The European Central Bank (ECB) and the Bank of England (BoE) have announced their intention to maintain a large stock of reserves, mainly using the standard refinancing to distribute these reserves in the banking system. This implies that central banks will have a significant role in financing and liquidity plans banks on a permanent basis, which generally makes banks’ funding profiles more flexible. This is what emerges from a new S&P Global Ratings report (S&P) on the European banking sector and the role of the ECB and BoE in supporting the funding and liquidity plans of the continent’s banks.
In order for these new operational frameworks to be effective, – it is highlighted in the report – it will be necessary to eliminate the potential stigma which accompanies the use of central bank credit lines and ensures that the banks are operationally prepared to access it. This is a complex challenge, but not an insurmountable one. S&P does not necessarily consider a bank’s decision to rely on central bank emergency funds to cover potential liquidity outflows to be a liquidity weakness. Instead, it would welcome banks’ increased preparation to access such facilities, for example by pre-positioning eligible assets.
The extent of demand is still uncertain
Both the ECB and the BoE have acknowledged the uncertainties on the exact level of demand for reserves by banks. For example, the BoE estimate a preferable minimum reserve range between between £345 billion and £490 billion, based on market research. For the Euro areaS&P economists predict a gradual reduction of excess reservespossibly up to to 1.500-2 thousand billion of euros by mid-2026, from a peak of €4.6 trillion in mid-2022 and €3 trillion today. This estimate takes into account European banks’ historical demand for liquidity relative to customer deposits and the duration of their ECB bond portfolios. However, this estimate could be increased once more details are known about the structural bond portfolio that the ECB will build. Beyond the question of the size of the central bank’s excess reserves is the question of their supply.
There BoE has opted for a demand-driven system, in the sense that will provide reserves to banks mainly through secured refinancing operations rather than asset purchases over time. Two key benefits of this approach are that the central bank can maintain more responsive balance sheets, but also avoid bearing the interest rate risk associated with bond holdings. The BoE introduced a new weekly short-term repo (STR) facility in 2022, priced at the bank rate. This facility ensures that reserves are elastically supplied on a weekly basis, without a pre-set limit. In 2022, the BoE introduced a new weekly short-term repo (STR) facility at the bank rate. This facility ensures that reserves are elastically supplied on a weekly basis, without a pre-set limit.
This means that banks’ demands are fully met, provided they provide adequate collateral. That said, due to the high operational burden associated with weekly maturities, the provision of a large stock of reserves cannot be entirely dependent on the STR facility. The BoE intends for banks to also turn to the Indexed Long-Term Repo (ILTR) facility, which provides liquidity for six months against a wide range of collateral. The price of cash is above the bank rate following a competitive bidding process. To make the ILTR facility more suitable for the permanent provision of reserves to banks, the BoE plans to amend its terms and conditions in the coming months.
Central banks will influence banks’ funding and liquidity management
The new scenarios imply that central bank refinancing operations will play a more central role in banks’ funding and liquidity management strategies. central bank refinancing operations Indeed, they represent new sources of contingent liquidity that all banks can draw on if their funding conditions deteriorate, provided that they are operationally prepared to do so and provide adequate collateral. In the long run, and once reserve levels are closer to banks’ actual needs, central banks expect banks to make systematic use of refinancing measures to cover their permanent reserve needs. Such instruments, however, do not replace more traditional emergency liquidity measures provided by central banks as lenders of last resort, such as emergency liquidity assistance under the Eurosystem.
