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European Banks: Preparedness Is Key To Unlocking Central Bank Funding

The ECB and BoE's intention to maintain a stock of ample reserves in the European banking system will give banks permanent access to central bank funding as and when they require. Positively, S&P Global Ratings believes that this will give the central banks a significant role in banks' funding and liquidity risk management.

However, we see banks' operational preparedness as key to them accessing the central bank reserves. We would take a favorable view of banks enhancing their preparedness, for instance, by pre-positioning eligible assets to post as collateral, as this would reduce execution risk. Moreover, we wouldn't necessarily view a bank's plans to rely on central bank contingency funding to cover potential stressed outflows as a sign of liquidity weakness. Over time, easier access to central bank facilities could lead some banks to increase their liquidity and funding risk appetite, but at this point we deem it unlikely.

Prompting the central banks' move was their desire to provide more guidance on the future size of central banks' reserves as their programs of quantitative tightening progressed, having in mind not only monetary policy, but also the potential implications for financial stability (see "Credit FAQ: What An Acceleration Of Quantitative Tightening Could Mean For Eurozone Banks," published Sept. 13, 2023).

Chart 1

image

The Scale Of Demand Is Still Uncertain

Both the ECB and BoE have acknowledged uncertainties on the exact level of banks' demand 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 gradually come down, possibly to €1,500 billion-€2,000 billion by mid-2026, from a peak of €4,600 billion in mid-2022 and €3,000 billion at present. This estimate takes into account European banks' historical liquidity demand relative to their customer deposits and the duration of their ECB bond portfolios. However, this estimate could be increased, once more details become known on the structural bond portfolio that the ECB will set 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 more responsive balance sheets, but also avoid bearing the interest rate risk associated with bond holdings.

The BoE introduced a new weekly short-term repo (STR) facility in 2022, priced at the bank rate. This facility ensures that reserves are supplied elastically on a weekly basis, with no pre-set limit. This means that banks' demands are fully met, subject to their provision of adequate collateral. That said, the delivery of a large stock of reserves cannot wholly rely on the STR facility due to the high operational burden associated with weekly maturities.

The BoE's intention is that banks will also turn to the Indexed Long-Term Repo (ILTR) facility, which provides cash for six months against a broad range of collateral. The cash is priced above the bank rate following a competitive bidding process. To make the ILTR facility more suited to the permanent provision of reserves to banks, the BoE plans to modify its terms and conditions in the coming months.

The ECB also intends for secured refinancing operations to play a central role in providing reserves to banks. However, we expect that the ECB will also 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 set a limit on the amount that banks can borrow against adequate collateral.

Importantly, the ECB has announced a change in the relative pricing of the MROs and LTROs, which will drop 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 (see chart 2). The ECB intends this narrowing of the spread to incentivize banks' use of the facilities. The ECB also intends to develop new structural refinancing operations to avoid the operational burden that the short-term maturities of the MROs and LTROs create, but it has not communicated any details about this yet.

Chart 2

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Central Banks Will Influence Banks' Funding And Liquidity Management

The new frameworks mean that central banks' refinancing operations will play a more central role in banks' funding and liquidity management strategies (see chart 3). At this point, the central banks' refinancing operations represent new sources of contingent liquidity that all banks can tap into if their funding conditions deteriorate, providing they are operationally prepared to do so and provide adequate collateral.

In the longer run, and once the reserve levels are closer to the banks' actual needs, the central banks expect banks to make routine use of the refinancing facilities to cover their permanent need for reserves. Notably, these facilities are distinct and do not replace the more traditional emergency liquidity measures that the central banks provided as lenders of last resort, such as the emergency liquidity assistance under the Eurosystem framework.

Chart 3

image

The Frameworks Represent A Major Change To Banks' Funding

Beyond the technicalities, the new operational frameworks mark a pivotal shift from the situation before the global financial crisis, when central banks' financing to banks was more narrowly defined. Central banks either provided financing in emergency situations as lenders of last resort, or acted as marginal providers of short-term liquidity, mainly to allow banks to meet their payment-clearing needs. Central banks provided such short-term liquidity for pre-set and limited amounts, meaning that banks had to turn to the interbank markets to manage their liquidity more broadly.

The new operational frameworks will also serve to close a gap between European and U.S. banks. The latter have long benefited from contingent and ongoing public funding via the Federal Home Loan Bank (FHLB) System.

Finally, the 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 facility for nonbank financial institutions (NBFIs).

