What an acceleration of quantitative tightening could mean for Eurozone banks
Amid a broad consensus that core inflation will remain above target for another two years, S&P Global Ratings’ economists expect the European Central Bank’s (ECB’s) monetary policy to continue normalizing once rates have peaked. If inflation does indeed exceed the target for another two years, we believe the current passive form of quantitative tightening (QT) could give way to a more active form, which would involve the ECB starting to sell bonds on the market.
Today, the ECB holds about €5tn in bonds and we believe it could reduce this sum by €1.0tn-€1.5tn. This is on top of a €600bn balance-sheet reduction via targeted longer-term refinancing operation (TLTRO) repayments that are set to take place by the end of 2024. One important question is at what speed the reduction in bond holdings should occur.
For Eurozone banks, a hypothetical acceleration of QT would not have a major direct impact on their capital adequacy or liquidity and funding ratios. However, it would fuel the normalization of funding costs and net interest margins already under way (see “European Banks: Protecting Liquidity Will Come At An Increasing Cost,” published June 29, 2023). Indeed, active QT would likely lead to deposit outflows, as nonbanks use bank deposits to buy parts of the bonds that the ECB sells.
The ECB could also decide to lower the remuneration of banks’ excess reserves to incentivize them to buy parts of these bonds. A key determinant of banks’ willingness to buy the ECB’s bonds will be the risk-adjusted spread between the yields on the bonds and the rate at which banks can deposit their excess reserves with the ECB, namely, the deposit facility rate (DFR; currently 3.75%). For now, this spread is mostly negative, meaning that banks have few incentives to swap deposits at the ECB for bonds.
Besides this, the acceleration of QT could lead to unpredictable secondary effects on banks and the financial system at large. In the US, where the Federal Reserve restarted its QT program in April 2022, banks have seen deposit outflows weigh heavily on their funding, liquidity, and spread income. In the Eurozone, we see banks as well placed to manage the transition, but we are mindful that QT could also have profound implications for financial institutions’ business models and financial profiles. Competition for a shrinking pool of deposits could intensify, leading to a rise in banks’ funding costs. Tighter liquidity conditions could exacerbate refinancing risks for nonbanks. Banks may also increase exposures to their domestic sovereign over time, thereby reinvigorating the so-called sovereign-bank nexus–the interconnectedness of sovereigns and banks–which was a major catalyst of previous financial crises.