Falling reserves push banks towards market funding

European Central Bank (ECB) officials have said that euro area banks are adjusting to declining central bank reserves while continuing to rely on favourable market conditions to manage liquidity.

In a recent blog post, financial markets experts and senior officials in the ECB’s market operations division examined how banks are responding as the Eurosystem gradually normalises its balance sheet.

“Central bank reserves – banks’ most liquid asset – keep declining,” the authors said, explaining that this trend reflects the broader policy shift following years of monetary expansion.

Reserves have fallen sharply from a peak of €4.9 trillion in 2022 to €2.6 trillion in early 2026, although the ECB stressed that liquidity remains abundant overall.

At the same time, reserves are unevenly distributed across institutions, meaning some banks will need to seek additional liquidity sooner than others.

“Some banks may need to source reserves sooner than others,” the authors said, pointing to growing divergence in liquidity positions across the system.

The ECB also highlighted that money market rates are converging towards the deposit facility rate, the central bank’s key policy benchmark.

Secured repo rates are now trading as close to the deposit facility rate as they did in 2020, signalling tighter alignment between market pricing and policy rates.

Survey data cited in the post showed that 26 per cent of euro area banking assets are now near preferred reserve levels, up from 15 per cent a year earlier.

This group includes globally systemically important banks, as well as custodians and asset managers that tend to manage liquidity more actively.

Looking ahead, reserves are projected to decline by around €470 billion per year, although the ECB cautioned that this outlook is subject to uncertainty.

By the end of 2026, banks representing about 50 per cent of total assets are expected to reach their preferred reserve levels.

“Banks will have to more actively manage their liquidity,” the authors said, underlining the implications of this shift.

As reserves decline further, banks are expected to increasingly rely on money markets and Eurosystem refinancing operations to meet their needs.

The ECB said institutions closest to their preferred reserve thresholds or regulatory targets are typically the first to seek additional liquidity.

“Those closest to their preferred reserve levels borrow the most,” the authors said, referring to activity in short-term repo markets.

The central bank emphasised that liquidity redistribution across the euro area remains smooth, with no signs of market fragmentation.

Banks are actively lending and borrowing in money markets, ensuring reserves continue to circulate effectively across countries and institutions.

The repo market remains dominated by dealer banks with abundant reserves, although participation by other banks is increasing.

At the same time, banks are also active in term money markets, using longer maturities to comply with Basel III liquidity requirements.

“Banks set internal targets above the 100 per cent regulatory minimum,” the authors said, adding that institutions are keen to maintain buffers above required levels.

This activity has pushed up premia on term liquidity, particularly as banks close to regulatory thresholds increase borrowing.

The ECB stated that developments in term markets can serve as an early indicator of changing liquidity conditions and the attractiveness of central bank operations.

Moreover, short-term interest rates, both secured and unsecured, remain close to the ECB’s deposit facility rate.

The spread between the euro short-term rate and the policy rate has narrowed, while repo rates have also converged.

Although the share of overnight repo trades above the deposit facility rate has risen to 40 per cent, the ECB said this does not signal funding stress.

“This does not reflect funding pressures for banks,” the authors said, attributing the increase mainly to demand from hedge funds.

They explained that non-bank demand for cash and collateral dynamics can influence market rates independently of reserve scarcity.

“Rising rates do not necessarily signal increasing scarcity of reserves,” the authors said, warning that such movements should be interpreted with caution.

Despite the gradual tightening in liquidity conditions, demand for Eurosystem standard refinancing operations remains limited.

Money market rates continue to sit below the main refinancing operation rate, currently at 2.15 per cent compared with a 2.0 per cent deposit facility rate.

As a result, banks can still access cheaper funding in private markets than from the central bank.

Take-up in standard refinancing operations has averaged around €20 billion over the past year.

However, longer-term market funding has become more expensive, partly due to its regulatory benefits under the net stable funding ratio.

The ECB noted that some banks are already participating in refinancing operations through test bids or to cover temporary liquidity needs.

“There is little urgency to borrow from the ECB as of now,” the authors said, while stressing the importance of operational readiness.

Looking ahead, the ECB expects demand for central bank operations to increase as reserves decline and relative pricing shifts.

“SROs are designed to serve as the marginal tool for meeting banks’ liquidity needs,” the authors said, highlighting their role in the operational framework.

They added that increased use of these facilities would help stabilise market rates by injecting reserves back into the system.

Broadly, the ECB concluded that the euro area financial system has so far adjusted well to declining reserves, with banks effectively managing liquidity through markets.

“There are no signs of fragmentation,” the authors said, reaffirming confidence in current market functioning.

However, they stressed that banks will need to remain prepared to use central bank tools more routinely as reserves continue to fall.

“It will be important for banks to be ready to use Eurosystem operations,” the authors stated, pointing to the next phase of adjustment in the monetary policy cycle.