Blog Post

Shrinking times

Over the last 5 years, the Eurozone financial system has been flooded with liquidity, due to the ECB’s very special response to the very special bank-sovereign euro crisis. 

By: Date: April 25, 2014 Topic: European Macroeconomics & Governance

Over the last 5 years, the Eurozone financial system has been flooded with liquidity, due to the ECB’s very special response to the very special bank-sovereign euro crisis. 

In 2008, faced with an almost frozen interbank market, the ECB changed the way it allocates the Central Bank’s funds, introducing a policy of full allotment. As a result, the amount of liquidity provided to banks in the euro area was no longer determined by the ECB’s assessment of the banking system’s overall liquidity needs, but by banks’ own assessment of their individual liquidity needs. Supply started to be anchored 1:1 to demand and consequently taken out of the control of the central bank.

Then, in December 2011 and February 2012, the ECB conducted two Very Long-Term Refinancing Operations (VLTROs) with maturity of three years, under which banks borrowed as much as 1 trillion of very cheap and long-term liquidity. Additional 200bn were borrowed from other facilities, for a total outstanding liquidity of 1.2tr. Therefore, the balance sheet of the ECB more than doubled with respect to its pre-crisis level and the average maturity of the asset side lengthened. At the peak, in summer 2012, lending to banks amounted to 41% of all ECB’s assets, and 86% of it had maturity of three years (Figure 1).

The result was the creation of an environment in which excess liquidity became the norm.

Excess liquidity is the liquidity that banks hold in excess of the aggregate needs arising from minimum reserve requirements and autonomous factors amount.

Excess liquidity is defined as deposits at the deposit facility net of the recourse to the marginal lending facility, plus current account holdings in excess of those contributing to the minimum reserve requirements.

In normal times, when the interbank market functions properly, banks would channel liquidity to each other across the system and excess liquidity would have little or no reason to exist, because the cost opportunity of holding it would be just too high.

Banks in fact would deposit the liquidity in excess of their needs back into the ECB’s deposit facility, which before the crisis was remunerated at a positive interest rate. On the other hand, by lending that liquidity on the interbank market, banks could ask for an interest rate no smaller than the benchmark rate at which the ECB itself lends liquidity to banks, i.e. the Main Refinancing Rate (MRO rate). Since the refinancing rate is above the deposit rate, in normal conditions banks would prefer to lend their liquidity surplus to other banks rather than hoarding it at the deposit facility.

All this logic broke down during the financial crisis, when uncertainty and risk aversion became the most relevant drivers of banks liquidity policy.

Faced with a blocked and increasingly expensive interbank market, banks started to demand central bank liquidity well in excess of their needs, as a form of insurance against liquidity shocks and the risk of being cut off from interbank lending. Consequently, at the height of the crisis excess liquidity in the Eurozone peaked at 800 billion.

In early 2013, the ECB offered banks the possibility to repay (early) the funds they had borrowed under the LTROs. Since then, banks have used this possibility extensively.

The largest repayments have come from Spain, where banks had previously been most reliant of the ECB financing (see Figure 3). Italian banks have also started to repay LTRO funds recently and so have banks in Germany and the core (which however had not borrowed much in the first place). Therefore, the amount of excess liquidity in the system has been almost entirely reabsorbed.

Today’s ECB overnight liquidity operation report shows that excess liquidity in the euro area is now close to 92.8 billion, versus 115.25 billion yesterday. This is the first time since 2011 that excess liquidity drops below 100 billion, a threshold that has been generally regarded as key for the impact on overnight rates.

The rise and fall of excess liquidity has in fact consequences on the market interest rate, in particular the EONIA.

Before the crisis, the ECB’s main rate would steer short-term money market rates, resulting in the close alignment of the EONIA and the MRO rate. The crisis, and the introduction of the full allotment procedure, changed all the normal benchmarks. As a result of the increasing amount of excess liquidity in the system, the EONIA dis-anchored from the MRO and fell to the bottom of the so called interest rate corridor, i.e. just a few basis points above the rate on the ECB deposit facility. This is the lowest possible bound for the EONIA, as banks are unlikely to lend on the money market more cheaply.

Consequently, the rate on the ECB deposit facility became the main driver of money market rates, and when it was lowered to zero, it also took the EONIA alongside it, to unprecedented low levels.

