Some monetary policy tools inject money into the banking system. This can lead to more money being available than banks strictly need. We call this money “excess liquidity”. Let’s take a closer look at what this means and where excess liquidity comes from.
First, what is liquidity and where does it come from?
“Liquidity” refers to the money held by commercial banks. Some liquidity is kept as cash in banks’ own vaults but it is mainly money that they keep in accounts with the central bank. These liquid funds that commercial banks hold with a central bank are often called “central bank reserves”.
A central bank provides liquidity mostly through its monetary policy operations. At the ECB, these are our refinancing operations and asset purchases.
What is liquidity used for?
Banks use this liquidity to meet their short-term obligations such as payments and customer withdrawals. They also use it to meet minimum reserve requirements set by central banks.
For central banks, the liquidity they provide – specifically how much of it and at what cost – is an important way of influencing financial market conditions and transmitting monetary policy.
If there is less liquidity available or it is more expensive, this will influence banks’ decisions on how much, and at what conditions, they lend and borrow. Experts refer to this as a tightening of financing conditions.
And with tighter financing conditions and higher interest rates, people and businesses are more reluctant to borrow so they consume or invest less. As a result, the economy cools and inflation comes down.
The opposite is also true. When more liquidity is available at a lower cost to banks, people and businesses are more willing to borrow. This easing of financing conditions stimulates bank lending and boosts the economy.
So, if that's liquidity, what is excess liquidity?
Excess liquidity is the money in the banking system that is left over after commercial banks have met specific requirements to hold minimum levels of reserves. Banks must hold these minimum reserves to cover certain liabilities, mainly customer deposits. They keep these funds on their current account with their national central bank.
This excess liquidity can flow around the banking system as banks do business with one another.
Why is there excess liquidity in the banking system?
The 2008 financial crisis was a watershed moment. Before the crisis, the ECB would estimate how much liquidity the euro area banking system needed as a whole and then make the relevant amount of money available to banks. This was done through loans offered via regular refinancing operations. Banks would then bid for the loans just like in an auction. If a bank was successful with its bids, it could cover its needs or lend the money out to other banks in what is called “interbank lending”.
But after the collapse of Lehman Brothers, banks tended to trust each other less and less. And they essentially stopped lending each other money. In such a climate of distrust, they were inclined to turn to the central bank as the only reliable source of liquidity, bidding more aggressively in the ECB’s refinancing auctions and pushing up the interest rates on loans in the process. So, at this point, the ECB switched to providing as much liquidity as banks needed at a fixed rate (known as “fixed rate full allotment”). Of course, banks in return had to provide enough collateral as a guarantee against the amount they were requesting.
Under this new system, banks felt it was better to demand a bit more liquidity than they needed. More and more banks began “hoarding” liquidity just to be on the safe side. And the banking system as a whole ended up requesting more liquidity than was strictly necessary to meet short-term obligations and minimum reserve requirements. This created excess liquidity in the banking system.
Commercial banks can deposit their excess liquidity at the central bank, either in a current account or in the central bank’s deposit facility. The ECB’s Governing Council decides on the interest rate on the deposit facility, which is one of its three policy rates. The interest rate paid on current account balances is zero.
So where do we stand now with this excess liquidity?
Banks can still get all the liquidity they need under our fixed-rate full-allotment system, which remains in place.
For a period, the amount of excess liquidity in the banking system had risen further, owing to the ECB’s asset purchases and targeted longer-term refinancing operations.
The purchase programmes offered more monetary easing at a time when interest rates could not be cut further. But since November 2022 there is less and less excess liquidity. This is mainly because banks are gradually repaying the funds borrowed in our targeted longer-term refinancing operations. Another reason is that the Eurosystem has been reducing the holdings of its monetary policy securities portfolios since March 2023.
Source: European Central Bank
Published: 28 December 2017
Update Date: 31 October 2023
The above presentation was created for educational purposes.