Commercial banks need reserves for lending
ECB lending to banks how it works. Why still deposit business at 0.0% key interest rate?
How does the ECB allocate its billions of euros to banks? The following is a short version of the possible variants:
- There is a quick variant, the "marginal lending business", in which the ECB even lends overnight. The top lending rate of currently 0.25% applies for this.
- In the normal withdrawal procedure, the “main refinancing operation”, the banks report their need for money to the ECB via the national central banks on a weekly basis. After approval, the credit is posted to the bank's central bank account. The term of the central bank loan is 7 days. The fresh ECB money bears interest at the main refinancing rate, the key rate of currently 0.00%.
- In another variant, with which the ECB is trying a little more aggressively to pump money into the financial cycle, the term “tender” plays a role. The ECB creates money, the vernacular likes to say "prints money" and makes a bundled offer, e.g. according to the pattern "Today we are awarding 500 billion with a term of 1 year". If the banks with money requirements meet the demands of the ECB, they receive a tranche from the tender and have to repay the money accordingly in installments by the end of the term. The main refinancing rate also applies here, colloquially the key interest rate of currently 0.00%.
- Another way to increase a commercial bank's account balance with the central bank is through open market operations, in which the ECB buys shares, government bonds and other securities from a bank.
Who does the ECB lend money to?
All approved business partners are banks with a corresponding banking license. Otherwise everyone could get the idea of taking out a 0% loan.
What collateral do the banks need?
Collateral suitable for central banks such as bonds, especially government bonds and shares, must be deposited. Without this, the ECB will not grant any loans. In order to keep banks in problem countries liquid, government bonds from problem countries such as Italy and Greece are also accepted.
Why do banks need central bank money?
- First of all, the ECB money secures the daily banking business via the Target2 payment system. If bank A transfers an amount to bank B and at the end of the day no offsetting transfers from bank B to bank A have accrued, bank B receiving the money only books the credit if the sending bank “provides” the corresponding consideration. Central bank money is usually required for this. The balance on the central bank account of bank A decreases, the balance on the central bank account at bank B increases.
In order to be prepared for times when funds tend to run out, banks hold a certain minimum reserve. In practice, this is the case, for example, when the bank lowers the deposit interest, e.g. for overnight money, and customers switch their money to other banks.
- The bank lends it on in the form of loans at a premium. Bank X is currently borrowing at 0% and lending at 4%. The interest rate differential is the bank's margin. Sounds good, but the bank bears the risk of default if a debtor can no longer pay their installments.
What is the minimum reserve / liquidity reserve?
Every bank is required to deposit a minimum reserve with the central bank. The minimum reserve is an important instrument for stabilizing the banking sector. Deposits that are available daily and fixed-interest deposits with an agreed term of up to 2 years from customers are subject to reserve requirements. For example, approx. 1% of the total of the daily available customer deposits must be deposited with the ECB as a minimum reserve. This liquidity reserve protects the bank and prevents bottlenecks, e.g. if many customers liquidate their deposits and the bank has to pay out money.
When customers withdraw money, the minimum reserve, i.e. the bank's balance on the ECB account, is reduced. If the deposits at Bank X increase on a monthly basis, the minimum reserve and thus the bank's account balance on the ECB account increases.
Why do banks have to park money with the ECB?
Parked money is exclusively “central bank money” above the amount of the required minimum reserve, which is not fed back into the banking community.
The reasons banks have excess liquidity with the ECB.
- Since the interbank market, characterized by resentment and mistrust after the Lehmann bankruptcy, through which banks can borrow central bank money from one another, offers almost no more opportunities, German banks in particular are keeping the cheap ECB money in reserve.
- The lending rates are low and so does the margin when lending by the bank. For this reason, some banks are restrictive in their lending business.
- The banks are cautious and give little venture capital. A loan transaction can only be carried out if there is sufficient collateral.
Penalty interest is a burden on the banks.
For said ECB funds that exceed the minimum reserve, the banks have to pay the so-called penalty interest, more precisely the "deposit interest rate" of currently -0.50% p.a. A bank cannot simply transfer central bank money to a business account and thus escape penalty interest.
Why does a bank need overnight deposits, savings accounts and fixed-term deposits?
A legitimate question, because it seems cheaper to use central bank money to finance loans than capital that flows in through fixed-term deposits, for which the bank pays up to 2% interest, depending on the term.
- On a day-to-day basis, a bank must always have enough cash available for customers to use checking accounts. Customer deposits are a source of refinancing, as transfers made to third-party banks, e.g. to a current account or overnight deposit account (sight deposits), have to be covered with "cash-compatible" central bank money. Payments of money by customers to the current account allow real cash to flow in and also ensure “cash liquidity”.
- Without having to deposit collateral with the ECB, customers use the assets in excess of the minimum reserve for lending purposes. Savings accounts (savings investments), fixed-term deposits and savings bonds (time deposits) with long terms create a certain level of planning security for the bank, as the deposits will only become due in years.
- The deposit business is also a kind of “customer care”. The ECB can turn off the "money tap" at any time. Clever banks are multi-pronged and keep the way of raising money through savings deposits open.
Sources for our research: FAZ, Bundesbank
Image source: psdesign1 - Fotolia
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