SPEECH
A tale of two money markets: fragmentation or
concentration
Speech by Benoît Coeuré, Member of the Executive Board of the ECB, at the ECB workshop on
money markets, monetary policy implementation and central bank balance sheets
Frankfurt am Main, 12 November 2019
Since the outbreak of the global financial crisis, central banks have injected a huge amount of liquidity into
the financial system.[1]
The monetary policy assets on the Eurosystem's consolidated balance sheet, for example, have expanded
from around €0.5 trillion on the eve of the crisis in July 2008 to nearly €3.3 trillion at the end of September
this year.
Not all of the expansion in central bank balance sheets reflects direct monetary policy actions, however.
Part of it relates to regulatory factors, as I will explain shortly in more detail. And part of it relates to
autonomous factors, such as the steady increase in the demand for banknotes.[2]
Yet, changes in the way we operate and implement monetary policy - in our case, the fixed-rate full
allotment at our main refinancing operations, (targeted) long-term refinancing operations and our asset
purchase programme - have resulted in considerably more liquidity being injected into the financial system
than is required by banks to meet their immediate liquidity needs.
These excess liquidity holdings were first a sign of uncertainty and mistrust, and then of a dysfunctional
money market. As a result, central bank operations substituted for market-based intermediation in times of
crisis.
Today, large excess reserve holdings are, by and large, a reflection of the accommodative monetary policy
that central banks have conducted in recent years, and that many, including the ECB, are still conducting
today in view of stubbornly low inflation rates. You can see this on my first slide. Excess liquidity increased
as we rolled out our unconventional policy measures.
In this environment, an important - albeit by no means the only - role of excess liquidity is to firmly anchor
short-term interest rates at the levels judged appropriate by policymakers. In the case of the euro area, this
is currently the level of our deposit facility rate.
And yet, recent events in the euro area and the United States have highlighted that the current ample
excess liquidity levels may not guarantee that short-term interest rates will reflect policymakers' desired
levels at all times.
In the United States, short-term funding rates experienced severe upward pressure towards the end of
September, which required the Federal Reserve to conduct additional liquidity-providing operations. In the
euro area, the introduction of a two-tiered reserve remuneration system triggered expectations among
market participants of some, albeit limited, upward pressure on overnight rates.
In my remarks this morning I would like to use these two episodes as examples for explaining why
managing liquidity conditions in the post-crisis environment has become more complex. In the United
States, a prime reason behind the increased complexity relates to the highly uneven distribution of excess
liquidity across individual banks. In the euro area, it relates to an uneven distribution across jurisdictions.
And in both cases, it also relates to the growing role of intermediaries without access to central bank
balance sheets.
I will argue that this concentration of excess liquidity may ultimately require policymakers to tolerate central
bank balance sheets that are larger than would be required to control short-term interest rates if liquidity
was more evenly distributed. And I will argue that if there would be a need for policymakers to increase
their control of short-term rates in an environment of excess liquidity, providing non-banks with access to
central bank balance sheets is a powerful option.[3]
The distribution of excess liquidity across banks
Demand for central bank liquidity has increased considerably since the financial crisis. A number of
liquidity regulations affecting banks, such as the net stable funding ratio and the liquidity coverage ratio
(LCR), require banks to hold a sufficient quantity of high-quality liquid assets. Central bank reserves count
as such high-quality liquid assets.
Naturally, the role of central bank reserves in meeting regulatory requirements depends on the availability
of other high-quality liquid assets, such as government bills and bonds. In the euro area, the supply of
such alternatives has declined notably over recent years, reflecting both crisis-related downgrades of
sovereign issuer credit ratings and fiscal surpluses in some jurisdictions, including Germany.
As a result, ECB staff estimate that the introduction of the LCR increased demand for reserves in the euro
area by up to €200 billion in a sample of systemically important euro area banks from mid-2015 to the end
of 2016. On my next slide you can see that banks, especially those with low LCRs, are estimated to have
significantly increased their demand for central bank reserves.
