ECB: from a supply to a demand-driven floor?

European Central Bank officials will enter a key debate in the coming weeks. But, despite still too-high inflation, this one will not revolve around the number of rate increases needed to durably bring inflation back to the 2% target. Instead, the governing council will discuss changes to the central bank’s operational framework. Although technical in nature, the final choice will be determined in part by the very nature of the eurozone: a monetary union with fragmented fiscal policies as well as by the ultra-loose measures implemented to boost inflation in the decade after the sovereign debt crisis and Covid-19 pandemic.

Importantly, the new framework will determine how far the ECB will be willing and able to go in reducing its balance sheet over the coming years. The governing council has already started to reduce liquidity as part of its efforts to rein in inflation. Although interest rates remain the key policy tool, the ECB has increased the deposit rate from -0.5% to 3.75% since July 2022, balance sheet management will become increasingly important in the coming months. 

“TLTRO [targeted long-term refinancing operations] repayments and quantitative tightening have started this process, but the endpoint is uncertain and depends on the operational framework the ECB intends to use going forward,” says Bas van Geffen, senior macro strategist with Rabobank. “We believe the ECB is looking for a sweet spot where its balance sheet is as small as possible, while keeping control over market rates and avoiding unintended side-effects as much as it can.”

Last year, ECB president Christine Lagarde said the review will be ready by the end of 2023. Most observers expect the central bank to adopt a system of ample reserves based on a demand-driven floor to replace the original corridor system and the supply-driven floor system the ECB has implemented in practice over the past decade. However, the exact model is far from certain given discrepancies in views among national central banks.

From corridor to leaky floor

Before the 2008 financial crisis, the ECB operated a corridor system. This meant it provided just enough reserves for banks to meet their liquidity needs. A bank with spare liquidity could deposit it at the ECB and receive the central bank’s deposit rate, and one short of liquidity could borrow overnight from the central bank at the higher marginal lending facility.

In the interbank market, banks with excess liquidity offered it at a rate above the deposit facility rate, while banks short on liquidity borrowed at a lower rate than the marginal lending facility. This system created the incentives to distribute reserves evenly across the bloc. In a context of reserves scarcity, the interbank market rate tended to be within the corridor, close to the one-week main refinancing operations rate.

However, the crisis imposed unsustainable pressures on the system that ended up transforming it. Firstly, it weakened banks’ trust in each other and dramatically lowered their risk tolerance. Due to a malfunctioning interbank market, the ECB replaced weekly liquidity auctions with fixed-rate tenders with full allotment in 2008. These allowed banks to borrow as much liquidity as they wanted. The ECB later added TLTROs, allowing banks to borrow liquidity for as long as several years.

The intervention prevented the market from seizing again, but it permanently increased reserves to a point where it was no longer possible to assess their adequate level, and removed the incentive for banks to deal with each other. Instead, they have become used to relying on the ECB.

Additionally, asset purchase programmes boosted liquidity further. This initially lowered unsecured overnight rates towards those of the deposit facility rate, the system’s floor. The launch of the Asset Purchase Programme (APP) in 2015 put a definitive end to the corridor.

To put the ECB’s balance sheet transformation into perspective, it increased from slightly over €1.2 trillion ($1.4 trillion) in August 2007 to close to €7.2 trillion now. The peak was at €8.8 trillion in the fourth quarter of 2022 – at the end of last year, the Eurosystem held monetary policy assets amounting to around 56% of the eurozone’s GDP.

Moreover, the floor has been unable to prevent market rates from going below it. The unsecured overnight euro short-term rate (€STR) now trades below the deposit facility rate. The third round of the TLTROs and the Pandemic Emergency Purchase Programme (PEPP), which contributed to rapidly increase the Eurosystem’s balance sheet during the coronavirus pandemic, increased the spread between them. It now hovers around 10 basis points.

A widening ‘leaky floor’ is far from ideal in a context of high inflation and higher policy rates. €STR has tracked up with the deposit rate following the sharp increase in policy rates implemented by the governing council over the past year. It traded at 3.655% on August 18. Nonetheless, the gap signals the ECB’s monetary policy transmission is imperfect.

“The leaky floor partly stems from higher excess liquidity and the higher yield environment,” says Piet Haines Christiansen, Danske Bank chief analyst.

€STR is the wholesale rate. It is relevant as not all banks have access to the ECB’s deposit facility rate, which in a context of excess liquidity, results in their being a lower unsecured rate. “For instance, if you are a small German savings bank with no access to the ECB you may park your money at a counterpart with access, typically the larger banks,” says Christiansen. “But when these bigger banks park these funds at the ECB they will charge a spread. It may be a few basis points or even less than one, but it builds up over time.”

