Markets expect negative overnight rates in the Eurozone through mid 2016 as reserves become a "hot potato"

Last week's unexpected decision by the ECB to set the rate on bank excess reserves to -0.2% is sending liquidity holders scrambling. The idea behind negative rates is to penalize cash position holders. The amount of reserves in the Eurosystem is constant at any one time, so the penalty-carrying reserves just bounce around from bank to bank like a "hot potato". The ones stuck with liquidity overnight will pay the 20bp penalty. The ECB hopes this will force the banking sector into more lending, with some lenders preferring extra credit risk over the pain of holding reserves.

Of course a great deal of this is wishful thinking, as undercapitalization and deleveraging (combined with tepid demand) will continue to plague credit creation. Quite soon the Eurozone banks will be forced to raise massive amounts of equity capital in order to improve leverage ratios (see story) and additional lending would require even more capital raising. The timing is not great.

So what are banks doing with their cash? The easiest option is to buy sovereign debt, particularly short term notes. Government paper has minimal to no impact on regulatory capital needs and does not cost banks the 20bp charged by the ECB. That's why banks (and others) are willing to (in effect) pay the German government to hold some of their excess liquidity. Below is the chart of German 6-month bill yield.

Banks are also trying to lend to each other as liquidity sloshes through the system. Taking bank credit risk does raise capital requirements, but if limited to the higher rated banks, the marginal capital needs for those loans are relatively small. Of course the better rated banks are taking advantage of this situation by funding themselves in the interbank market at zero to negative rates. The chart below is the EONIA (overnight) interbank rate (equivalent to the Fed Funds rate in the US).

Source: ECB

Moreover, the forward markets are now pricing EONIA rates to stay firmly planted in the negative territory through at least the mid-2016. The chart below shows the forward curve before and after the ECB action.

Source: Natixis

As the ECB expands its balance sheet via the TLTRO program, excess reserves in the banking system will grow. This liquidity will become increasingly expensive due to sheer size of cash balances that are costing banks 20bp. That's why the market expects even lower EONIA rates going forward, as banks pay more to avoid getting stuck with large overnight reserve balances.

Just as Japan is getting caught in what is becoming a perpetual quantitative easing program (see discussion), the Eurozone is looking at negative rates for some time to come. The unprecedented monetary experiments by global central banks will be with us far longer than originally expected.


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Fed's experimental reverse repo program ramps up

Growth in US reserve balances (funds that banks hold at the Federal Reserve) has stalled recently. Part of the reason for the slower growth is of course the Fed's taper. Yet the Fed's balance sheet is still increasing, albeit at a slower rate. Which means that bank reserves should be growing as well, unless of course some reserves have been "drained".

There are a couple of ways the Fed can drain the reserves: sell securities or take in deposits/borrow. It turns out that the Fed is doing the latter by borrowing overnight via reverse repo (RRP). The newly established Overnight Fixed-Rate Reverse Repurchase Agreement program that the Fed has been testing (discussed here) has become quite popular. There is a limit of $10bn per participant (here is the list of counterparties allowed to participate), with the Fed now rolling about $200 bn of reverse repo daily. The experimental program has been ramping up and $200 bn has been drained from the reserves as a result. That's why we see bank reserves growth stalling (chart above).

The demand makes sense because this program allows money market funds to earn overnight rates that are higher than treasury bills. Federal Reserve officials are signaling their support for employing this new tool as a way to control the overnight rates.

Reuters: - Dudley said that "early evidence" shows that the Fed's new reverse repo facility  ... "would help strengthen our control over money market rates."

That's important, he said, because better control over short-term rates is likely to help the Fed keep a lid on inflation and inflation expectations. Under the facility, which the Fed has been testing for a year, banks, dealers, and money market funds effectively make overnight cash loans to the central bank, eliminating that liquidity from the system.

That's why when we finally hear the Fed announcing a rate hike, the central bank will be setting the Fed Funds Rate, the Discount Rate (which is more symbolic at this point), and the RRP Rate - with the latter being the most impactful for the overall economy.

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From our sponsor:

US commercial banks' changing asset mix

Here are some updates to the recent discussion on loan growth weakness relative to rising deposit balances at US commercial banks (see post).

1. Loan growth rate in the US, while better than in the Eurozone, remains on a downward path. The latest figures suggest that loans are increasing at less than 2%, while deposits continue to grow at 6-7% per year.

