What is excess liquidity? (2024)

28 December 2017 (Last updated on: 31 October 2023)

Some monetary policy tools inject money into the banking system. This can lead to more money being available than banks strictly need. We call this money “excess liquidity”. Let’s take a closer look at what this means and where excess liquidity comes from.

First, what is liquidity and where does it come from?

“Liquidity” refers to the money held by commercial banks. Some liquidity is kept as cash in banks’ own vaults but it is mainly money that they keep in accounts with the central bank. These liquid funds that commercial banks hold with a central bank are often called “central bank reserves”.

A central bank provides liquidity mostly through its monetary policy operations. At the ECB, these are our refinancing operations and asset purchases.

What is liquidity used for?

Banks use this liquidity to meet their short-term obligations such as payments and customer withdrawals. They also use it to meet minimum reserve requirements set by central banks.

For central banks, the liquidity they provide – specifically how much of it and at what cost – is an important way of influencing financial market conditions and transmitting monetary policy.

If there is less liquidity available or it is more expensive, this will influence banks’ decisions on how much, and at what conditions, they lend and borrow. Experts refer to this as a tightening of financing conditions.

And with tighter financing conditions and higher interest rates, people and businesses are more reluctant to borrow so they consume or invest less. As a result, the economy cools and inflation comes down.

The opposite is also true. When more liquidity is available at a lower cost to banks, people and businesses are more willing to borrow. This easing of financing conditions stimulates bank lending and boosts the economy.

So, if that’s liquidity, what is excess liquidity?

Excess liquidity is the money in the banking system that is left over after commercial banks have met specific requirements to hold minimum levels of reserves. Banks must hold these minimum reserves to cover certain liabilities, mainly customer deposits. They keep these funds on their current account with their national central bank.

This excess liquidity can flow around the banking system as banks do business with one another.

Why is there excess liquidity in the banking system?

The 2008 financial crisis was a watershed moment. Before the crisis, the ECB would estimate how much liquidity the euro area banking system needed as a whole and then make the relevant amount of money available to banks. This was done through loans offered via regular refinancing operations. Banks would then bid for the loans just like in an auction. If a bank was successful with its bids, it could cover its needs or lend the money out to other banks in what is called “interbank lending”.

But after the collapse of Lehman Brothers, banks tended to trust each other less and less. And they essentially stopped lending each other money. In such a climate of distrust, they were inclined to turn to the central bank as the only reliable source of liquidity, bidding more aggressively in the ECB’s refinancing auctions and pushing up the interest rates on loans in the process. So, at this point, the ECB switched to providing as much liquidity as banks needed at a fixed rate (known as “fixed rate full allotment”). Of course, banks in return had to provide enough collateral as a guarantee against the amount they were requesting.

Under this new system, banks felt it was better to demand a bit more liquidity than they needed. More and more banks began “hoarding” liquidity just to be on the safe side. And the banking system as a whole ended up requesting more liquidity than was strictly necessary to meet short-term obligations and minimum reserve requirements. This created excess liquidity in the banking system.

Commercial banks can deposit their excess liquidity at the central bank, either in a current account or in the central bank’s deposit facility. The ECB’s Governing Council decides on the interest rate on the deposit facility, which is one of its three policy rates. The interest rate paid on current account balances is zero.

So where do we stand now with this excess liquidity?

Banks can still get all the liquidity they need under our fixed-rate full-allotment system, which remains in place.

For a period, the amount of excess liquidity in the banking system had risen further, owing to the ECB’s asset purchases and targeted longer-term refinancing operations.

The purchase programmes offered more monetary easing at a time when interest rates could not be cut further. But since November 2022 there is less and less excess liquidity. This is mainly because banks are gradually repaying the funds borrowed in our targeted longer-term refinancing operations. Another reason is that the Eurosystem has been reducing the holdings of its monetary policy securities portfolios since March 2023.

What is excess liquidity? (2024)

FAQs

What is excess liquidity? ›

Excess liquidity is the money in the banking system that is left over after commercial banks have met specific requirements to hold minimum levels of reserves. Banks must hold these minimum reserves to cover certain liabilities, mainly customer deposits.

What does excess liquidity mean in interactive brokers? ›

Your Excess Liquidity tells you whether you have sufficient cushion to maintain your current positions, and your Buying Power tells you how much you have at your disposal including your equity and IB's margin.

