Deepening: Banks need more active liquidity management

DEEPENING – Banks need more active liquidity management 48

DEEPENING – Banks need more active liquidity management

Banks need to get used to an environment where central bank liquidity decreases as the Riksbank reduces its securities holdings. This places greater demands on banks to redistribute liquidity more effectively among themselves. However, the banks that are the Riksbank's monetary policy counterparts choose to maintain a liquidity buffer in the form of central bank reserves instead of placing the entire surplus in certificates or using the overnight loan market. Many of them have never participated in the overnight loan market. This suggests that banks have weak incentives to smooth out liquidity on the overnight loan market, and that there may be frictions affecting banks' liquidity management. It is important for interest rate steering that banks utilize the overnight loan market and use the Riksbank's instruments for liquidity provision as intended. Banks should also feel unimpeded in using the Riksbank's standing facilities – they are there to be used when needed.

Banks' liquidity management is too passive

The interest rate steering system should contribute to efficient liquidity management

The Riksbank's interest rate steering system aims to steer the short-term market interest rate toward the policy rate. To do this, the Riksbank mainly uses standing facilities and various types of market operations.

The Riksbank conducts weekly market operations at the policy rate. When the banking system has a structural liquidity surplus, the banks that are monetary policy counterparts can place central bank liquidity in reserves and certificates.58 If banks do not place the entire liquidity surplus in certificates, a surplus of reserves remains. If the banking system instead has a structural deficit, the Riksbank adds reserves via monetary policy repos or lending against collateral. The purpose is to balance the banking system's liquidity position so that reserves are close to zero during the maturity of the certificates or repos, and to signal which interest rate level should be established in the market for short-term maturities in Swedish kronor.

58 Reserves are banks' money placed as overnight deposits at the Riksbank (accounted payment instruments), and certificates are the Riksbank's issued transferable securities, normally with a one-week maturity, which can be converted into reserves. Central bank liquidity refers to the sum of reserves and certificates. For more information, see Counterparties | Sveriges Riksbank and The Riksbank's monetary policy steering system - overall description.

DEEPENING – Banks need more active liquidity management 49

The Riksbank's standing facilities give banks the opportunity to place or borrow unlimited reserves with an overnight maturity at an deposit rate that is 10 basis points below the policy rate, or a lending rate that is 10 basis points above.59 The difference between the deposit and lending rates is usually called the interest rate corridor.

The idea is that the interest rate corridor should create incentives for banks to smooth out surpluses or deficits among themselves on the overnight loan market as much as possible, since they can offer each other more attractive interest rates. The interest rate corridor should therefore be wide enough to create incentives for banks to borrow from each other on the overnight loan market. In this way, the overnight loan rate can end up close to the decided level of the policy rate in the middle of the corridor. If the overnight loan rate fulfills its function as an anchor for longer-term rates, the level of the policy rate propagates through the economy.

Incentives for market-based liquidity management are too weak

Between 2015 and 2022, the Riksbank injected large amounts of liquidity into the banking system.60 This means that the banking system has had a structural liquidity surplus relative to the Riksbank for some time (see Diagram 27, left).

Diagram 27. The banking system's liquidity surplus and activity on the overnight loan market Billion SEK

Note: Turnover on the overnight loan market refers to volumes of overnight loans without collateral in Swedish kronor between monetary policy counterparts. Source: Riksbank.

During the same period, the number of monetary policy counterparts increased from 15 to 29 banks. The increase has mainly consisted of smaller banks. This means that most counterparts

59 In practice, the monetary policy counterparts' surplus in the RIX system is automatically converted into placements in the deposit facility at the end of the day, while a deficit at the end of the day is interpreted as a request to borrow in the standing lending facility. Lending of reserves occurs against approved collateral. 60 This occurred partly through the Riksbank's purchase of Swedish securities, which was a complementary monetary policy measure, so-called quantitative easing (QE), and partly as a result of the Riksbank self-financing its foreign exchange reserves with Swedish kronor since January 2021. Both of these have been financed by the Riksbank borrowing Swedish kronor from banks.

DEEPENING – Banks need more active liquidity management 50

have only been counterparts when the system had a structural liquidity surplus. Since 2020, 14 of them have never participated in the overnight loan market. Additionally, 9 counterparts currently have no collateral at the Riksbank, and 14 counterparts have never borrowed in the Riksbank's lending facility. This means that these banks do not have active liquidity management but only place funds in the Riksbank in the form of certificates and reserves.

Banks' demand for certificates and reserves has varied during the period (see Diagram 27, left). Between 2015 and 2019, the banking sector had between 1 and 175 billion in reserves. During the coronavirus pandemic, the Riksbank limited the offered volume of certificates, which forced banks to increase their placements in reserves. At that time, activity on the overnight loan market also dropped quickly (see Diagram 27, right). Since 2023, banks have again been able to place the entire structural liquidity surplus in certificates. Nevertheless, reserves amount to between 50 and 250 billion. Activity on the overnight loan market has indeed increased somewhat after 2023, but it remains low. The amount of available reserves thus affects banks' need to utilize the overnight loan market.

