Two-Tier Bank Penalty: Why the ECB Should do Nothing at All

Causing the latest round of euro weakness was speculation that the European Central Bank (ECB) would announce a two-tier deposit rate in December.

The euro had been looking to head towards the 1.07 marker against the US dollar ahead of the news but subsequently slumped back towards 1.06 confirming how negative the event turned out to be.

The ECB apparently has up to 20 new ideas on the table for announcement in December according to reports. One involves levying a penalty charge on banks that are seen hoarding cash in the ECB’s deposit facility.

How would this work?

Kim Liu, Senior Fixed Income Strategist at ABN Amro explains:

“Commercial banks that deposit a relatively low level of funds would face a less negative deposit rate, while those that deposit more funds would face a more negative one.

“Core banks tend to use the deposit rate facility the most, so they might be most affected by a more negative ‘penalty rate’ for excess cash.”

ABN Amro believe the advantages of the dual system are that it would cut banks that do not deposit ‘too’ much liquidity at the ECB with some slack, in the sense that they could continue to deposit their funds at a lesser negative rate.

“It would therefore cushion the blow to bank profits, while still delivering a bigger rate cut. By doing so, the ECB could keep the euro under pressure,” says Liu.

The disadvantage is that the system would become more complex.

Another option being explored is for the ECB to buy the debt of towns and administrative regions.

The sense we are getting is that the ECB is coming up with more creative ways into shocking the markets into pushing the euro yet lower.

The Eurozone needs a weaker euro to ensure exports remain resilient and the manufacturing power-house that is Germany continues to grow.

The problem is, markets have priced significant action into the price of the euro and any disappointments will see the currency move higher.

Indeed, there are some economists who point out that the ECB does not actually need to do anything as it is trying to fight an imaginary foe.

That foe is inflation; a few days ago we heard Draghi rattle off the reasons as to why inflation is dangerous.

The argument made by Draghi is tenuous though it is argued.

“Clearly, consumers appear to be undeterred by low inflation rates. There is currently no evidence for the scenario invoked by the ECB of a downward spiral of declining inflation rates and consumer spending,” argues Dr. Gertrud R. Traud, Chief Economist and Head of Research at Helaba Bank.

Traud believes the ECB has made a mistake in falling for the idea that lower inflation rates are exclusively a result of weak demand.

“But it is palpably clear that the main factor for lower rates of inflation is the considerable drop in commodity prices,” says Traud.

Could the ECB wake up to this notion over coming weeks or months? If so then the case for a more hawkish ECB in 2016 starts to appear.

A hawkish ECB translates into a potentially higher euro.

Indeed, economists don’t see much potential downside left in the euro / pound exchange rate from current levels with polls showing 0.6944 being the consensus forecast for year-end 2016.

The risks, we believe, are for this level to rise over coming months as the ECB is exposed as being overly proactive.