NEW challenges are emerging for the central banks worldwide while the European Central Bank is in the eye of the storm. Its capability to resolve the eurozone crisis has been put to a critical test.

What worries the ECB the most is that impaired bank lending may have more serious consequences in the eurozone than in other economies where alternate market sources of funding are more important. This and the fact that European banks are still sitting on $900 billion excess liquidity explains why the ECB is ready to reflect on penalising banks by charging interest on their surplus funds.

Eurozone money market has responded nervously to this suggestion. The EONIA or Eurozone overnight interest rate for December shrank half to close at just six basis points the day the market got wind of this suggestion. Similarly three-month EURIBOR (European interbank offered rate) touched an all-time low at 0.451 per cent.

Interest rates strategist at the RBS Simon Pack was quoted by Reuters as saying that if ECB really went for sub-zero return on overnight bank deposits it could send the already negative yields on sovereign bonds of even a strong European country like Germany. Two-year German bonds’ yield was last traded at minus 0.06 per cent.

In July the ECB cut from 0.25 per cent to zero the return it pays to banks when they park overnight surplus funds with it. It also reduced from one per cent to 0.75 per cent the rate it charges from banks when they make overnight borrowings from it.

After the announcement of this move, the ECB executive board member Benoit Coeure said the ECB also had an option to begin charging banks for parking surplus funds. But can markets function in that case? “Some of them can. Some of them apparently can’t. So before making the next step which would be moving the deposit facility to a negative yield, we’ll reflect about it,” he said.

In their fight against financial crisis and the recession of 2008-09 the central banks of the US, UK and Japan opted for quantitative easing or targeted injection of short-term funds to maintain liquidity in financial markets. But according to the ECB, its own measures remained targeted towards “assigning banks the central role they play in credit intermediation with around two-thirds of euro area firms’ external financing intermediated by banks in recent years.”

Central bankers here say Eurozone financial market is not as wide and deep as that of the US, UK or Japan. “In some ways European financial market is a blend of financially open yet structurally somewhat averse to too much of openness,” remarked a senior official of the SBP.

“Corporate sector in the eurozone is much more reliant on banks for credit intermediation compared to corporate sector in America for example. In the US the opportunities to borrow funds other than from banks are too huge. It’s a separate story though that these opportunities carry big risks.”

Central bankers say the SBP is watching the eurozone crisis closely to assess how it would impact on the country’s external sector which is already in stress and how economic growth would be affected if the crisis spreads or deepens further.

“In our context, the focus of the central bank should be to enliven economic growth by persuading banks to lend more to the private sector,” says a former executive director of SBP.

One way could be to relax monetary policy and simultaneously make it more difficult for banks to sit on surplus funds.

But the dilemma here is that the central bank itself injects huge amounts of cash in banking system ahead of treasury bills auctions to facilitate government borrowing from banks. If the SBP stops doing it the government would borrow even more from the central bank which would accelerate inflation making it all the more difficult for the SBP to relax monetary policy. And if banks remain insufficiently liquid ahead of treasury bills auctions the cost of government borrowing would shoot up creating further complications in the economy.

Penalising banks for finishing the day’s business with unused funds by cutting the return on such funds does not look feasible even otherwise. There is already a huge gap of 300 basis points between the rate at which the SBP makes overnight lending to banks and the one at which banks place their overnight surplus cash with the central bank.

“Any reduction in the rate at which the SBP pays banks on their surplus cash placement without making a similar cut in the policy rate will expand this gap to impractical levels,” opined an official of the SBP. In India this gap is much lower—100bps when banks borrow overnight funds from the RBI against government securities and 200bps when they make clean borrowing.

Another option that the SBP can exercise is lowering banks’ SLR (statutory liquidity ratio). That theoretically ensures a higher level of liquidity in the banking system thereby easing the need for the SBP to inject huge amounts of money in the system before auctioning of treasury bills.

But the problem is with banks non-performing loans (and within that loans categories as losses) have ballooned and this situation requires sufficiently high SLR for banks for sound banking practices.

“Besides, several banks are already maintaining more than required percentage of SLR because of their over-exposure in government securities. So even if, SLR is reduced (which by the way is unlikely at a time when the economy needs easing in monetary policy), those banks may still keep their SLR high,” according to a senior central banker.

Cash reserve requirement or CRR already carries no return. “So we are left with one thing. Over-investment of banks in government securities beyond a certain limit, whether they keep those securities for SLR purposes or not, should be discouraged by SBP through some regulatory measures,” suggests a retired central banker.

But that would bring the whole discussion back to the basic issue “can banks be really dissuaded from investing heavily in government papers when the sovereign demand for funds remains insatiable.”