The result is that smaller banks receive a lower yield for their deposits on €STR than they would on the ECB’s deposit facility.

Sources of growth

The system’s transformation is so profound that few believe recovering the pre-crisis corridor system is feasible. “The size of our balance sheet will not return to the levels seen before the global financial crisis,” pointed out Isabel Schnabel, ECB executive board member in charge of market operations, in a speech in March.

“In August 2007, when the financial crisis started, the ECB didn’t have an outright portfolio. Now, we probably are in a situation where we can recognise that it will have one,” says Jens Eisenschmidt, chief Europe economist at Morgan Stanley. “Why? Because of demand for banknotes, banks’ demand for excess liquidity and stricter bank regulation.”

Beyond direct ECB lending operations and asset purchases, the balance sheet’s size is determined by reserve requirements and autonomous factors, including official sector deposits and banknotes, which have rapidly grown since 2007. For instance, banknotes in circulation amounted to €636 billion in August 2007. But now they represent close to €1.6 trillion.

“Demand for the euro has grown over time. The euro is a reserve currency. And banknotes are a stable store of value, relatively speaking. There are not that many equally stable products out there,” Eisenschmidt says.

Additionally, in August 2007, eurozone government deposits stood at €36.6 billion, and non-eurozone central bank deposits stood at €19 billion. In July 2022, these figures were €647 billion and €433 billion respectively. Crucially, banks’ deposits beyond minimum reserve requirements have skyrocketed from barely €100 million in 2007 to €3.6 trillion now.

“Banks now consider more risks than before the great financial crisis. These include trading with other banks, which has created a need for the ECB to step in and provide the liquidity banks demand,” adds Eisenschmidt. “And of course, banks also have incentives to hold onto liquidity due to regulation.”

The 2010 Basel III capital accord agreement introduced two new requirements: the liquidity coverage ratio (LCR); and the net stable funding ratio (NSFR). They were implemented since 2014 and 2018 respectively. The LCR requires banks to have an adequate stock of high-quality liquid assets (HQLAs) that can be converted into cash easily and immediately in private markets. These assets need to cover liquidity requirements for 30 calendar days of liquidity stress. The NSFR focuses on fostering funding resilience over a longer time horizon. It requires banks to fund long-term assets with long-term liabilities to limit maturity mismatches.

To cover these relatively new requirements, banks rely to a great extent on central bank reserves. Currently, eurozone banks hold approximately 33% of their HQLA in sovereign bonds, around 60% in central bank reserves and the rest in cash. “Banks prefer to hold at least part of their buffers in central bank reserves regardless of the relative costs, since these do not need to be liquidated before they can be used to cover outflows,” says van Geffen.

Nonetheless, despite these strong incentives sustaining excess liquidity, most governing council members agree such a large balance sheet gives the ECB an outsized role in the economy, runs counter to its efforts to tighten monetary policy and reduces its policy space to provide accommodation in future crises. Thus, it has taken steps to reduce it.

Most analysts agree a very large central bank balance sheet creates distortions in money markets and capital markets. It adds a virtually risk-free asset that only banks have access to, contributes to collateral scarcity in the eurozone, removes incentives to revive the interbank market, blurs the monetary-fiscal divide and exposes the ECB to hefty losses on its sovereign bond holdings.

“Given that inflation remains too high, it makes sense they aim to normalise the balance sheet and revisit the framework,” says Konstantin Veit, executive vice-president and portfolio manager at Pimco.

But the ECB will need to be wary of causing any stability concerns in the banking system, especially as a failure to hedge against policy tightening caused problems for some mid-sized US banks earlier this year.

“The ECB will also be keen to implement any changes in a non-disruptive fashion,” Veit says. “Bearing in mind the lessons from March, you want to make sure you don’t shake things up unnecessarily from a financial stability perspective. That speaks to a measured and careful approach, and to give banks time to adapt.”

Nonetheless, Veit adds: “The direction of travel seems reasonably clear. The idea is to return to a leaner balance sheet, both from an interest rate sensitivity and credit risk perspective.”

Initial reduction

In March, the central bank started quantitative tightening (QT). It partially halted reinvestments of maturing assets held under the APP, but it limited this to €15 billion a month. Since July, it allows all APP assets to mature. However, from August 2023 until July 2024, these will average just under €28 billion a month. This is a relatively small proportion of the total. In July 2023, total APP holdings stood at over €3.1 trillion.

