ECB expected to tighten liquidity

While there is no doubt that key interest rates will be raised again, the European Central Bank may also want to tackle the excess liquidity in the banking system. The Targeted Longer-Term Refinancing Operations (TLTRO) are in the ECB’s sights.

The Governing Council of the European Central Bank (ECB) will meet again on 27 October to decide on the continuation of its normalisation policy. The previous monetary policy meeting on 8 September resulted in a 75 base point interest rate hike. When announcing the decision, ECB president Christine Lagarde stressed that the institution would take a meeting-by-meeting approach. In this respect, she stated that it would take “more than two meetings, but less than five meetings to arrive at the end of the key rate hikes”.

The ECB did not start raising rates until its July policy meeting, with a 0.50% increase, followed by the September meeting, with a 0.75% increase.

Simon Harvey, head of FX analysis at Money Europe, observes that the conditions are once again right for another rate hike: “With inflation rising, energy prices moderating and hard data pointing to stagnant growth in the third quarter, we believe that economic conditions remain broadly unchanged from the September meeting and continue to justify a further 75bp hike.” Such a hike should allow the Frankfurt institution to guard against the growing risk of a second round effect, in this case the price-wage spiral.


In addition to a likely further rise in interest rates, the ECB may also take action in the form of TLTROs (Targeted Longer-Term Refinancing Operations), i.e. loans offered by the ECB to banks on a longer-term basis and at favourable rates. This encourages banks to lend to businesses and households, keeping borrowing costs low, while supporting spending and investment.

“We expect the ECB to introduce a system to reduce the gains of banks benefiting from cheap TLTRO loans (whose average rate is lower than the ECB deposit rate) and redeploying their excess reserves to the ECB (at a lower rate than the ECB),” notes Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management. Indeed, the interest rate paid by banks benefiting from TLTRO is set as the average ECB deposit rate, which is currently lower than the current deposit rate of 0.75%. This has come about as the ECB has undertaken to raise its key rates faster than expected when the TLTRO instrument was designed.

€4.7 trillion of excess liquidity

The ECB had decided not to discuss TLTROs at its September meeting. However, the debate is growing. When policy rates rise, banks’ excess reserves are remunerated by higher deposit rates. The problem is not monetary policy, says Frederik Ducrozet, but the “huge amount” of reserves created by the TLTROs to the tune of €2.1trn for eurozone banks and €4.9trn of quantitative easing (QE). “This leads to an excess of liquidity of 4.7 trillion euros in the system,” said Ducrozet.

ING analysts also expect the ECB to reduce the volume of “subsidies paid to banks” in the context of the TLTRO. “The central bank seems determined to act before the TLTRO loans mature, which is as early as next June for the majority of them. The question now is what change the ECB will implement,” they commented.

ECB action on TLTROs would not, however, guarantee that banks would repay these loans. Some banks may not have the liquidity to repay the ECB at the next opportunity next December, say ING analysts. Others may decide to hold on to their loans until they mature, given the difficult funding environment for banks.