By Anna Hirtenstein
The interest rate that European banks use to lend among themselves dropped to a record low this week in a sign of how credit markets have been distorted by central banks' aggressive measures this year.
The euro short-term rate, known as EURSTR, slipped to minus 0.555% Wednesday, from minus 0.539% at the beginning of the year. On Monday, the cost of overnight lending operations between the banks dropped to minus 0.557%, the lowest it has been since coming into effect in October 2019 after rate-rigging scandals led to the elimination of previous benchmarks.
The subzero rates essentially mean that banks and other financial institutions are offering to pay rivals to take money off their hands, albeit for a short period.
The recent decline in borrowing costs is a result of the European Central Bank's massive monetary stimulus program, which includes generous loans made to the region's banks to bolster the flow of money to businesses and households. That has left credit institutions so flush with cash that they currently hold about EUR2.9 trillion ($3.44 trillion) more than they have to for reserve requirements, according to research by UBS Group, in a phenomenon known as excess liquidity.
Many banks and lending institutions are also borrowing directly from the ECB, rather than tapping the interbank lending market, according to analysts. This two-pronged drop in demand is weighing on the euro short-term rate.
"The interbank market has been almost paralyzed by the ECB," said Carsten Brzeski, chief economist for the eurozone at ING. "No one really wants liquidity."
The ECB has lent over EUR1.3 trillion to banks since June in the latest iteration of a stimulus program known as longer-term refinancing operations, or LTROs. The central bank had nearly EUR1.6 trillion in outstanding loans in total at the end of August. The lending rate through that program can be as low as minus 1% if borrowers meet certain conditions. That means some banks can get paid more when they borrow from the ECB, rather than from each other.
Banks and investors in Europe are to some extent used to wrestling with the impact of subzero interest rates: The eurozone has had negative rates since 2014, and the ECB pushed its policy rate further down to minus 0.5% a year ago.
The euro short-term rate's slide mainly has consequences for banks that don't qualify to deposit their money directly at the ECB, or take loans from the central bank. They depend on the rates set in the interbank lending market for money that they borrow or lend overnight.
The interbank rate is also used in what's known as wholesale banking, by asset managers, pension funds and insurers. Such firms account for many of the transactions that use the euro short-term rate as a benchmark.
The decline in rates also affects short-term borrowers such as corporate treasury departments and investors in what is known as the money market. Transactions in money markets are used to calculate overnight lending rates including the euro short-term rate.
"We now have less visibility," said Julien Russo, a money-market portfolio manager at Swiss Life Asset Managers. "Everything is relative: now that we passed the zero bound, why not go lower?"
Analysts expect that the euro short-term rate could drop further, particularly if the economy takes time to recover from the pandemic-induced downturn. The interbank lending market's woes would likely be exacerbated if the ECB extends its stimulus programs again, pumping more money into the system.
"Maybe by the year-end, we could see it drop by another basis point or two, purely because there's so much excess liquidity in the system," said Rohan Khanna, a director of European interest-rate strategy at UBS. "The ECB's quantitative-easing operations are still ongoing, ending up on banks' balance sheets."
A rate that becomes increasingly negative would mean pension funds, asset managers and insurers get further penalized for keeping deposits overnight at their banks.
But too much reliance on the central bank could also eventually present a problem. The stimulus program will eventually be scaled back and banks will have to remember how to fund themselves again. This could lead to a spike in volatility in the euro short-term rate and distortions in the market, ING's Mr. Brzeski cautioned.
"As long as the ECB is very active, there aren't really implications. But they might arise when things start to normalize," he said.
Write to Anna Hirtenstein at email@example.com