Interest rate steering as liquidity declines

What does monetary policy implementation mean and what is interest rate steering?

The Governing Council of the European Central Bank (ECB) decides on the level of interest rates for the euro area. In its decisions, the Governing Council sets the principal policy rate and the two other key interest rates. Monetary policy implementation steers short-term money market rates towards these three key ECB interest rates, or policy rates. This implementation process is, in a sense, the engine of monetary policy. It ensures that the principal policy rate is effectively transmitted to money market rates, so that monetary policy has the intended effect on the euro area economy and inflation remains at the ECB’s 2% target over the medium term.

Over the past few years, the steering of short-term market rates has taken place in an environment where the Eurosystem’s balance sheet has been exceptionally large and the banking system has had considerable excess liquidity, that is, deposits that commercial banks hold at their national central bank. Due to this excess liquidity in the system, banks have not needed to borrow from one another or regularly from the central bank. Therefore, overnight rates have remained close to the deposit facility rate (DFR; currently at 2.50%), the interest rate at which banks make deposits with the Eurosystem.

The Eurosystem balance sheet has continued to decline as planned (Chart 1). Securities acquired in asset purchase programmes have matured and redemptions will continue in the years ahead. At the same time, the amount of liquidity in the banking system, which the Eurosystem had created through its purchases of debt securities¹, will decline.

In March 2024, the Governing Council of the ECB decided on changes to the procedures for implementing monetary policy, setting out how short-term interest rates will be steered in the future.² As banks’ liquidity declines, the practical significance of these changes will increase. However, some details of the new operational mode still remain undecided and will be determined at a later stage. Some of the key outstanding issues are the more detailed conditions for structural operations and the timing for introducing different instruments.³

The key aim with the new mode of implementation is that in the future, banks will participate more in the Eurosystem’s refinancing operations and also trade more actively with one another in the money market. Only a small number of banks so far are participating in the Eurosystem’s standard refinancing operations – the one-week main refinancing operations (MROs) and the three-month longer-term refinancing operations (LTROs) – although the number of participating banks is growing steadily. The transition to the new mode of implementing monetary policy will bring significant changes to the way in which banks obtain funding from the central bank and from the money market.

This article looks at how short-term money market rates are steered currently and what will change in the future. It also examines the transition to a new liquidity environment and the extent of the Eurosystem’s preparedness for any challenging situations associated with it.

Current state of the euro area money market

The deposit facility rate (DFR), the interest rate which banks receive when they deposit excess liquidity with their national central bank, is currently the ECB’s principal policy rate. In accordance with the ECB’s March 2024 decisions, the aim is to keep short-term money market rates in the vicinity of the DFR. In addition to making deposits, banks can currently borrow funds from their Eurosystem central bank through standard refinancing operations at the main refinancing operations rate (MRO), which is 0.15 percentage points above the DFR and, if necessary, obtain overnight credit through the marginal lending facility (MLF) to meet unexpected liquidity needs at a rate 0.4 percentage points above the DFR.

As liquidity remains abundant in the banking system, banks make little use of Eurosystem borrowing. Nevertheless, trading continues in the money market, and the Eurosystem’s DFR is the main factor determining the level of market interest rates. However, interest rates vary to some extent across different money market segments and are determined in part by different factors.

€STR is the main unsecured rate

The main unsecured reference rate in the euro area money market is the ECB’s euro short-term rate (€STR).⁴ This rate reflects the wholesale euro unsecured overnight borrowing costs of banks located in the euro area. In practice, the €STR measures the price at which financial institutions make overnight deposits with euro area banks. The role of the €STR is particularly important as it serves as a reference rate for the most common money market derivatives, such as the overnight indexed swaps (OIS).

In recent years, the €STR has been slightly below the DFR (Chart 2). This is due to the structure of the unsecured money market, which currently consists mainly of deposits made with banks by financial institutions, such as money market funds, investment funds, pension funds and insurance companies. Since these institutions cannot deposit funds directly with the Eurosystem’s national central banks, they invest their short-term cash holdings in, for example, bank deposits. The receipt of these deposits increases banks’ balance sheets, which in turn raises operational and regulatory costs. When liquidity is abundant, banks do not need to compete for these deposits by offering higher interest rates. Instead, they can pass the costs on to customers by paying a lower return on deposits than the DFR. However, the decline in liquidity has also been reflected slightly in the €STR rate. Over the last couple of years, the €STR has gradually edged closer to the DFR (Chart 2).

