(Bloomberg) -- The European Central Bank’s drive to mop up trillions of euros in excess liquidity is already lifting borrowing costs in the region’s funding markets, according to a Bank of America strategist.
On a secured or unsecured basis, rates are likely to continue increasing for the region’s lenders, as the ECB makes further headway in reversing years of easy monetary policy, strategist Ronald Man said.
“The shift in repo rates is definitely a reflection of increased funding demand,” Man said in a phone interview, referring to Europe’s €11 trillion ($11.8 trillion) market that’s a crucial source of daily liquidity for banks and other borrowers. “As the ECB reduces its balance sheet, banks will compete more for reserves.”
The challenges in weaning Europe’s banking sector off cheap liquidity is a focus for the region’s money markets. While banks’ levels of reserves and funding sources have been watched closely since the global financial crisis, scrutiny has intensified since last year’s collapse of Credit Suisse Group AG and several US lenders.
Read more: ECB to Push Banks for Weekly Liquidity Data as Scrutiny Grows
Currently, the amount of excess liquidity outstanding in the European banking system looks relatively high: it’s at around €3.5 trillion, more than double the average between 2015 and 2019. But Bank of America argues that stricter regulation and banks’ bigger balance sheets mean demand for reserves has increased.
At its peak in September 2022, excess liquidity reached €4.8 trillion. It’s declined fairly steadily since then, as the ECB reduces its bond holdings via a process known as quantitative tightening and as the region’s lenders repay trillions of euros of funds borrowed via targeted longer-term refinancing operations, or TLTROs.
BofA also acknowledges that the moves in repo rates aren’t purely down to growing competition for funding, but also reflects better availability of German bonds which are used as collateral. That’s driven the gap between bond yields and interest-rates on swaps — a type of derivative — to some of the tightest levels in years.
Read more: Collateral Scarcity That Stalked Europe’s Repo Market Is No More
Man sees the German general collateral repo rate rising to as much as 10 basis points over the Euro short-term rate (€str). On average it’s been about six basis points below over the past two years. The German rate was around eight basis points above its Euro counterpart on Tuesday, RepoFunds Rates Benchmark data from CME Group show.
The funding pressures may also weigh on Euribor, the rate at which European banks borrow from each other on an unsecured basis. BofA recommends positioning for the rate to widen to 20 basis points over €str by September, from 11 basis points now.
Italy, Spain Vulnerable
To be sure, funding pressures would ease if the ECB were to change tack, for example by slowing the pace of QT or introducing new lending operations if markets ran into trouble.
Still, the uneven distribution of excess liquidity through banking system poses another potential challenge, with Italy and Spain looking most vulnerable. That’s likely to drive a bigger wedge between German and Italian repo rates, according to Bank of America.
For a long time, Italian banks did not have enough reserves to repay the TLTROs. While that’s since been remedied via asset sales and debt issuance, BofA estimates they may need to accumulate at least a further €220 billion by the end of this year to satisfy liquidity requirements, while Spanish lenders may need a further €90 billion.
“Even banks in cash-rich countries are likely to need to pay up for funding if banks in cash-poor countries compete harder for reserves,” Man said.
(Updates prices throughout.)
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