Shrinking the Eurosystem’s Footprint without Offshoring the Euro

Euro area central banks are reporting losses as they pay banks 4 percent but collect only 1 percent on trillions of euros of bonds bought to spur growth with lower yields. Once central banks exhaust their capital, they may need to go to their governments. Recently, the European Central Bank (ECB) ceased to pay interest on commercial banks’ 1 percent required reserve against deposits. Now, some propose jacking this up tenfold to stanch central bank losses. With large profits and rich dividends, it is argued that commercial banks can easily pay.

Foisting central bank losses onto euro area commercial banks by not paying interest on banks’ reserves with the Eurosystem would be self-defeating. If large unremunerated reserves are required, banks and depositors would respond by shifting euro deposits offshore. Only immobile depositors would pay the tax, and the tax base and revenue would fall short. Undercapitalized domestic shadow banks would gain an edge over banks, and financial stability in the euro area would suffer.

A new policy brief written by Robert N. McCauley and published by SUERF – the European Money and Finance Forum discusses an alternative approach that would shrink the Eurosystem’s footprint without offshoring the euro or driving business out of regulated banks. Governments could book gains on their central banks’ holding of government bonds, thereby reducing government debt.

McCauley argues the proposed bond swap would avoid the adverse unintended consequences of large unremunerated reserve requirements and would ultimately allow monetary policy-making to “get up from the floor” without increasing the odds of a bond market crisis requiring bond buying of last resort to maintain market functioning.