2. Loan-to-deposit ratio in the banking system hit a 35-year low recently.

3. Loans as a percentage of banks' total assets are at 52.2% - the lowest level on record. Just to put this into perspective, here is the breakdown of bank assets now vs. 10 years ago.

Source: FRB (note that derivatives and trading assets were not tracked separately 10 years ago)

Source: FRB (note that the bulk of "cash" assets are excess reserves held with the Fed) 

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From our sponsor:

How bank reserves make the gap between deposits and loans disappear

Earlier this week, CNN Money ran a story on JPMorgan's quarterly results. Instead of focusing on the earnings, the author's (Stephen Gandel) discussed the fact that JPMorgan's loan-to-deposit ratio (LTD) hit a new low.

FORTUNE: - The nation's largest banks are healthier than they have been in years. Someone, apparently, forgot to tell their loan officers.

JPMorgan Chase reported its 2013 profits on Tuesday. The news was mostly good -- bottom line: $18 billion -- but there was one significant black spot, not just for the bank, but for the economy in general. A key lending metric, the ratio of the bank's loans-to-deposits, hit a new low.

In 2013, JPMorgan on average lent out just 57% of its deposits. That's down from 61% a year ago and the lowest that ratio has been in at least a decade. Back in 2004, JPMorgan's loan-to-deposit percentage was as high as 88%.

While JPMorgan's LTD is particularly low, the bank is by no means unique. As discussed earlier (see post), LTD in the US is at the lows not seen in decades. On an absolute basis the gap between deposits and loans is now at some $2.4 trillion and growing. This divergence seems completely unique to the post-financial crisis environment.

Red = loans and leases, Blue = deposits (all commercial banks)

As the CNN story suggests, there are a few possible explanations for this trend. Here are four of them.

1. Demand for credit remains weak due to economic uncertainty, large amounts of cash on corporate balance sheets, jittery labor markets, poor wage growth expectations, general unease with taking on debt, etc.

2. Regulatory uncertainty and tighter (and to some extent unknown) capital requirements are preventing banks from extending more credit.

3. Exceptionally low rates make some forms of lending unprofitable.

4. Banks are running unusually large excess reserve positions with the Fed that are "crowding out" lending.  These reserves are effectively "loans" to the Fed paying 25bp, funded with bank deposits that pay near zero, creating riskless profits with zero regulatory capital requirement.

There are arguments to be made for all four. The last one however is particularly intriguing because the $2.4 trillion gap between deposits and loans is a familiar number. The excess reserves in the banking system is now ... also around $2.4 trillion.

The chart below adds bank reserves held with the Fed to loans and leases - and the gap "disappears" (here we use total reserves vs. just the excess reserves, but the difference is not material to this trend.)

Red = loans and leases + bank reserves, Blue = deposits (all commercial banks)

Coincidence? Perhaps. But if there is any validity to the explanation #4 above, it would suggest that QE, which is directly responsible for the $2.4 trillion in excess reserves, was not helpful (and possibly harmful) to credit growth in the US.

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From our sponsor:

QE3: the act of doing the same thing and expecting different results

As we approach the first anniversary of the Fed's monetary expansion effort (QE3), it's worth comparing the success of the current program with that of 2010-11 (QE2). At this stage the two are roughly equivalent in growing bank reserves.

Note: The official start dates were a bit different but the announcements took place around the same time

In fact just in the past few weeks the QE3-induced reserve growth exceeded that of QE2, as the total bank reserves (commercial banks' deposits with the Federal Reserve banks) move above $2 trillion (and the US monetary base moves above $3.2 trillion).

The key to these programs' effectiveness is their impact on credit growth. Here is the comparison. One could presumably argue that QE2 resulted in stemming the credit contraction taking place in 2010. It's hard to make that argument for QE3.

Given this result, why would any central bank want to continue on its current path? Some would argue it is to keep longer term interest rates low. But the 30-year mortgage rate is now some 60+ basis points higher than it was when QE3 was announced. So if it's not credit growth or interest rates, what is the mechanism to transmit this "unconventional" monetary policy into the economy and job growth?

You hear economists talk about how the Fed should continue buying securities at the current pace because the US economic growth remains tepid. But isn't this simply doing the same thing (now for a year) and expecting different results?

