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As ECB gets ready to cut rates further, a multiple-tier system may protect banks

The European Central Bank (ECB), struggling to revive activity and inflation in the euro zone, may adopt a radical policy tool on Thursday that its Japanese and Swiss counterparts have used to reinvigorate their own soggy economies.

The ECB could use its scheduled policy meeting to announce a plan that levies a penalty on only a portion of banks' reserves, as it aims to cushion the impact of negative rates on the region's financial system, analysts said.

Expectations of a multi-tiered system, in which different deposit rates are applied to the reserves that lenders place with the central bank, have risen recently amid concerns that banks are increasingly on the hook as global central banks try newer approaches to fuel growth.

In the ECB's case, the deposit rate is negative, which means banks have to pay the ECB for the privilege of parking their cash.

The sharp rout in European bank stocks in recent weeks is a perfect reason to introduce a multi-tier model, said Mitul Kotecha, head of Asia FX and rates strategy at Barclays.

"It would protect banks to some extent and potentially allow much more negative rates than the ECB would have been able to implement otherwise. Currently, just having a flat negative rate hits banks; you have a limit as to how far you can go. A multi-tiered system lets you cut rates even further."

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The idea of a multi-tier model was first mentioned by the ECB vice president Vitor Constancio last month, who said any potential round of new stimulus would be designed to reduce the immediate impact on the cost on banks.

The model, used by the Swiss National Bank, made headlines in January when unexpectedly employed the Bank of Japan.

The general consensus for Thursday's meeting is for the deposit facility rate to be cut by 10 basis points, bringing it to negative 40 basis points. But should that happen, it's set to hurt bank profitability and potentially hit lending to companies and households.

"Multi-tiered rates would address concerns about bank profitability by protecting banks that are cash-rich and incentivizing," noted Eric Robertson, head of global macro strategy at Standard Chartered Bank.

"Even if this isn't announced on Thursday, Draghi could say that a technical committee is working on the details, something that Coeure has hinted at."

Last week, ECB executive board member Benoit Coeure said the bank was carefully studying "schemes used in other jurisdictions to mitigate possible adverse consequences for the bank lending channel."

Reuters has cited unnamed sources who noted that a multi-tier approach would be too radical for the ECB, but experts still believe there's a good chance it may happen.

"Markets were clearly very disappointed with December's easing package by the ECB, and no doubt they will be keen to try and exceed market expectations this time. Some of the more hawkish representatives on the ECB are not voting at this meeting, and that may give ECB President Mario Draghi the space to exceed market expectations.," stated IG market strategist Angus Nicholson in a note.

Indeed, the fear of disappointment is the key risk surrounding Thursday's meeting, echoed Kotecha.

"Our concern is that so much is priced in that there's a real risk Draghi disappoints...He needs to over-deliver. There are other steps he could take [excluding multi-tier rates], such as removing the floor in terms of asset purchases and the variety of asses that can be purchased."

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