How ECB Tiered Remuneration Encourages Interbank Liquidity Trading
Summary
The document explains how the ECB’s two-tier reserve system can create an incentive for banks to trade excess liquidity. In a simplified example, banks have different daily reserve balances and different allowances for deposits exempt from negative rates. A bank with unused allowance can benefit by lending to a bank whose balance exceeds its allowance, at a rate between the exempt deposit rate and the rate charged on excess reserves. The trade reallocates the system’s liquidity and can benefit both banks relative to leaving all balances at the central bank.
This mechanism is presented as an illustration of how tiering may stimulate money-market activity through collective optimization. The answer also claims that recent data show the system operates close to optimal allocation, but supplies no supporting data or method for that estimate. The example is stylized, and the document does not establish how much actual trading the policy generates or how real-world frictions affect the incentive.
Key ideas
- Tiered reserve remuneration can give banks different incentives depending on their exempt deposit allowances.
- A bank with unused allowance may gain by borrowing or receiving funds from a bank above its allowance.
- An interbank rate between the exempt and negative deposit rates can make both counterparties better off.
- The example frames liquidity allocation as a system-wide optimization problem.
- The document offers no detailed evidence on the actual volume of trading generated by the policy.
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Full text
# ECB - Two Tier System # ECB - Two Tier System It's said the theoretical aim of the ECB Two-tier system (exempt a portion of the excess reserves from negative rates) was designed to: - offset the direct costs of negative interest rates on banks, thereby helping to sustain the pass-through of low policy rates to bank lending rates - push banks to trade/lend their excess liquidity in the money markets. I get point one, but struggling with 2), can you help out? ## Answer by Attack68 (score 1) https://quant.stackexchange.com/a/60618 Consider a world in which 4 banks have 3000 EUR to deposit on a daily basis with the ECB, where all of that is deposited at the going rate of -1% (minimum reserve requirements and the excess deposits) On any given day, due to operations, banks A, B, C and D may have any allocation of that 3000 EUR to be deposited, say 100, 1000, 400, 1500 respectively. Provided everyone is above their minimum reserve requirements none of those banks has any interest in lending/borrowing money from each other, since there is no money to be made from the activity (the non-arbitrage lending rate is -1%) and this would just incur operational headache. The next day the allocations may be completely different (due to cashflows/redemptions) but the status quo remains: still no interest in interbank lending. Now suppose a new rule. Each bank is assigned an amount (6 times their minimum reserves requirement) which they can deposit at 0% instead of -1% with ECB. For the sake of argument lets say that each banks daily assignment is 300, 400, 200, 100 respectively. Now we have a system wide optimisation problem and given the original allocation of 3000 EUR one can identify that there is slack in the system. Bank A has 200 excess capacity, whilst banks B, C and D are 600, 200 and 1400 over their assignments. An artificial market has been created, bank A should trade with either B, C and D at a rate anywhere between -1% and 0% in a size of 200 and both trading counterparties will profit at the expense of the ECB. By providing the incentive of collective optimisation solving via market forces, the ECB has stimulated this market. Real recent data suggests it is being solved within 1% of optimality, although how much trading it stimulates I have no experience of, albeit I would expect a reasonable amount.
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