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From our sponsor:

QE ineffectiveness is playing out on banks' balance sheets

Cash holdings are an increasingly large component of US commercial banks' balance sheets. This demonstrates the fact that thus far the Fed's monetary expansion is not producing the "optimal" result. Banks are not growing the non-cash portion of their balance sheets fast enough to offset these rising reserves. A more optimal policy would be able to take that into account.

In fact the latest data shows that the non-cash component is declining.

Source: FRB (click to enlarge)

For those who are interested, the Fed recently published a technical paper (here) indicating that a massive QE program in the face of a "large and persistent adverse demand shock" is suboptimal. The data on credit expansion (above) seem to support that argument.

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From our sponsor:

The Fed's latest dilemma

The Fed continues to be divided over the next steps for its unprecedented monetary expansion program. Varying interpretations and conflicting headlines in the press leave the public bewildered and frustrated. The following two stories for example have appeared right next to one another on Bloomberg today.

But now the Fed has a new problem. The central bank's securities purchases are financed with bank reserves, which have been rising steadily in 2013 (chart below).

Source: FRB

And to many on the Fed that was justifiable as long as US commercial banks continued to expand their balance sheets. But recently that expansion has stalled.

Source: FRB

To some this calls into question the effectiveness of the whole program, since the transmission from reserves into credit is so weak. The Fed is now facing the following choices:
1. slow the purchases and run the risk of shrinking credit and rising interest rates or
2. continue with the program and risk QE "side effects" without the needed credit expansion (which has stalled).

That's why we are likely to see the Fed even more divided going forward, adding to more uncertainty and frustration by investors (including those outside the US) as well as the public.

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From our sponsor:

Draining excess reserves and the exit strategy

Questions continue to surround the Fed’s eventual exit from years of quantitative easing. The ultimate fate of what is to become of the 3.5 - 4 trillion dollar portfolio of securities (the expected peak holdings of Fed’s balance sheet) will determine, among other things, long-term interest rates, mortgage rates, corporate and US government borrowing costs, profitability of the banking system, returns on pension and insurance portfolios, and even the value of the dollar. In short, the exit strategy will drive the fixed income markets for years to come.

Some argue that the Fed has no need to sell securities and can simply sit on the portfolio as it winds down naturally through maturities and prepayments. The Fed can keep the economy from overheating by simply raising rates on excess reserves. And the fact that bank reserves (deposits at the Fed) will be in the trillions for years to come shouldn't matter they argue. That's because these reserves do not result in excessive lending and therefore are not inflationary. The lack of transmission from excess reserves to lending is visible in the so-called money multiplier (discussed here), which is at historical lows.

In normal times this argument may hold, but these are by no means normal times. By purchasing unprecedented amounts of securities, the Fed “created” trillions of excess reserves. And the central bank may not want to wait until 2020 (see post) for the reserves to decline to more normal levels on their own. Here are some reasons:

1. Some economists feel that even though reserves do not immediately transmit into lending, bank loans and leases have been rising steadily since early 2011 (QE2), and over the years could, if left unchecked, raise the money supply to inflationary levels.

Loans and leases on US banks' balance sheets (source: NY Fed)

2. Bloated excess reserves may ultimately impact the value of the dollar.

3. There are concerns that over a longer period, excess reserves could distort certain markets, creating financial bubbles - as banks seek to deploy cheap capital (in real estate for example).

4. With the reserves at their expected peak the Fed would be paying out about $6bn per year in interest to banks on riskless deposits. And those of us who have checking and savings accounts know that the rate we get on deposits is close to zero. Corporate accounts are not much better. That means that the banking system will get to keep most of that money. Now if the Fed raises the rate it pays on reserves (as suggested above), the banks will generate multiples of that amount in riskless profits. Once again, in a normal environment that would not be a big deal, but these days the Fed doling out free money to banks is not going to be very popular with the public.

These are some of the reasons the Fed may choose to drain at least some of the reserves. Selling assets may be one way to do it, but that may shake up the markets and significantly raise long-term interest rates. It will also generate realized losses for the Fed – another potentially unpopular outcome. But there is another solution. Back in 2009 the Fed set up tri-party repo arrangements with a number of dealers (see 2009 post). Eventually that will allow the central bank to lend out the securities instead of selling them. As dealers borrow the securities over a period of a week for example, they post cash as collateral to the Fed (dealers pay the coupon on the securities they borrow and receive the market repo rate on their cash “collateral”). That cash going into the repo account is taken out of “circulation”, thus draining the reserves.

