The ECB’s deposit facility rate is a referencing point in financial markets
Banks earn the ECB’s deposit facility rate (DFR) on the funds they hold on deposit at one of the central banks in the euro area (i.e. the Eurosystem). As such, the DFR represents the lower limit at which banks are prepared to lend funds; after all, the Eurosystem is the safest place for banks to hold funds. As a result, alternatives need to carry a higher interest rate. Logically speaking, the DFR should therefore act as a bottom rate in financial markets – as it used to do prior to the financial crisis. Indeed, if rates drop below the DFR, banks are incentivised to borrow at this lower rate in order to hold these additional funds at the central bank and cash out the difference (‘arbitrage’).
Short-term market rates have dropped below the deposit rate
Yields on relatively short-term government bonds of several euro area member countries have progressively dropped below the DFR since the Eurosystem is injecting liquidity through its large-scale Asset Purchase Programme (See Figure 1 and the March 2015 DNBulletin for further information ). This progressive decline is driven by three factors: 1) rising excess liquidity, 2) the balance sheet frictions that banks face in arbitraging between the DFR and short-term market rates and 3) the Eurosystem purchases of short-term government bonds at yields below the DFR.
Figure 1 – Yields on short-term Dutch government bonds have dropped to -1%; short-term interbank rates however continue to trade above the DFR