What is excess liquidity and why does it matter?

28 December 2017

The ECB, together with the national central banks of countries in the euro area (the Eurosystem) has been lending unlimited amounts of money to banks in response to the financial crisis. In addition, it has been buying bonds from market participants. As a result, there is more money – or liquidity – in the banking system as a whole than is strictly needed. This is called excess liquidity.

But what exactly is excess liquidity? What can banks do with it? Is it just idly lying around doing nothing for the economy and for citizens, as is sometimes claimed?

What exactly is excess liquidity?

Let’s first look at what we mean by liquidity and the role of the central bank in providing it. Healthy banks may hold long-term assets, such as house mortgages, but face very short-term calls to pay out on liabilities – money out of ATMs, for example. Banks also need liquidity to fulfil minimum reserve requirements. One place that solvent banks can turn to for such short-term liquidity is the central bank. All liquidity available in the banking system that exceeds the needs of banks is called excess liquidity.

What can banks do with excess liquidity?

Commercial banks have current accounts with central banks. All (excess) liquidity is held either in these central bank current accounts or in the deposit facility. In other words, excess liquidity by definition stays with the central bank. An individual bank can reduce its excess liquidity, for example by lending to other banks, purchasing assets or transferring funds on behalf of its clients, but the banking system as a whole cannot: the liquidity always ends up with another bank and thus in an account at the central bank. It is a self-contained or, in other words, closed system. The liquidity cannot even leave the euro area, unless physically in the form of banknotes.

If an investor from the euro area wants to invest in US corporate bonds, for instance, the money first needs to be converted into US dollars. For this, the investor needs to sell his or her euros in exchange for US dollars, possibly at the euro area subsidiary of a US bank. The US dollars can then be used to invest in US corporate bonds. The euros stay in the account of the European subsidiary of the US bank. And this subsidiary also has an account with the national central bank.

Why does the ECB allow an excess of liquidity to exist?

Until the financial crisis started, the ECB satisfied the liquidity needs of the euro area banking system more or less exactly. It estimated the liquidity needs of the banking system every week and provided that amount of money in the form of loans to banks. The banks competed for these loans in an auction and the ECB ensured that the loans met the needs of the banking system as a whole. Once in the system, the liquidity was redistributed among the banks – via interbank lending – according to individual needs.

In October 2008, in response to the severe financial crisis following the collapse of Lehman Brothers, the ECB switched to a system of full allotment. This means that banks can borrow as much liquidity as they want, as long as they have sufficient eligible collateral. The reason for this switch was that banks were no longer redistributing liquidity among themselves via interbank lending, as they did before the crisis. The resulting lack of trust in the redistribution mechanism would have led to a situation in which banks aggressively competed for liquidity in auctions, thus raising interest rates on these loans. The full allotment system is still in place and means that these risks do not exist because individual banks can get as much liquidity as they need.

Following the switch to full allotment, banks considered that it was better to ask for a bit too much than for too little. That led the banking system as a whole to ask for more liquidity than was strictly needed to satisfy the demand, by the public, for cash, and to fulfil minimum reserve requirements. This resulted in excess liquidity in the system.

As a consequence of excess liquidity, market interest rates have stayed low. This means it is cheaper for companies and people to borrow money, thus helping the economy recover from the financial and economic crisis, and allowing the banking system to build up liquidity buffers.

Excess liquidity has increased even further as a consequence of the ECB’s asset purchase programme, which has provided additional monetary accommodation at a time when the interest rates could not be lowered much more.

So isn’t all this money sitting at the central bank idle money?

The fact that (electronic) money and excess liquidity always end up at the central bank does not mean it is not used in the economy. Let’s look at an example to explain this:

Excess liquidity Excess liquidity

Company 1 wants to invest in new machines and gets a loan from its bank, Bank 1 (a bank with excess liquidity). The money is lent to the company but until Company 1 uses the money it stays in the company’s account with Bank 1. Bank 1 has an account at the central bank, where its excess liquidity is kept. The loan in itself hasn’t changed the excess liquidity of Bank 1. Now Company 1 buys the new machines from Company 2 and instructs Bank 1 to transfer the money to the bank of Company 2, Bank 2 (a bank with excess liquidity). Bank 2 also has an account at the central bank which receives the transfer from Bank 1. Company 1’s payment for the new machines leads to a decrease in the excess liquidity of Bank 1 and an increase in the excess liquidity of Bank 2. Overall, the loan and the purchase of machines do not alter the excess liquidity in the banking system. Lending has taken place and the loan has been used for an investment in the economy.

The existence of excess liquidity is not an indicator of how much lending takes place in the economy. It is the monthly bank lending figures and lending growth rates that the ECB publishes that give an indication on how bank lending is developing.

Does it make a difference whether banks put excess liquidity in the deposit facility or their current account?

At the time of writing, it does not. In the past, banks received interest for the money they placed in the deposit facility. Since the ECB decided to introduce a negative rate on the deposit facility, it treats the current account balances (in excess of the minimum reserve requirement) and the deposit facility the same way.