If the Fed rolls these repo positions over time, the reserves will stay “drained” but the securities will still be owned by the Fed - until they pay down or mature. In effect the Fed would sterilize some or all of its securities purchases. Which means that draining the reserves does not have to entail the painful process of active portfolio unwind. And draining excess reserves is in fact a more likely exit strategy than some economists have been expecting.

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From our sponsor:

Fed's balance sheet grows above $3 trillion, finally impacting the monetary base

Total assets of Fed's balance sheet broke through $3 trillion last week, hitting a new high, as securities purchases are stepped up (including treasuries).

Fed's balance sheet as of 1/16/13 (source: FRB)

And for the first time since this program was launched it is starting to have a material impact on bank reserves (the dynamic component of the monetary base), which spiked last week.

Reserve balances with Federal Reserve Banks (source: FRB)

As discussed earlier (see post), 2013 will look quite different from last year. The monetary base will be expanded dramatically as long as the current securities purchases program is in place. "Money printing" is in now full swing.

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From our sponsor:

Fed lowers mortgage rates without "printing money"

The Fed remains in a holding pattern. Just as comparison, take a look at the pace of MBS purchases during QE1 in 2009 versus the current pace of expansion.

$bn, source: St Louis Fed

More importantly, bank reserves are basically holding flat...

Reserve balances with Federal Reserve Banks (source FRB)

... and so is the overall monetary base (effectively no new base money has been created since the start of the QE3 program).

$bn, source: St Louis Fed

Just the "threat" of open-ended MBS purchases by the Fed has created demand for agency MBS (see discussion), pushing MBS yields to new lows. That in return has sent mortgage rates to record lows as well.

Source: Bankrate

In fact today even as the 30y fixed rate hovers above absolute lows, the 15y fixed and the 30y jumbo both hit records.

Source: MortgageNewsDaily.com

If lowering mortgage rates was what the Fed intended to accomplish with the latest monetary expansion, the central bank has succeeded. And so far they have done it without a significant change in bank reserves. Whether this will translate into improved economic activity and job growth remains to be seen (see discussion).

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From our sponsor:

Regional banks release loss reserves to boost earnings

US regional banks have over-reserved for loan losses during 2009-2010 period, expecting a wave of defaults. Default rates however have been lower than projected and banks have been releasing these reserves into earnings in the past couple of years. According to Credit Suisse, that trend is expected to continue.

CS: - US Regional Bank reserve levels have declined by 38% from the peak levels of 1Q10. However, we think reserve levels may still decline by 11% to the trough, which we estimate will form in 3Q14.

Ratio of  loss reserves to loans (Source: CS)

As banks release reserves for existing loans (not to be confused with reserves at the Fed), the amount of loans they have on the books continues to grow. At some point (in 3Q14 according to CS), the absolute levels of reserves will begin to grow again. For now however the release in reserves is offsetting generally weaker than expected core revenues.

CS: - We remain cautious on the industry as we forecast core revenues to miss expectations over the next 12 months. While our net interest income forecasts trend below consensus expectations, our long-term EPS forecasts are only modestly below expectations as we have larger reserve releases than consensus in our models. Reserve reductions are low quality drivers of earnings; however, they still support higher capital payout ratios through the annual CCAR (capital stress test) process, and also imply a faster capital growth rate.

Declining interest income and fees are the reasons for this caution on core revenues. CS is also concerned about a recession next year, driven mostly by the US fiscal cliff (see discussion). So far however (particularly while releasing these loss reserves) regional banks have materially outperformed the overall banking sector and have continued to perform in line with the broader market.

KBE=banking ETF, KRE = regional banking ETF (source: Ycharts; click to enlarge)

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From our sponsor:

Gold lagging previous QE cycles but DB remains bullish

Deutsche Bank maintains its bullish stance on gold, in spite of missing their aggressive projection a few weeks ago (see discussion). Gold has underperformed the previous post-QE price moves, as shown in the chart below.

Source: DB

Part of the difference in this monetary expansion cycle from the previous ones is that the new program is having a fairly slow start in terms of its impact on base money. As shown in the chart above, Operation Twist for example had little effect on gold prices because it didn't involve increasing the monetary base (what some refer to as "money printing"). For every dollar in securities bought, there was roughly the same amount of securities sold, keeping base money from rising. Bank reserves, which is the primary mechanism for impacting base money, actually declined over the period since the Twist program was started (chart below). And the recent asset purchase initiative (QE3) has barely moved the reserve balances so far.

