ECB Closing In On Rule Change To Shave Banking Profits, Sources Say

European Central Bank policymakers are closing in on a deal to change rules governing trillions of euros worth of loans to banks in a move that will shave tens of billions of euros off in potential banking profits, sources close to the discussion said.

Euro zone banks sit on 2.1 trillion euros ($2.04 trillion) of cash handed out by the ECB at ultra-low, sometimes even negative interest rates, in the hopes that doing so would help kick-start the economy.

But after a string of unexpectedly quick and big rate hikes banks can now simply park this cash back at the ECB, earning a risk-free profit, irking policymakers who see it as gaming the system.

Policymakers reviewed five options at a seminar earlier this month to change the rules of these Targeted Longer-Term Refinancing Operations (TLTRO), all of which were deemed somewhat problematic because they raised a legal or political hurdle, or went counter to other policy goals, three sources told Reuters on condition of anonymity.

The five options were then narrowed to three, and staff are working on refining them.

"We are very close and a decision is going to come soon," one of the sources, who asked not to be named, said on the sidelines of the International Monetary Fund and World Bank annual meetings in Washington. "The ultimate design is going to hurt banks, and that is very much our intention."

All sources said that a decision could come at the Oct. 27 policy meeting because there's little benefit in waiting.

The impact of the move would be worth around 30 billion to 40 billion euros a year, one of the sources said, while a second source said the impact could be much higher if rates rise as markets now expect.

An ECB spokesman declined to comment.

French central bank chief Francois Villeroy de Galhau, who has long advocated changing the terms of the loans, earlier this week said the ECB should avoid "unintended incentives" to delay the repayment of these funds.

The problem is that the ECB's 0.75% deposit rate will rise further, probably close to 2% by the end of this year, and possibly higher in 2023, leaving the central bank with a huge potential interest expense.

THREE FINALISTS

Out of the three remaining options, the simplest would be to unilaterally change the terms of TLTROs, so cash parked back at the ECB would not be remunerated at the deposit rate.

The benefit is that all banks are affected the same way and the ECB would not be playing favorites. But this option is likely to raise a legal hurdle, with banks possibly filing lawsuits.

Another option would be that cash from TLTROs would be treated on similar terms as minimum reserves kept by commercial banks at the ECB.

Such reserves are now remunerated at 0.5%, below the ECB's deposit rate.

A third option would be to create a sort of tiering that would allow banks to enjoy more favorable up to a certain threshold, after which a lower rate would apply.

Policymakers argue that it's politically unacceptable that banks earn such a windfall while the economy is in a downturn and ordinary people suffer. They also said that this sort of accommodation is inconsistent with interest rate policy, which is being tightened.

But there is also a wider political issue at play.

Paying interest on these excess reserves deplete central banking profits, limiting their ability to pay cash into national budgets and depriving the state of vital income.

That risks putting political pressure on central banks around the euro zone. In extreme cases, central banks could even deplete their own capital, possibly forcing governments to recapitalize lenders.

($1 = 1.0318 euros)