Implementing New Operational Frameworks Poses Key Challenges For Central Banks

These include removing market stigma, addressing potential regulatory obstacles, and ensuring their own and banks' operational preparedness. This is no easy task, but, in our view, it is not insurmountable.

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 demand 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. There is a risk that bank counterparties will penalize banks accessing central bank facilities, thereby disincentivizing them from fully expressing their demand for such reserves.

Although this is a possibility, we see such market stigma as likely to be limited in practice. First, this is because the ECB's targeted longer-term refinancing operations and the BoE's term funding scheme 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.

In the U.S., the Federal Reserve is also trying to reduce the stigma of borrowing from the central bank, though it is not launching any new efforts to encourage banks to actively borrow from it for ongoing needs. Regulators have signaled they could require banks of a certain size to maintain a minimum amount of readily available liquidity at the Fed's discount window calculated relative to their uninsured deposits.

That potential new requirement would likely be a result of a lesson learned from the failure of Silicon Valley Bank (SVB). According to a Fed report on that failure, SVB wasn't able to quickly reallocate collateral from the FHLB system and its custody bank to the discount window; that step was part of its attempt to quickly obtain liquidity and meet a rapid outflow of deposits.

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. This framework includes an electronic collateral-assessment process, which, for nonmarketable securities, that is, credit claims, can be relatively burdensome.

Before granting the secured loan, the national central banks need to assess the credit risk of the collateral that the bank has provided, and they can only perform this assessment at the loan level, rather than at the portfolio level, using the bank's internal model, an external credit rating, if available, or the central bank's own credit assessment. These operational challenges could be alleviated if central banks could impose pre-positioning requirements on banks, forcing them to pre-assess and provide a set amount of assets, but this is not the case in the Eurosystem.

Central banks also have the problem of ensuring that supervisors take full account of banks' access to central bank funding as part of their assessment and expectations. Regulatory requirements emphasize on-balance-sheet liquidity, with a minimum requirement for the liquidity coverage ratio (LCR). As of March 2024, the average LCR stood at 158% for large euro area banks, far higher than the 100% minimum requirement. In our view, the central banks' new operating model will lead to a gradual reduction in banks' LCR levels as central bank reserves are gradually removed from the banking system. In parallel, the new model will lead banks to improve their readiness to access contingency funding, including from the central bank (see chart 4).

As part of their assessment, supervisors will continue to focus on banks' liquidity stress tests and their contingency funding plans, and would need to become more comfortable with banks' greater reliance on central bank facilities. Supervisors could also set expectations with regard to pre-positioning, alleviating the abovementioned operational challenges.

Chart 4

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Following the 2023 banking turmoil, we have seen bank supervisors actively rethinking the role of contingency funding plans (see "2023 Banking Turmoil: Global Regulators Reflect And React," published June 26, 2024). In our view, this rethinking would not necessarily require changes to the existing liquidity regulations, but rather an evolution in the supervisory approach and mindset. Similar challenges and considerations also apply in the U.S., where the authorities are keen to avoid a repeat of the 2019 money market seizure triggered in part by the quantitative tightening program.

Preparedness To Access Contingency Funds Is A Funding Strength

Reliance on contingency funding to meet potential stressed outflows is not necessarily a sign of liquidity weakness. In our rating analysis, we assess funding and liquidity separately and then combine the assessments to determine their aggregate impact on a 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 that 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 that regard, we take a positive view of banks pre-positioning a share of eligible assets with their central banks, as this reduces execution risk without undermining funding flexibility as long as the facilities remain undrawn.

Similarly, a bank regularly testing its own access to contingency funding can alleviate potential operational risks and reduce the potential market stigma. Finally, we also take a positive view of banks establishing a clear link between liquidity stress-testing based on harsh but plausible scenarios and triggers for accessing contingency funding.

Routine use of central bank facilities will throw up new analytical issues

Banks' gradual transition to a point where they use central bank facilities routinely to cover their reserve needs--that is, not only for contingency funding purposes--will raise new analytical questions. Our funding assessment focuses on the stability and diversity of a bank's funding base, and central bank funding can play a positive role in that regard, provided that it doesn't crowd out other funding sources.

In assessing liquidity, we mainly consider a bank's ability to meet potential liquidity outflows that could occur over a short period of stress, and the extent to which it would utilize either its on-balance-sheet liquidity or secondary sources--including contingency funding--or emergency sources, namely, lender-of-last-resort operations, to do so. As such, a bank's reliance on contingency funding to meet potential stressed outflows would not necessarily lead us to take a negative view of a bank's liquidity profile.