On one hand, the recent trend in excess liquidity is positive, as it points towards a normalisation of bank funding conditions in the euro area. On the other hand, it raises issues that the ECB should carefully consider.

First, there is obviously the impact that such developments could have on the short-term market rates. The relationship between excess liquidity and short-term rates is not an exact science, as its sensitivity is also influenced by external factors; in particular the degree of fragmentation in the interbank market [see also this ECB paper for more rigorous analysis]. However, in fact, since the end of 2013 when excess liquidity started approaching the threshold of €100 billion, the volatility of short-term interest rates has been increasing a lot.

After remaining stable at around 10 bp for more than one year, the EONIA embarked on an upward trajectory, spiking sometimes even above the MRO. The ECB had anticipated this in the Monthly Bulletin of January, where they pointed out that if "any transition period, as the liquidity provision normalises, would lead to greater volatility, which could imply that short-term rates could become less closely anchored to the ECB deposit facility rate. This would make expectations about future money market rates more complex to interpret, as several factors, such as future liquidity developments and uncertainty, would be priced in overnight index swaps, in addition to expectations about the future path of policy rates."

Now that excess liquidity has eventually fallen below the psychological threshold of 100 billion, the impact on short-term rates could be amplified and the ECB might need to take action to counteract unwanted developments. ECB Member Benoit Coeuré, for example, recently said that there might be “situations where the level of excess liquidity may not be appropriate for our monetary policy stance, and we would have to find ways to inject more liquidity into the system”.

Second, the shrinkage of excess liquidity is the mirror image of a more general problem. For a little bit more than a year now, the ECB balance sheet has been shrinking. This qualifies the ECB as a special case among the Central Banks of the major advanced economies, where balance sheets have instead been growing (or at least have remained stable) over the same period. What is “special” about the development in the ECB’s balance sheet is that fact that the shrinkage is outside the control of the ECB, as the main driver is precisely banks’ decision to reimburse funds they borrowed from the ECB itself. The shrinkage is not per se a negative thing, but the current economic context characterised by a very weak recovery and especially low inflation puts it in a different perspective, creating a rational for the ECB to regain control over the size of its balance sheet.

The most important question is what the ECB could actually do to halt the shrinkage of its balance sheet and prevent unwanted development on the short-term rates. Banks are voluntarily returning LTRO funds in the attempt to clean the stigma associated to them and get their books in order for the approaching Asset Quality Review that will assess, among other things, banks “liquidity risk”.

The appeal of another LTRO-like operation seems quite small if not non-existent in such a context. Therefore, the time has come for truly unconventional monetary policy.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.


Warning: Invalid argument supplied for foreach() in /home/bruegelo/public_html/wp-content/themes/bruegel/content.php on line 449
View comments
Read about event More on this topic

Past Event

Past Event

Perspectives on Universal Basic Income

At this event, we discussed the possible benefits but also the possible disadvantages of Universal Basic Income.

Speakers: Grégory Claeys, Olli Kangas, Professor Philippe Van Parijs and Prof. Dr. Hilmar Schneider Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: July 12, 2017
Read article More on this topic More by this author

Blog Post

The forward guidance paradox

What’s at stake: the term “forward guidance” is used in economic jargon to describe central bank communications about the likely future path of policy rates. Standard monetary models imply that far future forward guidance has huge effects on current outcomes, and recent literature has been trying to reconcile this with reality.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: July 10, 2017
Read about event

Past Event

Past Event

Is there a way out of non-performing loans in Europe?

At this event we looked at the issue of non-performing loans in Europe. The event also saw the launch of the latest issue of "European Economy – Banks, Regulation and the Real Sector."

Speakers: Emilios Avgouleas, Giorgio Barba Navaretti, Giacomo Calzolari, Maria Demertzis, Martin Hellwig, Helen Louri and Laura von Daniels Topic: European Macroeconomics & Governance, Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: July 6, 2017
Read article Download PDF More on this topic

External Publication

Review of EU-third country cooperation on policies falling within the ITRE domain in relation to Brexit

What is the possible future relationship between the EU and the UK in light of Brexit? The report provides a critical assessment of the implications of existing models of cooperation between third countries and the European Union on energy, electronic communications, research policy and small business policy.