Banks thus choose to have a liquidity buffer in the form of central bank reserves instead of placing these in certificates to get a higher interest rate or using the overnight loan market, as intended.

The liquidity surplus is unevenly distributed among banks

The five largest banks have approximately 80 percent of the banking system's current liquidity surplus (see Diagram 28, left). The Riksbank is now reducing the structural liquidity surplus through quantitative tightening (QT), where the Riksbank sells securities or lets them mature. So far, liquidity has mainly decreased for the five largest banks, while it has largely remained unchanged for the other banks (see Diagram 28, left and right). This indicates that smaller banks are passive regarding both the choice between placing in certificates or reserves, and participating in liquidity smoothing on the overnight loan market. Therefore, it is primarily the liquidity management of the five largest banks that is decisive for activity on the overnight loan market. But as the banking system's liquidity surplus decreases, greater demands will be placed on all banks, large and small, to be active and contribute to efficient liquidity redistribution.

DEEPENING – Banks need more active liquidity management 51

Diagram 28. The liquidity surplus and reserves distributed among banks Billion SEK

Note: The banking system's liquidity surplus against the Riksbank is the sum of reserves and certificates. The five largest banks are also the five largest monetary policy counterparts. Source: Riksbank.

Why do banks choose to hold central bank reserves?

If a bank were to suffer a sudden liquidity deficit, it could borrow reserves from other banks on the overnight loan market. It can also use approved collateral, including Riksbank certificates, to borrow reserves in the Riksbank's standing lending facility overnight. If the bank has certificates, it can also sell them back to the Riksbank to convert the certificates into reserves.61 But banks thus largely forego these alternatives and instead hold reserves as buffers. This suggests that incentives for market-based liquidity management are either too weak, that there are frictions in banks' daily liquidity management, or that both factors play a role. This may be due to several reasons.

The opportunity cost may be too low

The fact that banks retain a surplus of reserves may be due to the opportunity cost – in the form of the interest rate corridor – being too low, i.e., the cost of 10 basis points that it entails for a bank to place central bank liquidity as reserves compared to placing it in certificates. If it is too small, it does not contribute to efficient liquidity smoothing.

Some banks are unwilling to use the Riksbank's lending facility

There are a number of banks that state they do not wish to use the Riksbank's standing lending facility or sell back certificates because they are worried that other banks will

61 Upon resale to the Riksbank of certificates, the bank receives the reserves on the next banking day. If the bank instead uses the certificates as collateral for a loan in the standing lending facility, the bank receives the reserves on the same day.

DEEPENING – Banks need more active liquidity management 52

perceive it as a sign of weakness. This in turn affects banks' willingness to lend out reserves on the overnight loan market because they do not want to risk falling into deficit.

Several banks' operational capacity is lacking

Several banks have a deficient operational capacity to actively participate in liquidity smoothing on the overnight loan market and to be able to use the Riksbank's monetary policy instruments. For these banks, it may be rational to hold reserves at the Riksbank. But if an individual bank hoards reserves, it creates problems for the system as a whole because the reserves are then not distributed efficiently to the banks that currently need them. This in turn can lead to unwanted volatility in interest rate formation on short-term markets. By improving their operational capacities, banks can contribute to preventing volatility in short-term market interest rates.

Banks need to contribute to efficient liquidity redistribution and interest rate formation on the overnight loan market

The banks that are monetary policy counterparts need to adapt to an environment with a decreasing structural liquidity surplus by actively participating in efficient and market-oriented liquidity management. Banks should strive to handle their liquidity smoothing among themselves, but it is central that they, when needed and for the purpose of market maintenance, can unimpededly use the Riksbank's lending facility to obtain reserves. This is how the steering system is intended to function, and it should not be limited by stigma.

The liquidity surplus will still be significant after quantitative tightening is completed. However, this does not mean that all banks have access to the amount of reserves they need for their daily liquidity management. Banks therefore need competence and infrastructure, including limits with other banks, to be able to borrow and lend out reserves on the overnight loan market.

As monetary policy counterparts, banks need to be able to provide collateral and borrow reserves from the Riksbank, and release reserves by selling certificates back to the Riksbank. Here, the Riksbank can require them to participate in test transactions to regularly test and ensure that they are capable of providing collateral and borrowing reserves from the Riksbank.

62 The Riksbank can also promote activity on the overnight loan market by ensuring that the opportunity cost of money is large enough. 62 The Bank of England highlights in its consultation "Transitioning to repo led operating framework" that requirements for their counterparts to participate in regular test transactions are an important tool for ensuring counterparts' operational capacity to use their facilities.