Secured repo rates play a key role

Collateralised transactions form the largest segment of the euro area money market (Chart 3). The significance of repo rates (interest rates on repurchase agreements) has increased especially since the global financial crisis.⁵ This is due to regulation and market participants’ own risk management, which both encourage secured lending over unsecured lending. In addition, the increased use of central counterparties and improved collateral management infrastructure has encouraged the use of repo markets. It can be assumed that the repo market will continue to play a key role in interbank liquidity management.

Unlike unsecured rates, repo rates have two ‘moving parts’: cash and collateral. Therefore, the determination of repo rates is affected not only by liquidity demand and supply but also by the collateral used and by the demand and supply of collateral in general. Consequently, relative to the DFR, repo rates have fluctuated more over time than the €STR (Chart 2).

Because repo transactions involve collateral, repo rates are also more closely linked to other financial market segments than unsecured rates. For example, in the euro area government bond market, hedge funds often finance their government bond purchases by borrowing against purchased bonds in the repo market. In recent years, the role of these funds in the cash market for euro area government bonds and in the repo market has increased significantly.⁶

Currently, short-term repo rates are close to, or even slightly above, the ECB’s DFR (Chart 2). However, the interest rates on individual repo transactions vary considerably depending on the collateral and the counterparty. The general increase in repo rates reflects not only the decline in liquidity, but also the ample supply of collateral.⁷ Repo rates may even trade above the DFR, and this appears to be linked especially to strong demand for repo financing from hedge funds. Hedge funds are willing to pay a premium to finance their operations in other market segments. When banks borrow money in the repo market, the interest rates they pay are still typically below the DFR.⁸

It may seem counterintuitive that unsecured rates (€STR) are lower than secured rates (repos), as if it were cheaper to borrow money without collateral than against collateral. However, the difference between the €STR and repo rates does not primarily measure differences in the credit risk between secured and unsecured lending. Interest rates are determined in different markets where lenders, borrowers and trading drivers differ. The €STR largely reflects the price of cash offered to banks by other financial institutions, whereas repo rates also reflect the availability of collateral and, for example, hedge funds’ demand for funding.

What will change in transitioning to the new mode of implementing monetary policy?

Banks need liquidity for settlement of payments and precautionary purposes and to meet regulatory requirements.⁹ As a result of the Eurosystem’s large-scale asset purchases, the banking system has held more liquidity than banks need for these purposes. The Eurosystem will, in the near term, continue steering short-term interest rates in an environment where banks have an abundance of liquidity in excess of their minimum reserve requirements.

The minimum reserve requirement has in other respects become less important for steering interest rates, as banks now prefer to hold liquidity well in excess of their minimum reserve requirement (see box ‘Role of the minimum reserve system in monetary policy implementation’).

The liquidity coverage ratio (LCR) has become particularly important for liquidity demand. It requires banks to hold high-quality liquid assets (HQLA) to withstand sudden liquidity outflows. Although government bonds, for example, also qualify as HQLAs, banks prefer to meet part of their requirement with central bank reserves, i.e. liquidity, because these are not exposed to any market or liquidity risk. In order to steer market interest rates, the Eurosystem must provide banks with this liquidity.

The amount of liquidity that is needed is not known, as liquidity has not been scarce since changes to the regulatory framework. In the future, the Eurosystem will detect growth in the demand for liquidity on the basis of increases in central bank refinancing operations. The Eurosystem will conduct its standard refinancing operations (MROs and LTROs) on a fixed rate full allotment (FRFA) basis. This will allow banks to borrow unlimited amounts through these operations at the MRO rate, provided they have sufficient collateral.

