presented by chief economist Philip Lane or head of market operations Isabel Schnabel, one source said.

Two more officials said TLTRO changes represent the most straightforward solution to the reserve remuneration question. One agreed that it was likely the Executive Board would guide towards changes to TLTRO terms, but added that their national central bank was still concerned about potential legal challenges, which could disrupt policy transmission whilst being processed by the courts.

“If Philip Lane does put it on the table, I'd guess they are confident they have the backing, but the credibility issues it creates going forward don't disappear,” the source added.

RATE HIKE

Sources agreed that a rate hike of 75bps is almost certain this week, in line with market expectations. Officials calling for a different course of action would be more likely to argue for 100bps than 50bps, one said.

But Governing Council members are increasingly concerned by the slowdown in the euro area economy, as well as the prospect of a political backlash against central bank tightening.

Only after rates have peaked would the ECB begin quantitative tightening, which would initially take the form of a tapered end to reinvesting principal payments from the Asset Purchase Programme, rather than asset sales, officials said.

“It’s quite probable that the course of interest rate increases will go hand in hand with some kind of recession,” one official said. "I think it’ll be a long pause before the announcement and start [of QT], and that it will be done in terms of partial reinvestment: for example, 80% or something like this.”

Careful communication will be key.

“Whatever we do we have to start slowly and we should also communicate it clearly in terms of balance sheet run-off in order to avoid any taper tantrum,” said another source.

Recent events in the UK’s gilt market were a “salutary eye-opener” for Brussels and Frankfurt, one Eurosystem official said, pointing to the danger that any premature attempt at quantitative tightening could necessitate bond buying by the ECB’s new Transmission Protection Instrument, which is designed to limit any disproportionate blowout in eurozone spreads.