Why ECB Is Stuffing More Free Cash Into Bank Pockets

(Bloomberg) -- The European Central Bank is throwing every tool it has at a euro zone economy that's gone from sluggish to nearly frozen in the face of the coronavirus pandemic. One branch of this effort involves generous funding offers to lenders in the region, an expansion of an approach it used twice before over the past decade to stimulate growth. It has also tweaked its negative interest rate policy to limit the punitive side effects.

1. What's the ECB doing for banks?

It's expanding a program called Targeted Longer-Term Refinancing Operations (TLTROs) and adding a new one called Pandemic Emergency Longer-term Refinancing Operations (PELTROs).

2. What are TLTROs?

They're loans aimed at getting financial institutions to boost lending to companies and households, stimulating economic activity and creating jobs. That in turn should boost demand and drive up prices. Banks can always borrow short-term from the ECB, but the TLTROs are special: potentially cheaper, and with a longer maturity of three years.

3. How does the targeting work?

The amount a bank can borrow from the ECB under the program depends on the size of its loan book to the private sector, excluding mortgages. Initially, the interest rate was set at the ECB's main refinancing rate, which is currently zero. If a bank lends enough money to companies and households to meet a goal set by the ECB, it is rewarded with a cheaper interest rate. Last September, the ECB said the rate could fall to the level of the ECB's deposit rate, which was minus 0.5%. Now that rate will fall to minus 1%.

4. What are PELTROs?

They are loans that are described as “non targeted,” that is, not linked to any specific increase in lending. Interest on PELTROs will be 0.25% below the main refinancing rate that presently is zero. The ECB said PELTROs will effectively provide bridge financing when an older tranche of loans from the central bank begins to expire. They will also have shorter maturity than the TLTRO program -- from 16 to 8 months.

5. TLTROs sounds like a subsidy in disguise. Are they?

It's not even disguised. Former ECB President Mario Draghi himself said that “if there were no subsidies, then nobody would take up the TLTROs.” But there's another incentive as well: letting banks borrow at a subzero rate partially offsets the pain that policy makers have inflicted with their negative deposit rate.

6. How does a negative deposit rate hurt banks?

Banks make money by charging more for loans than they pay for customer deposits. Yet the ECB's negative rate has driven all rates lower -- including those on loans. At the same time, financial institutions must pay to keep their spare cash at the central bank. To maintain their profit margin, they would ideally impose negative rates on customer deposits. But that's a radical step and, except in the case of some companies and very wealthy customers, it has proved impossible. To ease the pressure, policy makers last fall introduced a system called tiering, which exempts some of banks' overnight deposits at the ECB from the negative rate.