ECB Must Launch a New Swap Instrument to Rein in Liquidity

As inflation steadily rises, the European Central Bank (ECB) has taken a firm stance on raising interest rates to combat the issue. However, another major issue hidden behind the scenes must be addressed for the ECB to maintain its stability: the central bank’s balance sheet. Massive expansion over the years has left a significant €4tn of idle liquidity in the pockets of euro area banks. Until this has been resolved, the ECB can only raise rates by subsidizing bank deposits.

A Subsidy to Bank Shareholders

The issue lies in the fact that the assets held by the ECB yield a return far below the funding cost, which will likely cause problems for the ECB and its respective national central banks in the future. Bundesbank President Joachim Nagel recently announced that losses incurred by the German central bank last year do not cover provisions, which may require financial support from the government and indirectly from taxpayers. Therefore, the only way for the ECB to remain steady is to keep its deposit facility rate low. The problem is that this action is only compatible with the intended monetary policy course if the bank’s liquidity and the central bank’s outright portfolio of securities are reduced in parallel and quickly. The ECB has already started scaling down its securities holdings, but the pace of €15bn a month on a net basis may not be sufficient. If everything remains equal, it will take approximately 27 years to reabsorb all the liquidity through this channel alone.

A New Swap Instrument

The ECB must create a new swap instrument allowing them to exchange their non-interest-bearing deposits with euro-area banks for securities at a fixed rate of return. This would prevent the ECB from having to pay the banks for nothing while still allowing the banks to access a risk-free rate of return. With the creation of this instrument, the ECB can start reducing the bank’s idle liquidity while preventing the depreciation of its asset holdings. This solution is less risky than a sudden hike in interest rates and can help to maintain the ECB’s independence in the long run.

Related Facts

• The ECB has been raising interest rates since last summer to combat inflation.
• The ECB’s balance sheet contains €4tn of idle liquidity, which must be reduced for the bank to maintain stability.
• The ECB is scaling down its securities holdings by €15bn a month on a net basis, but this is not enough to resolve the liquidity issue.
• Creating a new swap instrument would allow the ECB to reduce the bank’s idle liquidity while preventing the depreciation of its asset holdings.

Key Takeaway

To maintain independence and stability, the ECB must create a new swap instrument that would allow for the exchange of non-interest-bearing deposits with euro-area banks for securities at a fixed rate of return. By doing so, they can reduce banks’ idle liquidity and prevent the depreciation of their asset holdings, which is less risky than a sudden hike in interest rates.

Conclusion

The ECB must act to resolve the issue of idle liquidity and decrease the dependency on subsidies that support their bank’s shareholders. Creating a new swap instrument would be a significant step forward in the right direction for the bank to maintain its independence, stability, and reputation while also combating the growing inflation rates. This issue must be addressed quickly and efficiently to prevent any further problems that may arise in the future.