Source: FRB

Once the latest program begins to ramp up and bank reserves start growing again, real interest rates should move deeper into negative territory (see discussion) and the dollar should weaken (see discussion). That is likely to create a fairly bullish environment for gold. According to DB, the US fiscal uncertainty and potential risks of another debt downgrade will also support that market.

DB: - ... during the remainder of this year we expect the US fiscal cliff and further efforts by the Fed to extend QE will not only push long term real interest rates deeper into negative territory, but, also resume US dollar weakness. Moreover any speculation of an additional downgrade in US Treasury debt would be supportive to gold prices, in our view.

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US repo rates spike

The US repo rates have risen to a 3-year high this week. The chart below shows the so-called General Collateral (GC) treasury repo rate. GC simply means that the borrower under the repo loan can post any treasury securities as collateral - as opposed to specific bonds.

Source: JPMorgan

JPMorgan attributes this increase to several factors.

1. Banks' total reserve balances at the Fed has declined recently.

Bank reserves (source: FRB)

Empirically it can be shown that declines in reserves corresponds to rising repo rates. Reserves will begin rising again as the Fed commences balance sheet expansion.

Source: JPMorgan

 2. Dealer holdings of treasuries (which are not prohibited under the Volcker Rule) have risen recently, increasing demand for treasury financing.

3. US money market funds, tired of extraordinarily low rates in secured lending (repo), have rolled some of their assets into unsecured US bank paper (commercial paper and CDs). This reduction in repo lending contributed to rising rates. Note that US money funds still prefer secured lending in Europe (discussed here).

4. Quarter-end generally corresponds to higher rates, as banks try to reduce balance sheets ("window dressing") for reporting purposes.

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Outright asset purchases by the Fed will increase US banking system leverage ratios and potentially limit lending

There seems to be quite a bit of confusion about the impact of US banks' deposits at the Fed on the overall bank credit. People are asking "how can US banks be lending when they are keeping all this money in excess reserves (deposits) with the Federal Reserve"? "They are just hoarding cash, etc." But as discussed in this post on the ECB Deposit Facility, bank excess reserves are a function of the central bank's balance sheet, and have nothing to do with how much banks are lending. If banks in the US for example double their lending today, the deposit amount at the Fed would stay constant.

That's because if you borrow dollars from Bank A, you are going to deposit your cash at another bank (Bank B) or pay someone who will deposit this money at their bank (Bank C). Let's say Bank C buys securities with that money. But now whoever they bought securities from has that cash on deposit with Bank D, etc. Sooner or later some US bank will end up with that money and "deposit" it with the Fed - there is simply no other way around it. Here is a good quote from JPMorgan on how this works in practice:

"... increased (or decreased) lending will not change the amount of aggregate reserves within the banking system. For example, Bank A lends money to a business by writing that business a check. The business deposits that check in its own bank, Bank B, which presents that check to the Fed. The Fed then debits the reserves of Bank A and credits the reserves of Bank B. Reserves have been neither created nor destroyed, they have just changed hands. The Fed is the only institution that can change the aggregate amount of reserves."

When the Fed buys a security outright, it credits some bank the cost of the security (say X dollars) and the chain above begins until some bank (or multiple banks) ends up with that X dollars on deposit at the Fed, increasing total reserves. The only thing that could change this direct relationship between the Fed's balance sheet and bank reserves is the amount of physical cash notes under people's mattresses or in bank vaults. But that amount is small relative to the overall monetary base (total dollars) and tends to grow very gradually.

JPMorgan: - "The only thing a bank’s reserves can become—other than another bank’s reserves—is [physical] cash. ... the demand for cash changes slowly, so increasing vault cash will only increase banks’ storage and handling costs."

Fed's balance sheet vs. bank deposits at the Fed (reserves)

This means that as the Fed increases its balance sheet, it automatically raises bank reserves (deposits at the Fed) by roughly the same amount. And by doing so, the Fed grows the balance sheets of the US banking system (by increasing the amount of this particular asset banks hold). Even though deposits at the Fed do not require any regulatory capital (zero risk weighted assets), banks' reported leverage would increase, potentially causing them to limit lending activities.

