Money markets an ecb key rate cut could deter bank to bank lending

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A cut in the ECB's refinancing rate could push benchmark bank-to-bank Euribor rates to record lows, but it could also reduce trading in money markets, something the central bank would rather avoid. European Central Bank President Mario Draghi said last week the central bank was ready to act to support the euro zone economy, prompting speculation that it could reduce its benchmark refinancing rate by 25 basis points to 0.50 percent. The comments have boosted Euribor futures , which rise when market participants expect the three-month benchmark to settle at lower levels over time. When central banks cut interest rates they hope that commercial banks will follow by easing borrowing costs for their clients, boosting lending to the real economy. But in the euro zone, where official rates are already at record lows, it could have the opposite impact, as even lower rates may reduce the incentives banks have to participate in the money market where they lend to each other, analysts say. Reviving money market activity is crucial for the euro zone economy because banks need to feel confident they can find funds before taking on the risks of lending to businesses.

A lower ECB refinancing rate means banks that need cash would have access to cheaper money from the central bank, putting pressure on those that have cash to offer in the market to lower their own rates. However, with the three-month Euribor already at 21 bps , lenders would probably be reluctant to compete and may decide to deposit their money for a zero rate with the ECB - seen as the safest place in the region to keep cash."Euribor rates could revisit record lows, but it could also lead to a decline in actual turnover volumes in money markets," Commerzbank rate strategist Benjamin Schroeder said."The corridor (between the ECB's refi rate and the deposit rate) is in a way a penalty for those who don't participate in money markets and do their business only with the ECB. You basically cut the penalty."

The three-month Euribor rate hit a record low of 0.181 percent last year. Barclays Capital strategists see it heading towards 0.15 percent. UNCLEAR CONSEQUENCES

While lower interbank volumes are undesirable, it is difficult to say whether cutting the refinancing rate and lowering the premium it offers over the ECB's deposit rate would do more harm than good to the euro zone economy."The three-year (ECB emergency loans) are based on the refi rate so if they cut it, that makes them a little bit cheaper," said Emil Cardon, market economist at Rabobank. "Also it could cause Euribor rates to go down and most of the Spanish mortgages are based on Euribor." A debt overhang from a property crash is a major factor in perpetuating Spain's recession. An option to keep the ECB rate differential steady is to lower the deposit facility rate to negative levels, effectively penalising banks for keeping money with the central bank. But several ECB policymakers have expressed reluctance to make such a move. ECB board member Peter Praet has pointed to how Danish banks started charging consumers and firms more for loans after Demark's central bank pushed its deposit rate into negative territory. Expectations of where overnight interbank rates will settle later this year have remained steady at levels of 8-10 basis points, which analysts say suggest market participants do not expect the ECB to make such a move."Cutting the refi rate is already difficult for some (ECB) members, so I don't think a deposit rate cut is likely," said Rabobank's Cardon.