The European Central Bank is likely to limit the interest on reserves it pays to commercial banks as monetary policy tightens, most likely by imposing a tiering system, the ECB’s former director general for market operations Francesco Papadia told MNI.

The ECB used tiering to shelter banks from the full effect of negative interest rates, and now that rates are positive and rising fast, it would be appropriate for the central bank to limit their earnings on reserves, Papadia, now senior resident fellow at the Bruegel thinktank, said in an interview.

“I think the ECB could make the point to the banks that, they were helped with tiering and now should not overdo it in terms of making a lot of money from depositing money with the ECB,” he said. “The most likely [solution] in my view is that they would do something symmetrical to reserve tiering. They would start with the Reserve Requirement and apply a multiplying factor and say, upwards to that amount they would not remunerate reserves or deposits with the ECB.” (See MNI SOURCES: ECB's Focus Shifts To Interest On Reserves)

Policymakers will try to ensure that any move does not ruffle money markets, Papadia said. Reserve tiering could prompt banks to reduce liquidity by repaying the ECB’s longer-term refinancing operations more quickly than they otherwise would, and could also spur cross-border flows, given that the amounts that banks have deposited at the central bank will vary from country to country, he noted.

NO RUSH FOR QT

The ECB is some way from following the Federal Reserve into quantitative tightening, at least in terms of active sales of its balance sheet, though it could gradually wind down reinvestments of maturing bonds acquired under its Asset Purchase Programme, according to Papadia.

“I don’t think that the non-renewal of reinvestment under APP would be a substitute for rate increases, this would just be a soft accompanying measure, which they could calibrate as soft as they wish. They could also announce it for the future and not immediately, so they could do it in a softer form and not cause too many problems in the market,” he said.

“I don’t see the ECB embarking any time soon on the active selling of bonds from its APP portfolio.”

The ECB’s new Transmission Protection Instrument, which can be used to suppress any blowout in bond spreads within the eurozone, together with the flexible use of reinvestment flows from the Pandemic Emergency Purchase Programme would reduce the chances of market disruption from a reduction in APP reinvestments, Papadia said.

For the moment, details of how the TPI will operate are scant, and Papadia said more are unlikely to be provided until the ECB feels it is near deploying the facility.

“If they see things starting to get out of hand in the markets, they could give more details to show they are ready to act. In my sense that would mean that they think the probability that they will have to use it is increasing,” he said.

“Then maybe the announcement calms markets down and they don’t have to do it after all.”