It is certainly not the responsibility of central banks to help commercial banks meet their regulatory
requirements. Banks should stand on their own feet when it comes to capital and liquidity. But the hoarding
of central bank reserves for regulatory reasons becomes a matter of attention for policymakers insofar as it
has the potential to adversely affect the transmission of monetary policy.[4]
This provides the background to understand the recent events in the US money market.
As you can see on my next slide, excess reserves - the grey shaded area - currently stand well above $1
trillion - an extraordinary amount from a historical perspective and a level that, according to survey
evidence, market participants had expected to be sufficient to keep market rates tied to policy rates, even
when accounting for regulatory demand.
Nevertheless, and you can see this on the right-hand side more clearly, the secured overnight financing
rate surged markedly towards the end of September, well above the Federal Reserve's policy rates. Even
the effective federal funds rate briefly exceeded its target range.
Such volatility is clearly undesirable from a monetary policy perspective. Short-term rates - and the
relevant swap curves that are linked to them - are the key benchmark rates for the pricing of credit.
The Federal Reserve therefore added more than $200 billion in additional overnight and 14-day repo
operations and announced additional purchases of US Treasury bills at a pace of approximately $60 billion
per month at least into the second quarter of 2020.
These operations became necessary for a simple reason: because holdings of excess reserves in the US
financial system are highly concentrated. You can see this on my next slide. According to data from the US
Federal Deposit Insurance Corporation (FDIC), 86% of excess reserves are held by just 1% of US banks.
Four banks alone account for 40% of aggregate excess reserve holdings in the United States.
Whenever these intermediaries are reluctant, for regulatory or other reasons, to react to a shortage of
liquidity elsewhere in the system - even in response to short-term shocks to the supply of and demand for
liquidity - upward pressure on short-term rates becomes unavoidable.
In addition, liquidity may be increasingly supplied by intermediaries which do not have access to central
bank refinancing - a point to which I will return to later in my remarks. All in all, it is fair to say that the
supply of liquidity has become less elastic in recent years.
Excess reserves are, however, much more concentrated in the United States compared with the euro
area, despite the fact that there are almost twice as many banks in the United States than monetary
financial institutions in the euro area. On this side of the Atlantic, the top 1% of banks hold less than 50%
of excess liquidity.
And on the right-hand side you can see that the ten largest banks in the euro area hold just a little more
than a quarter of excess liquidity, compared with almost 70% in the United States.
At face value, the euro area's more even distribution of liquidity suggests that it may be less likely to
experience an episode of high interest rate volatility.
But there are two features - one of them specific to the euro area - that warrant caution.
The distribution of excess liquidity and the two-tier system
The first feature relates to the distribution of excess liquidity within and across euro area jurisdictions.
On the left-hand side of my next slide you can see that banks' excess liquidity is often much less evenly
distributed than at the country level. In Italy, for example, the top ten banks together hold 80% of excess
reserves - a concentration level that is, in fact, higher than in the United States. In France, the top 10
banks hold 70%.
On the right-hand side you can see that excess liquidity holdings in the euro area are also highly
concentrated in just a few countries.
Such concentration levels are, in principle, of little concern to policymakers in the presence of a deep and
active money market across the euro area - that is, as long as banks with excess liquidity holdings are
willing and able to smooth liquidity shortages elsewhere in the system.
If there is fragmentation, however, then temporary spikes in interest rates are also possible in the euro
area, despite the remarkable excess liquidity levels we are currently seeing.
In other words, in the euro area, compared to the United States, it is fragmentation rather than
concentration that may make liquidity supply less elastic.
The recent introduction of a two-tier reserve remuneration scheme for the excess reserves of euro area
banks provides an interesting showcase for just how fragmented our money markets remain today. The
scheme allows banks to deposit a pre-determined quantity of excess liquidity - their exemption allowances
- at a rate higher than the deposit facility rate.
To see the effect of the scheme on money markets, it is important to recall that exemption allowances are
allocated as a multiple of banks' reserve requirements.[5]
This allocation scheme has led to some banks receiving allowances that are higher than their excess
liquidity holdings.
Specifically, ECB staff calculations suggest that around one-third of exempt excess liquidity would need to
be traded across banks for the system as a whole to benefit fully from the two-tier scheme. Most of this
trading can take place within euro area jurisdictions, and often even within banking groups.
