European Banks Are Getting Ready for Central Bank Funding

By Nicolas Charnay, Managing Director & Sector Lead for European FIs, and Pierre Hollegien, Associate Director, Financial Services Ratings, S&P Global Ratings

The European Central Bank (ECB) and the Bank of England (BoE) have announced that they intend to maintain a stock of ample central bank reserves and mainly use standard bank-refinancing operations to deploy these reserves in the banking system. S&P Global Ratings believes the new frameworks will give central banks a significant role in banks’ funding and liquidity risk management. All else being equal, they will also make banks’ funding profiles more flexible, which we view positively.

Over the longer term, once reserve levels are closer to banks’ actual needs, central banks expect banks to use the refinancing facilities routinely to cover their permanent needs for reserves. Notably, these facilities are distinct and do not replace the more traditional emergency liquidity measures that central banks provide as lenders of last resort, such as the emergency liquidity assistance (ELA) under the Eurosystem framework.

The scale of demand remains uncertain

Both the ECB and the BoE have acknowledged uncertainties over the exact level of banks’ demands for reserves. For instance, the BoE estimates a preferred minimum-reserve range of £345 billion-£490 billion, based on market surveys. For the euro area, our economists expect excess reserves to fall gradually, possibly to €1,500 billion-€2,000 billion by mid-2026 from a peak of €4,600 billion in mid-2022 and the current €3,000 billion. This estimate takes into account European banks’ historical liquidity demands relative to their customers’ deposits and the durations of their ECB bond portfolios. However, this estimate could be increased once more details become known on the structural bond portfolio that the ECB sets up.

Beyond the question of the size of the excess central bank reserves lies the matter of their delivery. The BoE has opted for a demand-driven system, meaning that it will supply reserves to banks primarily via secured refinancing operations rather than asset purchases over time. Two key advantages of this approach are that the central bank can maintain a more responsive balance sheet but also avoid bearing the interest rate risk (IRR) associated with bond holdings.

The ECB intends secured refinancing operations to play a central role in providing reserves to banks. However, we expect the ECB to maintain a structural bond portfolio, and it has not yet announced the relative sizes of the two facilities. The ECB has refinancing facilities for one week (the main refinancing operations, or MROs), three months (the long-term refinancing operations, or LTROs) and overnight funding (the marginal lending facility, or MLF). It will continue with full allotment procedures for all these facilities, meaning that it will not limit the amount that banks can borrow against adequate collateral.

Importantly, the ECB announced a change in the relative pricing of MROs and LTROs, which dropped from 50 basis points (bps) to 15 bps above the deposit facility rate—the rate at which the ECB remunerates banks’ reserves—from Sept. 18, 2024. The ECB intends this narrowing of the spread to incentivize banks’ use of the facilities.

The new operational frameworks will also serve to close a gap between European and US banks. The latter have long benefited from contingent and ongoing public funding via the Federal Home Loan Bank (FHLB) System providing its members with liquidity to support housing and community development.

These frameworks should be considered from the broader perspective of central banks seeking to protect financial stability by providing contingency funding to key actors. An important upcoming change in this regard is the BoE’s introduction of a new contingent repo (repurchase agreement) facility for nonbank financial institutions (NBFIs). The Contingent NBFI Repo Facility (CNRF) aims to prevent market dysfunction that results from shocks and could temporarily increase NBFIs’ demand for liquidity.

Implementing the new operational frameworks poses key challenges for central banks

As central banks plan to rely on repo lending to banks to maintain ample reserves, they need to ensure that banks can fully express their demands for these reserves via refinancing operations without putting themselves at risk. The first obstacle in that regard is the market stigma that can surround accessing central bank facilities.

Yet we see such market stigma as likely to be limited in practice. First, this is because the ECB’s targeted longer-term refinancing operations (TLTROs) and the BoE’s Term Funding Scheme (TFS) for small and midsize enterprises showed that banks were able to access standard refinancing operations without being penalized. Second, the frameworks will form a core part of central banks’ operating models and will, therefore, become standard and permanent, and this should reduce the market’s negative perceptions.

Another challenge for central banks relates to their own operational readiness. For instance, in the Eurosystem, the monetary authority of the eurozone, the execution of bank-refinancing operations is left to national central banks under a common collateral framework defined at the Eurosystem level.

Central banks also have the problem of ensuring that supervisors take full account of banks’ access to central bank funding as part of their assessments and expectations. As part of their assessments, supervisors continue to focus on banks’ liquidity stress tests and contingency-funding plans, and they would need to become more comfortable with banks’ stronger reliance on central bank facilities.

Preparedness to access contingency funds is a funding strength for banks

Reliance on contingency funding to meet potential stressed outflows is not necessarily a sign of liquidity weakness. In our rating analysis of a bank, we assess funding and liquidity separately and then combine the assessments to determine their aggregate impact on the bank’s stand-alone credit profile.

Our funding assessment largely focuses on the stability and diversity of a bank’s funding sources, how well those sources match its assets and the likelihood and extent to which they will be available over an extended period to fund existing and new assets, including during times of market or idiosyncratic stress. As part of this analysis, we review and assess the robustness of contingency-funding plans.

All else being equal, having permanent access to central bank contingency funding adds to banks’ options and, therefore, can increase the robustness of their contingency-funding plans. That said, we also assess a bank’s preparedness to access its various sources of contingency funding, including central bank facilities. In this regard, we take a positive view of banks pre-positioning a share of eligible assets with their central banks, as this reduces the execution risk without undermining funding flexibility as long as the facilities remain undrawn.

Overall, we see little risk of banks increasing their liquidity and funding risk appetites. We consider banks enhancing their focuses on accessing contingency funding and improving their toolkits to do so as a net positive. The associated risks would likely only materialize in the long run if banking risk managers, regulators and supervisors were to misprice the risk completely.