Liquidity of the banking system

​The Eurosystem is the only funding source of the euro-denominated monetary base, which consists of cash and bank reserves in the central bank. The monetary base is composed of the most liquid assets, which can be used for settlement of financial transactions, and it constantly remains on the balance sheet of the central bank. Cash held by the public and banks’ deposits dominate the liability side of the central bank’s balance sheet. Loans to credit institutions provided through market operations and investment assets, including foreign exchange reserves, make up most of the assets on the central bank’s balance sheet.

The Eurosystem has decided to implement its monetary policy by maintaining a liquidity deficit in the banking system. To achieve this, the Eurosystem’s investment assets (incl. foreign exchange reserves) must be kept at a lower level than the sum of cash and the minimum reserve deposits required of the credit institutions. The liquidity deficit is funded by additional collateralised loans provided through market operations. Thus, the assessment of changes in investment assets and cash is of utmost importance in regulating the amount of funding to be provided through market operations.

Liquidity management, or estimation of the developments of central bank balance sheet items, and regulation of the amount of refinancing granted to the banks are essential to the implementation of monetary policy. Under normal conditions enough funding is provided through market operations to enable banks to meet their minimum reserve requirement. Any amounts diverging from this equilibrium show as overnight deposits with the central bank, in case excess funding has been provided through the operations, and as marginal lending, in case the credit institutions need additional funding to meet their minimum reserve requirement. Large scale use of the standing facilities or simultaneous use of the marginal lending facility and overnight deposit facility indicate an improperly functioning money market, as banks are unable to balance their funding needs in the interbank market.

Simplified balance sheet of the Eurosystem