But because of the uneven distribution of excess liquidity, ECB staff estimates that around 4% of
exemption allowances, or around €30 billion, could only be filled if banks trade across borders.
Such volumes are potentially large. For example, they are about the same size as the volumes currently
underpinning the daily computation of the €STR, and they amount to about 30% of the size of the current
daily turnover in the secured money market.
Yet, the impact on the €STR, as you know, has been very limited. You can see this on the left-hand side of
my next slide. Our analysis shows that this stability is not primarily the result of the statistical trimming
procedure that is applied to the €STR and that could potentially treat transactions at higher rates as
outliers.
It is rather a reflection of the remaining impediments to cross-border trading in the unsecured segment.
You can see from the chart that trading volumes for the €STR have hardly changed in response to the
introduction of the two-tier system.
Unsecured cross-border trading appears to remain limited to core countries even a decade after the
outbreak of the global financial crisis. Indeed, on the right-hand side you can see that unsecured borrowing
remains, by and large, domestic, particularly in countries where excess liquidity is high.
Of course, current elevated excess liquidity levels remove incentives to money market trading more
generally. But the muted response of unsecured market trading volumes to the introduction of the two-tier
system suggests that we may still be facing a situation in which banks in some parts of the euro area may
hold on to excess liquidity while those in other parts of the currency union may face a liquidity shortage.
Where we have initially seen a more pronounced reaction of rates to the introduction of the two-tier
system, however, is in the secured market, in which the use of collateral and central clearing can mitigate
counterparty risks. You can see this on the left-hand side of my next slide, which shows repo rates for
banks located in different countries.
The chart suggests, for example, that Italian banks with unused allowances increased their demand for
cash in the Italian repo market, which has led to a notable - albeit temporary - increase in repo rates.
Arbitrage opportunities caused other banks to increase their lending, however, which gradually mitigated
this upward pressure.
The observed movements in rates are broadly consistent with recent changes in cross-border flows in
excess liquidity. You can see this on the right-hand side. On the first day of operation of the two-tier system
we observed a considerable redistribution of excess liquidity, often away from liquidity-flush countries such
as Belgium, Germany and the Netherlands and towards countries with unused allowances, such as Italy.[6]
On my next slide you can see banks' progress in making full use of the exempt tier. For comparison, the
blue bars show the theoretical allocation of allowances before the start of the scheme. The chart shows
that the Italian banking system as a whole is almost fully benefiting from the allocated allowances, also in
response to the re-distribution of excess liquidity towards the Italian banking system.
But in some countries, particularly in smaller peripheral jurisdictions, which I have grouped together here,
but also in Germany, there still seem to be some remaining impediments that stop banks from making full
use of the scheme.
The distribution of excess liquidity across sectors
So, provided banks have sufficient collateral, secured interbank lending has been able to at least partly
offset the remaining constraints in unsecured cross-border lending. This was the first feature I alluded to.
The second feature that warrants caution relates to the distribution of liquidity across sectors, including
holdings outside the euro area.
The implications of this feature can be best appreciated when looking more closely at the trades
underlying the €STR. You can see this on the left-hand side of my next slide.
Today, almost 60% of €STR transactions are with euro area non-banks - typically, asset managers,
pension funds, insurance companies or corporate treasurers - and most of the remainder is accounted for
by non-euro area entities. Just 3% of trades are currently between euro area banks.
In other words, the significant accumulation of excess liquidity in the euro area banking sector in response
to the non-standard monetary policy measures implies that the overwhelming share of money market
transactions currently take place between entities that have access to the deposit facility and those that do
not.
As a result, €STR borrowing rates often reflect the rates charged by euro area banks on deposits by
entities without access to the ECB deposit facility. You can see this on the right-hand side.
Non-bank and non-euro area entities are prepared to pay rates below the deposit facility rate, and below
the rates offered by those with access to the facility, for two main reasons. First, because internal risk
management rules restrict their choice of counterparties to those with the lowest credit risk. And, second,
because alternative safe investments, such as short-term government bonds, are often even more costly.
