NEW YORK, March 27 (Reuters) - The European Central Bank could take a leaf from the Bank of England's book as it looks for new ways of managing liquidity in the banking sector and steering short-term interest rates on the market, ECB board member Isabel Schnabel said on Monday.
The ECB is now rapidly shrinking its balance sheet but this is unlikely to fall back to its level of before the 2008-2009 global financial crisis, so policymakers are now studying a new way to steer short-term interest rates in a new normal.
Outlining possible changes to the ECB's 'corridor system' of a wide gap between the deposit and lending rates, Schnabel pointed to the BoE's example, in which banks themselves determine the amount of liquidity they want to hold.
"The Bank of England’s approach has a number of benefits that may be particularly relevant for a large and heterogeneous currency area like the euro area," Schnabel, the head of the ECB's market operations, said.
"One is that it may provide better insurance against potential fragmentation shocks," she told a lecture at Columbia University. "A more balanced reserve distribution could strengthen the resilience of the currency union."
The BoE currently offers regular collateralised lending operations based on individual bank demands to fill any shortfall in the need for reserves as quantitative tightening or the reduction of bond holdings proceeds.
Using the same rate for providing and remunerating reserves ensures that money market rates will trade closely to the policy rate, Schnabel argued.
A benefit is that the BoE can wind down its massive government bond portfolio without needing to know ahead of time the demand for excess reserves, Schnabel added.
Another benefit of such a demand-driven framework is that it offers more flexibility on how the central bank provides reserves.
"A third benefit is that the Bank of England’s approach may potentially lead to a leaner balance sheet depending on banks’ demand for reserves," Schnabel said.
Schnabel also examined but appeared to dismiss a 'floor system' used by the U.S. Federal Reserve, in which the policy rate creates a lower bound, or floor, for the market interest rate, removing any incentive for banks to lend funds at a lower rate.
