(Bloomberg) -- Speculation is building over whether European lenders will be forced to park more cash with the central bank, a move that may hit their profitability and increase volatility in short-term euro rates. 

Strategists at firms including Commerzbank AG, Barclays Plc and UBS Group AG have warned the European Central Bank could surprise markets and increase the so-called Minimum Reserve Requirements, or MRR, as soon as this week as it seeks to reduce costs and drain excess liquidity.

Euro-area lenders are currently obliged to keep 1% of liabilities such as customer deposits at their respective central banks, for which they get paid no remuneration. An increase to the MRR could reduce excess reserves, which are still paid 4% interest, helping central banks rein in their losses after years of costly quantitative easing programs.

Most analysts expect an increase in the MRR within the next 12 months, according to a Bloomberg survey. Barclays and Commerzbank say it could be revised to 2% this week.

Locking up more of banks’ cash at the ECB not only hits their profitability, but also has direct implications for money markets. Lenders may resort to “avoidance strategies” to ease the burden of complying with the rules, for example by cutting overnight rates to encourage depositors to take their cash elsewhere. 

There were already signs of this behavior after the 0% remuneration on reserves came into effect on Sept. 20. The unsecured overnight borrowing rate for euro area lenders, known as ESTR, fell 2.6 basis points, the biggest month-end decline since December 2020. 

“This sort of volatility in the ECB’s overnight benchmark rate is never a desirable feature – benchmark rates have to be stable and reprice based on change in monetary policy settings rather than these technical quirks,” said Rohan Khanna, head of euro rates strategy at Barclays. “Implications of a higher MRR go well beyond just saving a few billion on interest expenses.” 

The ESTR drop at the end of October may be bigger still even if the MRR remains at 1%, according to Commerzbank strategist Christoph Rieger. 

“Like with passing on the negative depo rates, it probably takes some time before more banks factor the higher MRR cost into their depo pricing,” Rieger said. A technicality tied to the day of the week on which month-end falls also points to a bigger drop this month, he added.

There are concerns about the impact of banks’ avoidance strategies on repurchase agreements, or repo. Minutes from the ECB Money Market Contact Group’s September meeting highlighted the risk that money-market funds place their cash in the repo market instead of with banks, leading to “pronounced declines” in repo rates around reporting dates.

Read more: Holzmann Wants ECB to Cap Remuneration of Banks’ Deposits at 90%

Numerous ECB officials have weighed in on the MRR since July’s decision. Austrian central bank governor Robert Holzmann, among the Governing Council’s most hawkish members, has mooted lifting the requirement tenfold, arguing that banks benefited significantly from years of unconventional monetary policy. 

Others like Francois Villeroy have pushed back, arguing there’s “no monetary justification” for such a move. His colleague Isabel Schnabel, who is in charge of market operations, has said any decision should be part of the ECB’s ongoing wider operational framework review, which may only conclude early next year.

It’s possible therefore that the ECB will opt instead to start unwinding the €1.7 trillion ($1.8 trillion) stash of bonds it bought during the pandemic under a program known as PEPP. Such a move would enable it to reduce its sovereign bond exposure and drain liquidity at a more gradual and predictable pace, without the risk of distortion to policy transmission, according to Goldman Sachs strategist Simon Freycenet.

“Eventually, however, bond holdings and high MRR could become complements,” he said. “If the ECB wants to return to a lean balance sheet, having at the same time elevated MRR could create an environment of scarce liquidity.”

Still, the impact on banks’ balance sheets is causing concern. While there’s still more than €3.5 billion in excess liquidity in the system, it’s distributed unevenly and a higher MRR could create liquidity deficit among some lenders. 

Read more: Deutsche Bank, ING Face Next Blow as ECB Mulls Higher Reserves

An MRR increase of just one-percentage point would consume Italian banks’ aggregate net excess liquidity, according to Commerzbank calculations, potentially forcing them to raise new funding. 

“A revised uniformed rule may have unintended consequences in some markets where liquidity is more limited, for example Italy,” AXA Investment Managers economists Hugo Le Damany and Francois Cabau wrote in a note. 

--With assistance from Jana Randow.

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