As liquidity declines, banks will first seek to redistribute the existing liquidity among themselves in the money market. By reducing the uneven distribution of liquidity, efficient redistribution will curtail the desire to maintain liquidity buffers solely on these grounds. As excess liquidity declines and the shortest money market rates rise, banks will make increasing use of the Eurosystem’s refinancing operations, as these are the only means to increase the aggregate amount of liquidity in the banking system. Over time, the demand for refinancing operations will grow at the same pace as the assets held under the earlier purchase programmes mature. At that point, the aggregate amount of liquidity will have found a new equilibrium.¹⁰ Once demand proves sufficiently persistent in standard refinancing operations, part of it will be met through structural refinancing operations and a structural bond portfolio.¹¹

Short-term repo rates in the euro area will rise during the transition to the new mode of liquidity management, but the extent of the increase will depend on many factors. The rise in rates will give banks an incentive to participate in the central bank’s refinancing operations. For banks, the repo market will be the primary alternative to the Eurosystem’s refinancing operations. As long as short-term market funding is available at a lower rate than the ECB’s lending rate, banks will have no reason to make use of central bank refinancing operations. The logic also works in reverse, however. The MRO rate will set a ceiling on banks’ borrowing in the repo market, as it will not make sense to obtain market funding at a higher rate than that available from the central bank against the same collateral.¹²

It is difficult to predict precisely where repo rates will eventually settle relative to the ECB’s policy rates. This is because assets other than HQLAs are also eligible as collateral in the Eurosystem’s refinancing operations. By pledging these other assets in refinancing operations, banks obtain liquidity and can simultaneously improve their LCR position. Because of this regulatory benefit, banks have an incentive to pay a higher rate on Eurosystem credit than on government bond-backed repos, which do not provide an equivalent regulatory benefit. The value of this benefit varies over time and will ultimately determine the rate at which banks obtain funding through government bond-backed repos. Banks, in turn, lend in the repo market at a rate slightly higher than the borrowing rate, as determined by supply and demand.

Short-term unsecured money market rates, such as the €STR, will also rise as liquidity declines. However, they are very likely to remain closer to the DFR than repo rates. This is due to regulation that encourages banks to engage in secured rather than unsecured wholesale borrowing.¹³ In addition, unlike repo borrowing, unsecured borrowing increases banks’ minimum reserve requirements. These additional cost factors and differences in market structure will maintain the interest rate spread between the two markets, keeping unsecured rates below repo rates unless collateral becomes scarce in the repo market for some reason. However, no such collateral shortage is in sight.

Since the beginning of 2025, the spread between the GC Pooling repo rate and the €STR has generally been 5–10 basis points (Chart 4). The two rates have therefore, at least so far, risen at almost the same pace relative to the DFR. The spread may, however, change over time.

The decline in liquidity will also probably be reflected in a somewhat greater rise in long-term money market rates than in short-term rates. This, too, is due to regulation, which favours long-term funding and makes it more beneficial than short-term borrowing. The effect may be seen in, for example, a rise in Euribor rates relative to expected risk-free rates.

Main challenges of the transition

Important to ensure smooth uptake of standard refinancing operations

The main challenge of the transition to the new operational mode is to get banks to indicate their liquidity demand in a timely manner in the Eurosystem’s standard refinancing operations. Interest rate steering does not require the Eurosystem to know in advance the amount of liquidity needed in the banking system. However, banks must actively participate in the refinancing operations when their liquidity or market financing is no longer sufficient.

Banks make their decisions based on their own liquidity forecasts and their assessments of market conditions. They do not have access to detailed information on changes in the aggregate amount of liquidity in the system or other banks’ participation in the standard refinancing operations.¹⁴ Therefore, the amount of liquidity sought by banks through the refinancing operations may occasionally turn out to be either insufficient or excessive. This may, in turn, cause fluctuations in the money market, as seen in 2014, when liquidity declined in the Eurosystem as the advantageous three-year LTROs matured.¹⁵

To facilitate banks’ planning, the ECB publishes on its website the monthly redemption amounts for its asset purchase programmes at an annual frequency and with a 24-month horizon. As these redemptions account for the majority of the decline in liquidity, this schedule gives banks a good basis for assessing changes in the aggregate supply of liquidity.

The Eurosystem also uses the annual bank treasurer survey to estimate demand for liquidity and refinancing operations. The survey results are published to give banks further insight into the expected demand for liquidity. Based on the 2025 survey, the ECB estimates that around half of euro area banks, as measured by total assets, will have reached their preferred level of reserves by the end of 2026. Despite this, only a small proportion of banks had plans to participate in the Eurosystem’s standard refinancing operations in the immediate years ahead. This appears to potentially conflict with the estimate concerning the expected demand for liquidity.