JPMorgan: - "Although this asset has zero-weighted risk, it will increase banks’ leverage ratios. For this reason, banks may be inclined to reduce other forms of credit."

This is yet another reason the Fed will try avoiding outright asset purchases (QE3) for as long as possible, developing other easing alternatives instead.

SoberLook.com

EONIA rate averaging due to the 3Y LTRO’s

Guest post by Kostas Kalevras 
(Twitter: @kkalev)


One of the reasons that an averaging provision exists for banks required reserves during a maintenance period is that it stabilizes the money market interest rate. In the words of the ECB:

The averaging provision implies that institutions can profit from lending in the market and run a reserve deficit whenever the shortest money market rates are above those expected to prevail for the remainder of the maintenance period. In the opposite scenario, they can borrow in the market and run a reserve surplus.

Banks run deficit/surplus in their reserve accounts to take advantage of the averaging provision
(the recent drop represents the ECB lowering reserve requirements)

It seems that the latest 3 year LTRO’s might allow a similar smoothing scenario to occur in the EOINA rate for longer periods. The latest MRO (7 day refinancing operation) was less than 30 billion € while the rest of the banks liquidity is provided through long-term LTRO’s, with more than 1 trillion € corresponding to the 3 year LTRO’s and most of the remaining amount in 1 year LTRO.

The problem is that interest on the refinancing operations is paid on the operation maturity. With MRO’s payments happened every week while the rest of liquidity was provided through medium term LTRO’s (1 and 3 months maturity). That made the MRO rates quite ‘sticky’ since banks had to earn most of the interest quickly in order to be able to pay it on operation maturity (the 2011 MRO’s were usually quite large in size).

Now almost all of the interest will need to be paid in more than a year from now, allowing banks to play averaging games with EONIA. Since liquidity is basically an asset of ‘Euro-core’ banks (which try to find risk free places to park it, lowering the SMP term deposit rate close to the ECB’s overnight deposit rate and basically only loan among themselves), the combination of excess liquidity and low needs to earn interest fast, works to push the EONIA to even lower grounds and remove spikes (the drop of required reserves to 1% from 2% also helped since the spikes occurred on the last days of each maintenance period) since the first 3Y-LTRO:

EONIA rate

On the other hand, periphery banks have to borrow using low quality collateral (something which increases the effective lending rate) from ECB, while certain banks (like Greek banks) have to use the ELA mechanism and borrow at 3.75% (and an effective lending rate of close to 4-5%). The end result is that ‘Euro-core’ has an ‘accommodating’ monetary stance with low lending rates and excess liquidity, while the periphery faces an effectively ‘restrictive’ monetary stance while it needs exactly the opposite.

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China's 2012 monetary policy: gradual easing

Traditionally after a regime change, Chinese authorities don't want to implement anything drastic. China's new leadership will therefore be moving slowly on monetary easing. JPMorgan expects a gradual reduction in the reserve requirement ratios (RRR) and a stabilization later this year.

RRR forecast by JPMorgan

Note that large banks have been required to maintain higher capital ratios since the 2008 crisis. China does not need to go to Congress, seek comments from the industry, hold numerous Congressional hearings, etc. in order to implement higher capital rules for their "too big to fail" institutions. These are the "advantages" of a dictatorship.

JPMorgan: We expect monetary easing in 2012 to be moderate, and mainly consist of quantitative measures, including RRR cuts, OMOs, and window guidance on bank lending. In particular, we expect four more RRR cuts (totaling 200bp) in 2012, three in 1H. New loan creation should reach 8.2 trillion yuan (or 15% increase), up from 7.47 trillion in 2011. Meanwhile, the policy rate will likely remain on hold unless economic conditions deteriorate dramatically.

The expectation is that the PBoC will continue keeping loan growth limits fairly tight at the beginning of the year to give themselves room, should a more drastic action become necessary later. Tightening in the property markets will also continue. In the mean time the stimulus will be focused on major national infrastructure projects, affordable housing, and small businesses.

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Tired of hearing about the ECB Deposit Facility? Here is some good news.

A chart from Barclays Capital just may limit media coverage of the ECB Deposit Facility. The badly needed chart (below) shows Barcap's projections for what's called the "liquidity surplus" in the euro-system.

