The keenly-awaited plan, over a year in the making, aims to gradually reduce the size of the ECB’s footprint in the region’s financial system, in part by transforming how banks interact with the central bank—and with each other.
As it stepped in to restore trust and stability during recent crises, the ECB became a huge presence in the economy, warping how financial institutions behave. The new changes aim to tame this gravitational pull.
One of the goals is to revive short-term lending between banks and other financial institutions. This would restore normality after such transactions dried up—never to fully recover—when trust between institutions collapsed during the global financial crisis.
The changes don’t mean the ECB will recede into the background. It will maintain sizable bondholdings, and its presence in financial markets will still loom bigger than it did before the financial crisis broke out some 15 years ago.
That approach mirrors the Federal Reserve, whose Chair Jerome Powell said in December that the U.S. central bank planned to “slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level judged to be consistent with ample reserves.”
Some analysts said the ECB’s plans didn’t go far enough.
“The ECB is basically sticking to the system of high excess liquidity and will hold many securities in the long term,” said Jörg Krämer, chief economist at Commerzbank. “Fifteen years after the end of the financial crisis, the ECB could have dared to achieve more normality.”
With once abundant money growing scarcer as central banks drain cash from the economy, the ECB‘s new operational framework aims to keep providing cash to eurozone banks but at a price, creating an incentive for bankers to look beyond the central bank for opportunities to borrow.
The ECB said that it would continue to steer borrowing costs through the deposit rate, which is currently set at 4%. But under the new framework, this focus will shift toward the bank’s regular money auctions, where banks bid for cash at a fixed rate.
That rate will be set 0.15 percentage points above the bank‘s deposit rate, starting in September, down from a 0.5 percentage point gap at present.
The framework also creates a new bond-buying program separate from existing bond portfolios and aimed at smoothing the supply of money.
The makeover has no bearing on the ECB‘s interest-rate decisions. Rather, it concerns how the bank transmits those decisions to businesses and households. The new bondholdings won‘t aim to boost spending and growth, for example, which was the goal of the bank‘s earlier bond-buying programs.
Central bankers are aiming to avoid sharp movements in interest rates as they mop up the money created to support economies during recent crises. Sudden spikes in short-term financing markets can make it harder and more costly for businesses that need the money the most to access it.
The decision to keep money in the eurozone generally abundant reflects banks’ higher demand for safe and liquid assets, partly due to regulatory requirements designed to promote financial stability.
Both the Fed and ECB have various tools to steer interest rates. The ECB‘s tools operate more via the banking system because bank lending is more important in the region, while the Fed operates more through financial markets.
Until the 2008 global financial crisis, the ECB kept money scarce and steered interest rates by asking banks to bid for an amount of cash that it thought they needed at auction, and then borrow from one another. Today though, banks borrow much less from one another than before.
Money became abundant as central banks started lending banks as much as they requested to smooth market stress. Then the central banks started buying trillions of dollars of government and corporate debt, injecting even more money into the financial system.
As liquidity became abundant, the ECB‘s deposit rate, rather than its main refinancing rate, became the tool of choice to steer market rates because it provided a floor below which banks were unwilling to lend. That is because banks could get the same return from safely parking the money at the central bank.
Today, the ECB‘s regular auctions see little action, but the new operational framework should change that.
The ECB said it wouldn’t alter its reserve requirements, which some analysts had expected. The ECB could have saved money by exempting more bank reserves from interest payments, which are contributing to large losses at major central banks. Such a move would have been costly for banks and might especially hurt lenders in southern Europe with fewer reserves, analysts said.
Write to Tom Fairless at tom.fairless@wsj.com