The changeover from EONIA to the €STR made visible the pricing impact of differences in who can hold
central bank reserves. This also means that the €STR is a better and more transparent indicator of
prevailing market conditions than EONIA, as it helps deliver a more comprehensive picture of the
interactive effects of our actions and policy framework.
But it also implies a possible risk that the €STR might be less under our control than EONIA was. Changes
in the €STR are essentially a function of three main factors: the level of ECB policy rates, the level of
excess liquidity and the distribution of this excess liquidity across sectors.
All else being equal, a decline in the demand for liquidity services by non-banks - for example, due to a
sudden increase in risk aversion - might lead to upward pressure on the €STR at the same level of excess
liquidity. Also, a decline in excess liquidity can be expected to lead to faster upward pressure for €STR,
even in the absence of changes in policy rates.
It is these factors that may be a cause of concern in the current context of interest rate volatility. But I
would not be overly worried today for three main reasons.
First, we are a long way from expecting any reductions in excess liquidity in the euro area. In fact, as of
November, the ECB's renewed net asset purchases of €20 billion per month will further increase excess
liquidity.
The Governing Council is committed to continue net purchases for as long as necessary to reinforce the
accommodative impact of our policy rates, and to end shortly before we start raising the key ECB interest
rates, which in turn will depend on inflation robustly converging towards our aim. Even beyond the end our
net purchases, we will continue reinvesting the principal payments from maturing securities for an
extended period of time, which will keep excess liquidity abundant.
Second, the experience of the Federal Reserve has highlighted that policymakers have the tools to
respond quickly and efficiently to signs of market volatility. In particular, central banks always have the
option to broaden access to the liability side of their balance sheet to a wider set of financial
intermediaries, which would automatically make it easier to control rates.[7]
And, third, the remarkable stability of the EONIA-€STR spread over the past two years or so suggests that
regulatory costs related to the leverage ratio, and competition between banks to offer liquidity storage
services to entities without access to the deposit facility, are strong inertial forces that help mitigate large
and abrupt swings in the €STR, in both directions.
Conclusion
All this means, and with this I would like to conclude, that large aggregate excess liquidity levels are no
insurance that central banks will always find it easy to steer short-term interest rates.
Liquidity supply may have become less elastic in both the euro area and the United States, for different
reasons though: in the United States because of concentration among banks, in the euro area because of
fragmentation across countries, and in both cases because of the growing role of intermediaries without
access to central bank balance sheets. This calls for central banks to err on the side of caution and leave a
sufficient buffer in the financial system with a view to forestalling risks of unwarranted upward pressure on
short-term interest rates.
The launch of the €STR has been a welcome step in providing a more complete picture of the actual
borrowing conditions facing euro area banks. If policymakers in the future consider the impact of changes
in excess liquidity on the level of the €STR to be less desirable, they could consider expanding access to
the liability side of central bank balance sheets to other actors in financial markets.
Thank you.
[1]
I would like to thank Julian Schumacher and Annette Kamps for their contributions to this speech. I remain solely responsible for the
opinions contained herein.
[2]
As the economy grows, and the demand for banknotes increases, it is normal to see central bank balance sheets expand. In the five
years before the crisis, the ECB's balance sheet expanded by more than 50%.
[3]
See also Coeuré, B. (2016), "The ECB's operational framework in post-crisis times", speech at the Federal Reserve Bank of Kansas
City's 40th Economic Policy Symposium, Jackson Hole, 27 August.
[4]
See Coeuré, B. (2013), "Liquidity regulation and monetary policy implementation: from theory to practice", speech given at the
Toulouse School of Economics, Toulouse, 3 October.
[5]
See the press release "ECB introduces two-tier system for remunerating excess liquidity holdings", 12 September 2019.
[6]
The chart focuses on the first day of operation as excess liquidity subsequently increased during the course of November in response
to a decline in autonomous factors. The message remains unchanged, however.
[7]
See Coeuré, B. (2018), "The future of central bank money", speech at the International Center for Monetary and Banking Studies,
Geneva, 14 May.
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