As per our criteria (see table), we could assess a bank's liquidity profile as adequate, but not strong, even if we consider that it would likely need to tap secondary funding sources to meet potential stressed outflows. A lower assessment of moderate could apply in cases where we would expect the bank to rely on both secondary and emergency funding to meet potential stressed outflows.

Liquidity Assessment
What it typically means
Strong In our view, the entity will withstand a stressed outflow of liquidity (based on the type of liquidity risk it bears) completely or largely by utilizing on-balance-sheet sources of liquidity.
Adequate In our view, the entity is highly likely to withstand a stressed outflow of liquidity (based on the type of liquidity risk it bears), but our confidence in that assessment is somewhat lower than for an entity with strong liquidity. The entity may also need to utilize secondary sources of liquidity under some plausible stress scenarios.
Moderate In our view, the entity has a lower likelihood than an entity with adequate liquidity of withstanding a stressed outflow of liquidity (based on the type of liquidity risk it bears) and a higher likelihood of having to access secondary or emergency liquidity sources.
Weak We have limited confidence that the entity could withstand a stressed outflow of liquidity (based roughly on the type of liquidity risk it bears) without significantly utilizing emergency sources of liquidity. For a finco or business development company, a weak liquidity assessment may reduce the SACP to ‘b-’, or lower if 'CCC' criteria apply.
Another consequence of increased reliance on central bank funding is an increase in asset encumbrance

This is not specific to central bank facilities, but common to all forms of secured funding (see "European Banks: Covered Bonds Are A Cheap, Stable Funding Source With Limited Side Effects," published July 4, 2024). In our rating analysis, we do not have specific thresholds relating to asset encumbrance that would lead to downward rating pressure. Importantly, our credit ratings reflect our assessment of the relative likelihood of an institution defaulting, rather than the expected loss for creditors. As such, there is no automatic link between a bank's rising asset encumbrance, which shrinks the pool of available assets to help pay its unsecured obligations, and our ratings on the bank.

That said, we could see a material increase in asset encumbrance as a potential sign of reduced funding flexibility, as less collateral will be available for further secured funding, and the bank may find that unsecured creditors' appetites have weakened. Some counterparties could also react negatively if a bank seeks recourse to central bank funding, ignoring the distinction between access to contingency funding and lender-of-last-resort funding, despite central banks' communication efforts. In the modern world of fractional reserve banking, liquidity risks can never be wholly eliminated, and banks remain sensitive to a loss of confidence. However, we believe that better contingency planning plays an important role in mitigating liquidity risks.

We See Little Risk Of Banks Increasing Their Liquidity And Funding Risk Appetite

The design of the new operational frameworks is not without trade-offs. On the one hand, the provision of central bank liquidity to all banks against a broad set of collateral and at attractive rates is likely to support financial stability, providing that banks and central banks overcome the abovementioned challenges.

On the other hand, with attractive pricing and preferential conditions in terms of collateral and full allotment, we expect banks to have little incentive to turn to the interbank markets to manage their liquidity. The removal of this form of market discipline could, over time, lead some banks to increase their liquidity risk appetite or pay less attention to their contingency funding plans. In turn, this could create new funding vulnerabilities.

In practice, however, banks are subject to a set of minimum liquidity and funding requirements that create a backstop. In addition, banks are subject to supervision and other forms of market discipline. As always, the interplay between monetary policy, regulatory stance, and supervisory effectiveness is key to containing the buildup of financial vulnerabilities.

All in all, we see banks enhancing their focus on accessing contingency funding and improving their toolkit to do so as a net positive. The associated risks would likely only materialize in the long run if bank risk managers, regulators, and supervisors were to completely misprice the risk.

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:Nicolas Charnay, Paris +33623748591;
nicolas.charnay@spglobal.com
Giles Edwards, London + 44 20 7176 7014;
giles.edwards@spglobal.com
Pierre Hollegien, Paris + 33 14 075 2513;
Pierre.Hollegien@spglobal.com
Secondary Contacts:Richard Barnes, London + 44 20 7176 7227;
richard.barnes@spglobal.com
Michelle M Brennan, London + 44 20 7176 7205;
michelle.brennan@spglobal.com
Economists:Sylvain Broyer, Frankfurt + 49 693 399 9156;
sylvain.broyer@spglobal.com
Marion Amiot, London + 44(0)2071760128;
marion.amiot@spglobal.com

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