A smooth transition also requires banks to have the operational readiness to participate in standard refinancing operations. To ensure this, the ECB and the Bank of Finland have also urged banks to test their readiness for these refinancing operations on an annual basis, starting in 2026. The number of banks participating in the operations has, in fact, increased this year, even though the aggregate volume of outstanding refinancing operations has remained low (Chart 5).¹⁶ This suggests that banks are testing their readiness before their actual need for financing grows.

In addition to technical readiness, banks must be willing to participate in the refinancing operations when this is financially justified. Any reputational damage, or stigma, that may be associated with central bank refinancing operations could cause banks to postpone their participation in these. The ECB, as both a monetary and supervisory authority, has therefore emphasised that banks should consider these operations as an integral part of their day-to-day liquidity management.¹⁷ National central banks relay the same message to their counterparty banks. It is of paramount importance that this view of the refinancing operations is held not only by the authorities, but also by international credit rating agencies, investors and banks themselves.

Money market will play a greater role

The second challenge in transitioning to a new framework is to ensure a smooth flow of liquidity in the money market. The new mode of liquidity management encourages banks to seek liquidity and participate in interbank lending more actively than before. So far, developments have been favourable: commercial banks have been actively trading with each other and across national borders.¹⁸ As liquidity continues to decline, its redistribution needs to be further enhanced.

The efficient distribution of liquidity in the money market depends particularly on the functioning of the repo market. Banks differ in the extent to which they can use different trading platforms, central counterparties and intermediaries, as well as in the collateral available to them. Another factor that may restrict trading is the balance sheet capacity of intermediary banks. These factors may weaken the efficient redistribution of liquidity via the repo market. As a result, the role of unsecured money markets in smoothing liquidity shocks may once again increase, particularly as banks start to compete more actively for deposits from non-bank financial institutions.¹⁹

If liquidity does not move sufficiently smoothly between banks, this may lead to an uneven transition to the new mode of liquidity management. Increasing volatility may be seen in market rates, especially in connection with reporting and balance sheet dates. In addition, liquidity pressures may arise regionally in individual banks or in certain market segments, without being reflected significantly in general market rates. This may also widen the spreads between the different money market rates.

Frictions in the redistribution of liquidity on market terms could also lead to banks transitioning to the Eurosystem’s standard refinancing operations at different times. This is not a problem in itself, as the steering of interest rates is designed to meet the different liquidity needs of banks. However, if the transition continues to progress unevenly, banks may become split into those that obtain funding from the money market and those that participate in refinancing operations, and in the worst case this could disrupt the smooth transmission of monetary policy. This also increases the risk that a stigma might be attached to participating in standard refinancing operations.

All the challenges related to the transition ultimately lie in how these significant changes in banks’ funding – both from the central bank and from the money market – can be implemented while ensuring that the steering of short-term interest rates remains under the Eurosystem’s control. In September 2024, the ECB narrowed the spread between its MRO rate and the DFR to 15 basis points. The objective of the narrower interest rate corridor is to limit any excessive rise in interest rates and volatility in relation to the monetary policy stance sought by the ECB’s Governing Council, while still leaving sufficient room for market-based trading. The narrow interest rate corridor therefore reflects a balancing act between the effective steering of interest rates and the market-based distribution of liquidity.

Eurosystem will ensure controlled transition to new mode of steering interest rates

The Eurosystem will continue to steer money market interest rates with the aim of keeping them in the vicinity of the DFR even as the volume of liquidity declines. The new operational mode will be demand-driven, which means that the supply of liquidity will adapt to banks’ demand for reserves through the Eurosystem’s standard refinancing operations. Banks must therefore prepare for changes in money market conditions and be ready to use the central bank’s standard refinancing operations as part of their day-to-day liquidity management. In particular, the repo market is expected to play a key role in interbank trading in the money market.

The shift from the current abundance of liquidity to the new operational mode may occasionally cause money market rates to fluctuate more than in recent years. This is natural as all actors will adapt to the new situation in which the volume of liquidity in the banking system is determined by banks’ demand rather than by the abundant supply of liquidity from the central bank. The Eurosystem will closely monitor liquidity demand, market interest rates and banks’ activities and, if necessary, adjust monetary policy implementation to ensure that the transition progresses smoothly and that interest rate steering remains under the control of the Eurosystem.