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The liquidity management framework of the Eurosystem was developed around the concept of neutral liquidity allotments, which endeavoured to create balanced liquidity conditions in the money market and allowed the ECB to steer very short-term interest rates close to the minimum bid rate of its main refinancing operations. However, after introducing tender operations with fixed rate full allotments in October 2008 and, in particular, following the two three-year operations in December 2011 and February 2012, the euro area banking system experienced very ample liquidity conditions. On 1 March 2012, excess liquidity (defined as deposits at the deposit facility plus current account holdings in excess of those contributing to the minimum reserve requirements) reached a peak of €850 billion. Since January 2013, however, the banking system has experienced a progressive decline in excess liquidity, as banks have been increasingly exercising the early repayment option embedded in these operations.
This article examines money market rates and expectations about future short-term rates in the context of declining excess liquidity and changing market conditions. As a result, it provides important insight into the challenges that could arise were there to be a further decline in excess liquidity. This article reviews liquidity and market developments up to 10 December 2013, which is the last day of the 11th maintenance period in 2013.
Excess liquidity provision by the Eurosystem reached its peak in March 2012. More recently, the improving market conditions have reduced the demand for precautionary liquidity buffers, while reopening access to the wholesale funding market to counterparties that had experienced impairments in market access during 2011. This is reflected in a lower demand for excess liquidity in the Eurosystem’s refinancing operations and in the substitution of Eurosystem funding with market funding. As a consequence, euro area banks have been actively using the opportunity for early repayments of the amount borrowed in the three-year LTROs. Demand for liquidity in the other Eurosystem refinancing operations also declined.
Should excess liquidity remain abundant, money market rates would continue to be anchored at levels close to the ECB deposit facility rates. If, however, excess liquidity were to decline towards more neutral conditions, money market rates would tend to be anchored to the MRO rate. 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.