ECB adjusts operational framework as balance sheet normalises

Why does the operational framework need to be reviewed?

Before 2008, the ECB –  and most other central banks – operated in a “corridor system”, with a liquidity shortage in the banking system as a whole. This meant most banks had to borrow money from the ECB. As a result, money market rates were roughly equal to the rate at which the ECB lent this money through its main refinancing operations (MRO), see Figure 1. Since 2008, there has been excess liquidity in the banking system, partly due to the ECB’s purchases of government bonds. Because this leaves most banks with more than enough reserves, the interest rate paid by the ECB on these reserves – referred to as the deposit facility rate, or DFR – is now the most important interest rate. This is the lowest and therefore the ‘floor’ of the ECB’s policy rates. Other central banks have seen a similar shift to a floor system. 

Figure 1 - Short money market rates (EONIA/€STR) moved from the middle of the corridor to the floor

Since the summer of 2022, the ECB has been reducing the size of its balance sheet by letting purchased bonds and long-term refinancing operations mature, thus reducing excess reserves (see Figure 2). The ECB will continue to reduce its balance sheet for the time being, with the end point yet to be determined. Partly because the liquidity needs of banks have increased significantly due to regulation, a return to the traditional corridor system is not obvious. By providing clarity to the market on the future implementation of monetary policy, banks can prepare for an environment with less liquidity well in advance.

Figure 2 - ECB balance sheet past its peak

Through this review, the ECB aims to create a robust operational framework that facilitates the reduction of its balance sheet and also meets banks' liquidity needs in current and future economic environments. This involves a trade-off between effectiveness and efficiency. Effectiveness is about steering short-term money market rates as precisely as possible and minimising their volatility. Efficiency is about implementing monetary policy as efficiently as possible, i.e. with the smallest possible balance sheet. In other words, very strong control over money market rates goes hand in hand with a very large balance sheet and vice versa. The new operational framework attempts to strike a balance between these two principles and also take into account the specific needs of the euro area.

What does the new framework look like and what are the implications?

In essence, the new operational framework is a demand-driven floor system. Funding will be provided through a mix of instruments, but with a central role for lending to banks. Partly because interest rates on these lending operations are moving closer to the deposit facility rate (DFR), we expect interest rates to keep moving around the lower bound of the corridor (i.e. the DFR), although some volatility is possible. The system is an intermediate variant between the traditional corridor – where volatility is high and the central bank balance sheet is relatively small –  and a supply-driven floor, as operated by the US Federal Reserve – where a lot of liquidity is provided through bond purchases and the central bank balance sheet is large, but volatility is low. Banks can themselves determine how much liquidity they need through their participation in lending operations, so the ECB does not need to estimate this need. This is appropriate for a bank-based economy like the euro area, where the banking landscape is heterogeneous among member states.

As indicated above, the existing bond portfolios (PEPP and APP) will gradually shrink in the coming years and will drain reserves from the banking system. At some point, the ECB balance sheet will have to grow again to meet the banking system’s structural liquidity needs. These stem from “autonomous factors” such as banknotes in circulation and minimum reserve requirements, among other things. In the future, this liquidity need will be partly met through long-term refinancing operations and a structural bond portfolio. This prevents banks from becoming completely dependent on short-term lending (MROs), and encourages money market activity.