ECB to wean banks off free cash at gentlest pace

By Francesco Canepa

FRANKFURT (Reuters) -The European Central Bank wants to wean banks off free cash but it will try to do so gently enough not to upset the financial system or lending, the result of its long-awaited Operational Framework Review showed on Wednesday.

During nearly a decade of too-low inflation, the ECB inundated banks with cash via massive bond purchases, with the aim of spurring them to lend and stimulate price growth.

That largely removed the need for banks to borrow from each other, and effectively pinned the overnight rate on the interbank market to the one the central bank pays on deposits.

But this exceptionally generous system needs adapting to a new era in which inflation and interest rates are higher and the liquidity pumped into the system is being drained.

Under the new framework unveiled on Wednesday, the ECB will give banks more incentive to lend to each other, while also providing safety nets to limit the risk of financial tension.

"The framework will ensure that our policy implementation remains effective, robust, flexible and efficient in the future as our balance sheet normalises," ECB President Christine Lagarde said in a statement.

The central bank for the 20 countries that share the euro currency said it will aim to keep the interbank rate "in the vicinity" of its deposit rate, currently 4%.

But rather than single-handedly pumping free cash into the system, it will rely more on banks lending to each other as the bonds it bought mature and excess liquidity leaves the system.

Banks will still be able to tap the ECB for as much cash as they like, secured with collateral, at its weekly Main Refinancing Operations and 90-day auctions.

In a bid to lower the financial penalty and the stigma for borrowers turning to the central bank, the rate on these auctions, currently 4.50%, will be lowered to reduce the spread between it and the ECB's deposit rate to 15 basis points.

The ECB also plans to launch longer-term loans and bond-buying operations once it sees its balance sheet has started growing again as a result of banks' own borrowing.

"These operations will make a substantial contribution to covering the banking sector's structural liquidity needs arising from autonomous factors and minimum reserve requirements," the ECB said.

A likely implication is that future bond purchases will be focused on shorter-maturity bonds, rather than nearly all bonds on the market, like the ECB's stimulus programmes.

The ECB plans to review the new system in two years or even earlier if needed, it said.

(Reporting by Francesco Canepa; Editing by Catherine Evans)