Courtesy of Nomura’s euro area economics and strategy team (click to enlarge):
And as Nomura explains, in normal times…
…the level of ECB liquidity support is minimal as banks are able to lend and borrow funds via the interbank money markets. In a normal functioning money market, an ECB rate cut will lower the cost of interbank lending and borrowing. As money market rates decline, banks will lower their retail rates on loans and deposits (the interest rate channel). Faced with lower lending and deposit rates, households and firms are more inclined to increase consumption and investment than to increase savings.
The bank lending channel, albeit less direct, works in tandem with the interest rate channel and can amplify the effects of a policy rate cut. The idea is that a policy rate cut boosts the value of the asset side of a bank balance sheet (e.g. lower policy rates lead to a rise in government bond prices and loan valuations), which will enable banks to increase overall lending. As banks increase their lending to borrowers, deposit flows will increase as well (as bank lending eventually ends up as deposits within the banking system). To the extent that the policy rate boosts activity, demand for credit should increase as well. The bottom line is that with a well-functioning transmission mechanism, a rate cut by the ECB should trigger a tick up in money (i.e. deposits) and credit growth.
But, in abnormal times …
…if some banks are unable to access the interbank markets, the interest rate and the bank lending channel can break down. And when banks are shut out of the money markets, they are forced into asset fire sales; the pressure on bank balance sheets can be severe, preventing banks from expanding the supply of credit.
The ECB has responded to the dislocations on the money markets with a set of liquidity operations which have, in effect, made the Bank the lender of first resort for many European banks. While having ECB liquidity available is clearly preferable to the case of no ECB liquidity, the side-effect of having a two-tier banking system – as we will demonstrate below – (composed of banks addicted to ECB funding alongside well-functioning ones able to borrow and lending in the interbank money markets) is that it leaves the monetary transmission mechanism significantly impaired.
How broken is the mechanism?
If the spread between the bank retail lending rates and money market rates is anything to go by, Nomura believes a lot.
As they note:
In sum, it doesn’t appear that the interest rate channel has improved since 2008; a worrying conclusion given the myriad ECB unconventional policy interventions in that period.
No wonder the ECB is on the verge of an existential crisis.
Are western central banks having an existential crisis? – FT Alphaville
The cost of global central bank balance sheet expansion – FT Alphaville