The European Central Bank’s efforts to absorb excess liquidity totaling trillions of euros are already exerting upward pressure on borrowing costs in the region’s funding markets, according to a strategist at Bank of America. Ronald Man, the strategist, anticipates continued increases in rates, both on secured and unsecured bases, as the ECB progresses in unwinding years of accommodative monetary policy.
Man explained in a phone interview that the shift in repo rates reflects heightened funding demand in Europe’s crucial €11 trillion ($11.9 trillion) market, which serves as a daily liquidity source for banks and other borrowers. As the ECB reduces its balance sheet, banks are expected to compete more vigorously for reserves, contributing to the rise in rates.
The challenges of transitioning Europe’s banking sector away from cheap liquidity have become a focal point for the region’s money markets. Scrutiny on banks’ reserve levels and funding sources has intensified since the collapse of Credit Suisse Group AG and several US lenders last year.
Although the excess liquidity in the European banking system appears relatively high at around €3.5 trillion, more than double the average between 2015 and 2019, Bank of America argues that stricter regulation and larger balance sheets have increased the demand for reserves.
Since its peak in September 2022, excess liquidity has steadily declined as the ECB conducts quantitative tightening and as lenders in the region repay trillions of euros borrowed through targeted longer-term refinancing operations (TLTROs).
Additionally, the movements in repo rates are not solely attributable to increased competition for funding but also reflect improved availability of German bonds, which are used as collateral.
Man predicts that the German general collateral repo rate could rise to as much as 10 basis points over the Euro short-term rate (€str), compared to the average six basis points below over the past two years. This rate was approximately eight basis points above its Euro counterpart on Monday.
BofA recommends positioning for Euribor, the rate at which European banks borrow from each other on an unsecured basis, to widen to 20 basis points over €str by September, up from 11 basis points currently.
Despite the potential easing of funding pressures if the ECB alters its approach, the uneven distribution of excess liquidity throughout the banking system could pose challenges, particularly for banks in Italy and Spain. Bank of America suggests that Italian and Spanish banks may need to accumulate additional liquidity to satisfy requirements, potentially leading to higher funding costs.
“Even banks in cash-rich countries are likely to need to pay up for funding if banks in cash-poor countries compete harder for reserves,” remarked Man.