By: J. Scott Marcus, Georgios Petropoulos, André Sapir, Simone Tagliapietra, Alessio Terzi, Reinhilde Veugelers and Georg Zachmann Topic: European Macroeconomics & Governance Date: July 5, 2017
Read about event

Upcoming Event

Sep
7-8
09:00

Bruegel Annual Meetings 2017

The Annual Meetings are Bruegel’s flagship event. They offer a mixture of large public debates and small private sessions about key issues in European and global economics. In a series of high-level discussions, Bruegel’s scholars, members and stakeholders will address the economic policy challenges facing Europe.

Speakers: José Antonio Álvarez Álvarez, Agnès Bénassy-Quéré, Pervenche Béres, Jean Luc Demarty, Anna Ekström, Lowri Evans, Sandro Gozi, Peter Grünenfelder, Patrick Graichen, Reiner Hoffman, Levin Holle, Steffen Kampeter, Peter Kažimír, Emmanuel Lagarrigue, Steven Maijoor, Nathalie Moll, James Murray, Carlos Sallé Alonso, André Sapir, Dirk Schoenmaker, Mateusz Szczurek, Marianne Thyssen, Liviu Voinea, Johan Van Overtveldt, James Waterworth, Ida Wolden Bache and Guntram B. Wolff Topic: Energy & Climate, European Macroeconomics & Governance, Finance & Financial Regulation, Global Economics & Governance, Innovation & Competition Policy Location: Square - Brussels Meeting Centre
Read article More on this topic More by this author

Blog Post

Eurozone or EU budget? Confronting a complex political question

This week’s European Commission reflection paper is the latest document to ponder a distinction between EU and euro-area budgets. But do we need to split the two, and what would each budget be used for? In this post, I present an analytical framework for assessing this ultimately political question

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: June 29, 2017
Read about event

Upcoming Event

Sep
28
12:30

Unfinished business: The unexplored causes of the financial crisis and the lessons yet to be learned

At this event Tamim Bayoumi will present his upcoming book on the financial crisis, showing how how the Euro crisis and U.S. housing crash were, in fact, parasitically intertwined.

Speakers: Tamim Bayoumi, Maria Demertzis and Aerdt Houben Topic: European Macroeconomics & Governance, Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Blog Post

Raising the inflation target: a question of robustness

In an unexpected move, the Federal Reserve Chair Janet Yellen has recently brought up the issue of raising the inflation target. This blog argues that an increase in inflation targets may prove to be beneficial in achieving price stability in the long run. This would increase the credibility of central banks in achieving inflation goals and stave off the distortionary effects of deflation.

By: Maria Demertzis Topic: European Macroeconomics & Governance Date: June 22, 2017
Read article More on this topic

Blog Post

Can EU actors keep using common law after Brexit?

English common law is the choice of law for financial contracts, even for parties in EU members with civil law systems. This creates a lucrative legal sector in the UK, but Brexit could make UK court decisions difficult to enforce in the EU. Parties will be able to continue using English common law after Brexit, but how will these contracts be enforced? Some continental courts are preparing to make judicial decisions on common law cases in the English language.

By: Uuriintuya Batsaikhan and Dirk Schoenmaker Topic: European Macroeconomics & Governance Date: June 22, 2017
Read article More on this topic More by this author

Blog Post

The size and location of Europe’s defence industry

There is growing debate about a common European military policy and defence spending. Such moves would have major economic implications. We look at the supply side and summarise some key facts about the European defence sector: its size, structure, and ability to meet a possibly increased demand from EU member states.

By: Alexander Roth Topic: European Macroeconomics & Governance Date: June 22, 2017
Read article More by this author

Parliamentary Testimony

House of Commons

Exiting the European Union Committee

On 19 April 2017 Zsolt Darvas appeared as a witness at the Exiting the European Union Committee, the House of Commons, United Kingdom.

By: Zsolt Darvas Topic: European Macroeconomics & Governance, House of Commons, Testimonies Date: June 20, 2017
Read article More on this topic More by this author

Blog Post

Brexit and the future of the Irish border

The future of the Irish land border has been thrown into uncertainty by Brexit. The UK's confirmation that it will leave the EU's single market and customs union implies that customs checks will be needed. However, there is little desire for hard controls from any of the parties involved. This is especially true for Theresa May's potential partner, the DUP. Creative solutions are needed to reach a solution.

By: Filippo Biondi Topic: European Macroeconomics & Governance Date: June 19, 2017
Load more posts