Thread by @fwred

Our latest on the ECB: The Last Tiering Resort Option. A thread on negative rates and reserve tiering systems.1/n
perspectives.pictet.com/wp-content/upl…

While it is probably too early for the ECB to go into the nitty-gritty of tiered reserve systems this week, this will be the market’s focus over the next few months along with TLTRO-III pricing (which we expect to be announced in June). 2/n

The ECB ruled out tiering three years ago, but the situation has since changed and it could be implemented if policy rates were to remain negative for even longer into 2020. In the end, tiering may be about the ECB's *ability* to cut rates again in the next downturn. 3/n

The net impact of ECB’s negative rates on banks’ interest income is far from straightforward based on aggregated macro data, but the longer negative rates remain in place, the larger the cumulated impact on bank’s profitability. 4/n

Facts & numbers:
- Excess liquidity (current account holding - required reserves + deposit facility) is ~€1900bn
- Annual cost of -0.40% deposit rate = €7.6bn = ~2.5% of banks’ net interest income, or ~4.5% of pre-tax profits
- TLTRO-II have reduced this cost by ~€2.5bn
5/n

Importantly, the costs of negative rates are heavily skewed towards banks in the core (EUR6.6 bn, or 87%) relative to the periphery (EUR1.0 bn, or 13%). 6/n

Tiering would come with technical complications, potential arbitrage risks, and non-trivial effects on the distribution of excess liquidity across euro area countries. None of these issues are insurmountable - the price to pay for stronger forward guidance. 7/n

In practice, the ECB could go from the bottom (reserve requirement) or from the top (excess reserves). Our best guess is that the ECB would opt for a simple exemption system equivalent to an increase in the minimum reserve requirements. 8/n

For example, in a two-tiered system matching the SNB, exemptions could be set at 10x the required reserves, reducing the share of bank reserves subject to negative rates from 94% to 40% and the annual cost of negative rates by EUR 4bn, to EUR 3.5bn. 9/n

The key feature of any tiered system would be to maintain excess liquidity well above €300-400bn, for Eonia (and then €STR) to remain close to the deposit rate itself. 10/n

Again, in all cases there would be several complications and side-effects to deal with, including interactions with TLTRO-III. But the the ECB would likely see these issues as a manageable price to pay for policy rates to remain low for longer. /End