Euro-system Liquidity Surplus (source: Barcap)

The "liquidity surplus" represents the Deposit Facility balances plus banks' excess reserves. Excess reserves are the banks' current accounts (reserve accounts) at the ECB less the required reserves.  That amount fluctuates as banks "front load" their accounts to make sure the period average exceeds the required reserve amount.

Source: ECB

The excess reserves could be either positive or negative depending on where one is in the cycle. Therefore according to Barcap's chart, the Deposit Facility should be quite stable going forward except for the excess reserve cyclicality. Since the liquidity surplus is driven by the amount borrowed from the ECB (not banks hoarding cash), Barcap's forecast must assume that the net lending to banks by the ECB has stabilized.  With the 3-year LTRO significantly extending the average maturity, banks are not expected to repay their loans for a while. This will keep the net Deposit Facility balances reasonably stable, declining slightly over time.

And that is good news for those who don't want to hear about this facility any more. Since the facility is not expected to change for a while, it should result in the mainstream media staying away from covering the topic. It's just not going to be sensational enough going forward.

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The Deposit Facility is an indicator of net borrowings from the ECB

There have been a great deal of focus recently on the ECB Deposit Facility as it reached another record today.

London Evening Standard: The huge amount - busting the previous record set last week - comes despite the ECB flooding the banking system with €489 billion in cheap loans to more than 500 banks last month. Analysts warned that banks were stuffing the cash into the ECB because they are too afraid to lend it to other potentially struggling banks while some are hoarding the cash to pay off their own debts maturing this year. 

ECB Deposit Facility balances (EUR-mm, source: ECB)

Does it indicate "cash hoarding" by the Eurozone banking system because banks are afraid of lending or is there something else going on?

First of all the euro area is a “closed system”. That means every new euro created by the ECB stays within the system. When the ECB lends to a bank it “creates” new euros temporarily until the loan is repaid. The ECB credits these borrowed euros to the bank’s reserve account. The bank has a choice to either keep the funds at the reserve account or move them out to the Deposit Facility which tends to pay a better rate than excess reserves. Banks generally keep the minimum amount necessary in the reserve account. They just want to make sure that the daily balances average out to a number that is above the minimum reserve requirement over a specific time period. This makes the reserve amount “cyclical”.

Required reserves vs. actual balances (EUR-mm, source: ECB)

But what happens if a bank chooses not to deposit the borrowed money in the Deposit Facility? For example it decides to purchase an asset. If it purchases an asset from another bank, now that other bank has the extra money in its reserve account and has to make the same decision - whether to keep the funds in the reserve account or move them to the Deposit Facility. As Credit Suisse pointed out, it works a bit like musical chairs – with the last bank holding the cash in its reserves ultimately having to move it into the Deposit Facility.

Here is where it gets interesting. If a bank lends what it borrowed from the ECB to a corporation (or an individual or a government), that borrower deposits the money with her own bank (also in the eurozone), where it ends up in the reserve account. If the borrower buys a truck with her loan, the truck seller still has to deposit the money at a bank (unless the buyer uses physical cash, which is a tiny amount of the overall euros in the system).  No matter where it travels, that newly “created” euro ends up in some Eurozone bank’s reserve account. And unless that bank at the end of the musical chairs game needs that euro for its reserve requirement, it moves it into the Deposit Facility. Which means that even if the eurozone banks were lending massive amounts to each other, to governments, corporations, individuals, etc., the same amount of money would still end up at the Deposit Facility (assuming reserve requirements didn't increase).

So the balances in the Deposit Facility depend on two factors: how many new euros the ECB put into the banking system and what are the banks’ reserve requirements at the time. That means that the Deposit Facility balances have less to do with how much lending eurozone banks are doing and more to do with the net borrowings from the ECB. The more banks borrow from the central bank, the larger are the initial total reserve balances in the system and the more gets moved into the Deposit Facility. The chart below shows the combination of bank reserves and the deposit facility with the cyclical movements between the two accounts clearly visible (as reserves decrease, the Deposit Facility balances increase and vice versa). 

Reserve balances and the Deposit Facility balances (EUR-mm, source: ECB.)  Note: in this chart the Deposit Facility amount is sitting "on top" of the reserves amount - these are not two separate charts.

Therefore when the Deposit Facility balances increase, the banks are not really “hoarding cash” – they simply have no choice but to use the ECB's facility. The way to interpret this record deposit amount is that the banking system as a whole is borrowing record amounts from the ECB on a net basis.

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