What does excess liquid mean? ›

Hypervolemia, also known as fluid overload, is a condition where you have too much fluid volume in your body. Body fluids, like blood and water, are important to keep your organs functioning. People with heart and kidney conditions and people who are pregnant often experience hypervolemia.

What is a disadvantage of excess liquidity? ›

Answer and Explanation:

Liquidity on the current date is good but, excess liquidity leads to low returns in the future. 2. Increased risk: Lower returns can lead to increased risk. For example, if current debtors are increasing the liquidity of the company, there is a risk of default for that period.

Why is too high a liquidity bad? ›

But it's also important to remember that if your liquidity ratio is too high, it may indicate that you're keeping too much cash on hand and aren't allocating your capital effectively. Instead, you could use that cash to fund growth initiatives or investments, which will be more profitable in the long run.

What happens when there is excess liquidity? ›

Excess liquidity indicates low illiquidity risk, and since bankers' compensation is often volume-based, excess liquidity drives them to lend aggressively to increase their bonuses.

How do you manage excess liquidity? ›

Here's how:
  1. Buy long-term bonds and/or lend long-term fixed-rate loans and reap the benefits of their current yields.
  2. Use a forward starting pay-fixed swap to hedge the “out-years”. ...
  3. Use the strategy with an individual fixed-rate bond or loan, or a pool of fixed-rate assets.

What does it mean to pour off excess liquid? ›

Removing liquid from food by placing it in a strainer or colander and allowing the excess liquid to drain out.

What does excess fluid do? ›

Symptoms of hypervolemia can cause discomfort, stress on your body and even organ trouble. Signs of fluid overload may include: Rapid weight gain. Noticeable swelling (edema) in your arms, legs and face.

What does highly liquid mean in finance? ›

An asset that can be sold rapidly for its full value is said to be highly liquid. An asset that takes significant time to sell, or one that can only be sold at a discounted value, is considered less liquid or illiquid.

Is liquidity a bad thing? ›

Having liquidity is important for individuals and firms to pay off their short-term debts and obligations and avoid a liquidity crisis.

What is danger of liquidity? ›

Liquidity risk is defined as the risk that the Group has insufficient financial resources to meet its commitments as they fall due, or can only secure them at excessive cost. Liquidity exposure represents the potential stressed outflows in any future period less expected inflows.

Is excess reserves the same as excess liquidity? ›

Only in exceptional cases do banks hold excess reserves, e.g. if they do not have formal access to the deposit facility. The sum of excess reserves and deposits in the deposit facility is referred to as excess liquidity.

What do banks do with excess cash? ›

Banks have little incentive to maintain excess reserves because cash earns no return and may even lose value over time due to inflation. Thus, banks normally minimize their excess reserves, lending the money to clients rather than holding it in their vaults.

What is current excess liquidity? ›

Some monetary policy tools inject money into the banking system. This can lead to more money being available than banks strictly need. We call this money “excess liquidity”.

What is high risk of liquidity? ›

Typically, high liquidity risk indicates that particular security cannot be readily bought or sold in the share market. This is because an issuing company might face challenges in meeting its current liabilities due to reduced cash flow.

What does it mean if you have high liquidity? ›

A company's liquidity indicates its ability to pay debt obligations, or current liabilities, without having to raise external capital or take out loans. High liquidity means that a company can easily meet its short-term debts while low liquidity implies the opposite and that a company could imminently face bankruptcy.

What does it mean if an account has high liquidity? ›

Accounting liquidity refers to cash flow, or how easily you can meet your recurring obligations based on your available cash. Having strong accounting liquidity means being able to pay your bills, including debt payments, using your most liquid assets without resorting to selling nonliquid assets at a loss.

Are high liquidity stocks good or bad? ›

Liquidity in the stock market refers to the ease with which stocks can be bought or sold in the market without affecting their price significantly. High liquidity in a stock means that there are a large number of buyers and sellers, facilitating smooth and rapid transactions.

Does high liquidity mean high volatility? ›

Liquid markets such as forex tend to move in smaller increments because their high liquidity results in lower volatility. More traders trading at the same time usually results in the price making small movements up and down. However, drastic and sudden movements are also possible in the forex market.

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