Euro banking liquidity in 2024: all roads lead to Rome

Summary

• This report is about bank reserves in the Eurozone. The estimated aggregate level of bank reserves for year-end suggests that liquidity will remain ample, and that money market rates will remain stable for as far as the eye can see. But stability is highly contingent on capital continuing to flow from North to South like it did in 2023. Target2 imbalances must narrow further, which will redistribute the ever-shrinking pool of bank reserves less unevenly across the Eurozone.

• While the aggregate level or reserves will not fall to levels that could potentially trigger instability, TLTRO repayments are a real bleeder for banks’ Liquidity Coverage Ratio. Without banks stepping up, the aggregate LCR ratio will fall below 2019 levels.

• In the Goldilocks scenario, whereby intra-Eurozone capital flows mirror those of 2023, the ESTR deposit rate spread and the 6-month Euribor OIS spread narrow gradually. By several bps in case of the former, and by less than 10bps in case of the latter. The 10-year BTP Bund spread will show further sizeable declines. But even in the most benign scenario, accidents can happen think strong (spike-) increases in repo rates.

• I don’t expect the ECB operational review to result in anything noteworthy. In fact, in the Goldilocks scenario, I expect only modest growth in uptake at regular ECB refinancing. Thus, no alignment of the refinancing rate with the deposit rate.

• If capital flows turn out to be more restrictive, banks’ recourse to ECB regular refinancing will increase markedly. Not just in Italy, but also in France, which hemorrhaged reserves last year. The ECB will likely align the refinancing rate with the deposit rate.

• If the political peace is disturbed and capital flows back to the North, all bets are off. Italian banks will once again become strongly reliant on ECB funding. And the money market will become bifurcated: too easy in the North, and too tight in the South.

• This report is divided into three parts. After a one-page summary, I discuss the outlook for reserves and the LCR at the Eurozone level. In part two, I explain the workings of Target2 and discuss three scenarios with regards to intra-Eurozone capital flows. In the final part I discuss the implications for key rates and ECB policy.