ECB puts a significant bypass in place

As of today the ECB puts in place a significant change in the standing facilities corridor (see press release here). The band between the marginal lending facility (normally +100 bp above the minimum bid rate) and the deposit facility (normally 100 bp below the minimum bid rate) is narrowed from 200 to just 100 bp. In our view that is a major move to unclog the frozen money markets in EMU.

In normal times both the deposit facility, in which commercial banks can park excess liquidity, and the marginal lending facility, where banks can draw on central bank liquidity at a fixed rate against sound collateral, have not played a major role. The daily average for the recourse to the deposit facility stands at just 14 million EUR, the daily average for the recourse to the marginal lending facility at 420 million EUR.

However, this has changed significantly since mid-September when US authorities decided to let a major investment bank to go into bankruptcy. Money markets worldwide have seized up since as liquidity rich banks stopped lending to those in need of liquidity for fear of counter party risk. Recourse to the deposit facility surged to 102.8 billion EUR by early October and currently still stands at 49.5 billion. Recourse to the marginal lending facility also surged over the same period to 18.2 billion. In parallel normal money market rates have surged.

This reflects the fact that bank A is not willing to lend to bank B. The former is, however, willing to deposit funds with the secure counterparty of the central bank and the latter forced to take funds from the relatively expensive marginal lending facility.

In effect, the taken action strengthens the role of the ECB as a clearing house for interbank loans given the perceived counter party risks between banks. The crucial test for the effectiveness of this measure is, of course, whether it can drive open market interbank rates down. This could work through the expectations channel: perceived counter party risk is naturally lower if you know that there is a lender of last resort that would provide funds. The test is so important because there are a lot of private sector variable rate contracts that are directly linked to interbank money market rates which would all be in for massive increases if those rates were not to come down.