FRANKFURT (MNI) - The European Central Bank on Friday sent a clear signal that it is now in exit mode, issuing a surprise announcement of tougher collateral rules ahead.

A measure with little immediate impact, new collateral requirements are not just the prelude but appear to set the tone for a very gradual exit of non-standard policy measures.

"If you want to be gradualist, you have to anticipate," Council member Miguel Fernandez Ordonez summed up the central bank's approach last week.

The early announcement of changes to the collateral rules appear very much in-line with this philosophy, pushing banks to prepare for tighter conditions months in advance. New requirements of an additional rating will apply initially to ABS securities issued after March 2010 and to all ABS securities not until March 2011.

ECB policymakers have also stepped up their verbal pressure on banks to prepare for life without central bank support after reiterating that "not all our liquidity measures will be needed to the same extent as in the past."

"The financial system and individual institutions within it must act now to ensure that a future removal of central bank support can be managed without painful withdrawal symptoms," President Jean-Claude Trichet said Friday.

Similarly, Executive Board member Lorenzo Bini Smaghi emphasized that it is important that "the financial sector takes advantage of the current situation to complete its restructuring and equip itself to stand on its own feet."

There is a broad consensus that the ECB's next step will be to announce following the December 3 Governing Council meeting that it is discontinuing 1-year refi operations after the one scheduled for mid-December.

Council member Athanasios Orphanides indicated that we may also see fewer three and six month refi operations and that the fixed-rate full-allotment procedure could come to an end. "It may be deemed appropriate to reduce the frequency of some operations and perhaps change the terms of some others," he said.

The ECB's emphasis on gradualism, however, suggests that any such announcements are unlikely to come as soon as December 3.

As previously argued in greater detail, the ECB's engagement in moral suasion and the risks associated with adding a spread to December's 1-year refinancing auction tilt the odds in favour of no change of terms for this operation.

As for the terms and frequency of supplementary 3- and 6-month tenders, the ECB is under no pressure to make any announcements in December as it has already issued a full schedule until end-January 2010.

Rather than making any firm committments, the central bank should await the liquidity uptake of December's 1-year repo to get a better gauge of excess liquidity ahead and set its terms and schedule accordingly in January.

"The tricky part is perhaps not so much implementing the exit itself as managing the expectation about how the exit strategy will unfold. Communication is thus essential to prepare markets and explain the rationale for each decision," Bini Smaghi said last week.

The surprise announcement of tougher collateral rules should be viewed in this context rather than as a change in gears. While the ECB may not make many firm commitments, Trichet will certainly focus on "managing the expectation" on the broader liquidity framework during his press conference next week.

November 19, 2009:

FRANKFURT (MNI) - The ECB's engagement in moral suasion, and the risks associated with adding a spread to December's 1-year refinancing auction, tilt the odds in favour of a final round at a fixed 1%.

ECB President Jean-Claude Trichet's assurance that the ECB has "no intention at all at the moment" to steer market rates above levels close to the deposit rate suggests that the central bank's sole motive for adding a spread would be to reign in demand for liquidity.

That in itself could certainly be a strong enough motive, since another wave of excess liquidity may impair the ECB's ability to steer market rates and raise borrowing cost at some later date, when it deems necessary.

There is, however, a big question about whether raising the cost for December's refi is the appropriate tool for curbing liquidity demand.

To be effective, any premium would have to be higher than interest rate expectations, as undercutting those would leave the offer very attractive and thus do little to suppress demand.

With the EONIA pricing in an 80 bps hike over the next 12 months, the spread would have to be relatively high, and that could send a strong, potentially misleading signal for the interest rate trajectory.

The very cautious ECB appears likely to shy away from sending a signal that could unsettle markets, especially at a time when, according to Bank of Spain Governor Miguel Fernandez Ordonez, "any increase in [interest] rates is off the screen."

Apart from the potentially detrimental psychological effect of adding a premium in December, there's also the fact that some institutions still depend heavily on the ECB's cheap liquidity, as senior ECB officials told Market News International just a few weeks ago. Adding to their borrowing cost could hit them hard despite overall improvements in financial markets.

Rather than giving up their tried and tested strategy and risking unsettling still fragile financial markets, the ECB should continue to step up its moral suasion, urging banks to repair their balance sheets and refrain from undue take-up of central bank money.

During November's press conference, Trichet notably intensified the pressure on banks to ensure that they can function without the ECB's support.

Since then, MNI has learned that the ECB instructed national central banks to direct their local banking institutions to gradually withdraw from the emergency liquidity measures.

In a letter that a Greek central bank official described as "standard procedure" among national central banks, the Bank of Greece "directed a number of banks to show restraint in the December 12-month liquidity auction of the ECB in order to facilitate their exit from the emergency [liquidity] measures, which are expected to be withdrawn from the Eurosystem."

The ECB thus appears to bet on cooperation from private banks to keep demand in December from spiraling beyond what is needed, rather than adding a spread that could be either too low to deter bidding or too high for the markets to digest.