For this reason, and given that higher interest rates and QT have not triggered any tension in sovereign bond markets so far, some governing council members favour new steps to accelerate the reduction of the balance sheet. An obvious option would be to partially or completely discontinue reinvestments of PEPP assets. The ECB currently holds close to €1.7 trillion under the programme.

“At some point, this is over because legally you run into trouble,” says Eisenschmidt.

“Proportionality is key, and the APP was first conceived as a tool to fight deflation and the PEPP was linked to the pandemic. If neither of these situations apply, some people will ask, why don’t you take more actions to unwind them?”

More substantial progress has taken place through TLTRO repayments. These operations offer three-year maturity loans for banks to extend credit to the real economy, with the aim of preserving demand and ultimately boosting inflation. Through the three rounds of TLTRO, the ECB has extended loans amounting to more than €2.1 trillion to eurozone banks.

To encourage banks to make use of the third round of the programme, the central bank offered funds for lenders at 50bp below the average interest rate on the deposit facility over the loan’s life. In practice, this meant banks enjoyed a -1% interest rate on these borrowings. In October 2022, the ECB decided to increase rates on outstanding TLTRO III loans to the average key ECB rate starting on November 23. Additionally, it opened three voluntary early repayment dates, allowing banks to decide to repay part of their loans or the complete amount.

These changes have accelerated repayments, lowering ECB lending to eurozone banks from €2.1 trillion in October last year to €606 billion now.

Another factor reducing the ECB’s balance sheet are declining government deposits and deposits by international central banks. The former stood at €647 billion in July 2022 and the latter at almost €434 billion. They stand now at €224 billion and €245 billion, respectively.

Nonetheless, the governing council has been trying to slow down the process to preserve collateral availability and prevent wider disruptions in money markets. The risk was governments would abruptly transfer their deposits away from Eurosystem central banks to reap higher returns through repo markets.

The ECB imposed a 0% interest rate cap on domestic government deposits in 2014, when it resorted to negative interest rates in a context of below-target inflation and scant liquidity. However, as the governing council started to increase interest rates to tame high inflation in July 2022, the cap became untenable.

In September 2022, to preserve the “effectiveness of monetary policy transmission and safeguard orderly market functioning”, the governing council set the ceiling for remuneration of government deposits at the deposit facility rate or the euro short-term rate (€STR), whichever was lower. In February 2023, the governing council tweaked the system again. From May 1, the cap has been €STR minus 20bp.

Nonetheless, the ECB’s remit is limited in this field. It establishes the ceiling for the remuneration of government deposits, but national central banks retain the competence to determine the exact remuneration. In fact, on August 4, Deutsche Bundesbank’s executive board decided to reduce the remuneration of domestic government deposits to 0%.

Some market participants highlight the decision has no major implications per se. Nonetheless, the Bundesbank’s unilateral move shows there is no uniform position and assessment among eurozone central banks, analysts say.

And there are more signals that officials are actively debating how to remunerate liabilities on the Eurosystem’s balance sheet. At its latest policy decision on July 27, the governing council surprised most observers by unveiling that the remuneration of minimum reserve requirements will decline from the deposit facility to 0% as of the beginning of the reserve maintenance period on September 20, 2023. In October 2022, it had already reduced it from the main refinancing operations rate. The ECB argued the measure will “improve the efficiency of monetary policy by reducing the overall amount of interest that needs to be paid on reserves in order to implement the appropriate stance”.

However, observers stress the measure goes beyond increasing policy effectiveness.

“Behind that it’s essentially the concern about central bank losses. You lower these losses by lowering the remuneration,” says Eisenschmidt. Higher interest rates to fight inflation have reduced the value of bonds held in the Eurosystem’s balance sheet.

“But of course, there is a cost attached to this measure,” adds Eisenschmidt. “It makes the monetary policy stance more restrictive. It amounts to a tax on banks that will be passed onto households and businesses.”

The Morgan Stanley economist explains that lowering the remuneration of reserve requirements below the level at which banks obtain liquidity is a way to interfere in credit creation. “That’s why the ECB has a very long tradition of making this neutral. It has treated it as a liquidity buffer and nothing else.”

Alternative frameworks

Bearing in mind the balance sheet’s current size, the set of factors boosting central bank reserves, policy constraints and the priority to preserve stability, the governing council will tread a fine line when designing the new framework.

What is clear is that over the past decade, ECB asset purchases have done more to determine aggregate reserves than banks’ liquidity choices. And the new demand level for reserves is unknown.

Should the demand for reserves have shifted more fundamentally, then upward pressure on interest rates may well start earlier than estimates of the historical relationship between the level of excess reserves and market rates would suggest

Isabel Schnabel, ECB

“Should the demand for reserves have shifted more fundamentally, then upward pressure on interest rates may well start earlier than estimates of the historical relationship between the level of excess reserves and market rates would suggest,” said Schnabel in her March speech.

This is what happened in the US in late 2019. Back then, interbank market rates spiked over the federal funds rate, although the supply of reserves was above the level banks had indicated would be adequate. Additionally, banks’ lower risk tolerance could have permanently reduced their capacity to deal with each other in the interbank market.

If the wide corridor system is no longer an option, the ECB would have two main options. One would be the current supply-driven floor system. This is similar to the one implemented by the US Federal Reserve System. Crucially, it would entail maintaining a sufficiently large bond portfolio.

The other is to offer, through a floor or a narrow-corridor framework, collateralised lending operations to make sure banks have access to adequate liquidity while the central bank can continue with QT.

In the supply-driven system, the Fed addressed volatility in the interbank market by creating the overnight reverse repo facility (ON RRP). This offers non-banks access to the central banks’ balance sheet, remunerating cash held by selected non-banks at rates slightly below the one paid to banks.

Introducing a similar facility in the eurozone would affect the calculation of benchmark rates, argued Schnabel. “An ample reserve system disintermediates the unsecured money market, so that the computation of €STR relies heavily on banks’ trading with market participants who have no access to the Eurosystem’s balance sheet,” she said. “At the end of last year, for example, borrowing from non-banks accounted for nearly 90% of all unsecured money market transactions. We would, therefore, need to find ways to safeguard continued robustness of €STR.”

The ECB executive board member raised another objection to a supply-driven framework. The distribution of excess liquidity in the eurozone is uneven across banks and countries. For instance, 25 banks alone hold more than 40% of excess liquidity, and core economies such as Germany and the Netherlands concentrate a significant share of reserves.

In this context, “reserve scarcity in corners of the financial system might put upward pressure on interest rates even at high levels of aggregate excess reserves”, pointed out Schnabel. Thus, central banks would need to keep a significant buffer of excess reserves in the financial system to avoid volatility. “To provide ample reserves in this framework, the central bank is required, by and large, to maintain a significant outright ‘structural’ bond portfolio.”

This could extend risk exposure to interest rate risks on sovereign bond holdings, as well as perpetuate the ECB’s role in influencing sovereign bond prices.

Schnabel favors instead the adoption of a demand-driven floor framework like the one implemented by the Bank of England. The UK central bank offers collateralised lending operations to address liquidity shortages while it is able to implement QT.

The BoE offers reserves through short-term repo operations at the bank rate, the same rate it pays on its deposits. “Using the same rate for providing and remunerating reserves ensures that money market rates will trade closely to the policy rate at every level of excess reserves,” argued Schnabel.

A demand-driven floor would allow the ECB to reduce its balance sheet more than the current system. “But it comes with a cost, because you permanently take on banks’ liquidity risk on your own balance sheet,” says Eisenschmidt. “Ultimately, there’s no way around having a standing facility constantly available to provide liquidity, which right now the ECB does not have.”

Christiansen from Danske Bank says the critical point for the system to work is that the regulatory framework does not differentiate between funding sources. The Prudential Regulation Authority deems usage of the BoE facility in a similar manner to any other participation in money markets.

“Success in steering interest rates critically depends on banks’ willingness to regularly tap the lending operations as and when they begin to experience shortfalls relative to their reserves demand,” pointed out Schnabel. “Stigma may prevent banks from borrowing the amount needed to stabilise interest rates at the intended level.”

The Danske Bank analyst stresses banks in the UK enjoy “non-penal pricing; they can borrow from the Bank of England at the same rate the receive from deposits". He explains that "if a eurozone bank goes to the ECB it is charged at the marginal lending facility, which is 75 basis points over the deposit facility."

In addition, to eventually be able to have a smaller balance sheet than under a supply-driven framework, in the BoE’s model “the distribution of reserves would be expected to be more even than in a supply-driven floor system, where excess reserves are often very concentrated”, Schnabel stressed. “A more balanced reserve distribution could strengthen the resilience of the currency union.”

Nonetheless, although Schnabel is an influential council member and she took the initiative with her speech in the initial stages of the debate, the process is set to be extremely complex. And decisions such as the Bundesbank’s to unilaterally lower remuneration on government deposits indicates that finding a compromise will be a hard task.