Repeat After Me: The ECB Does NOT Control the Quantity of Reserves

by Dirk Ehnts, Econoblog101

Sometimes, what seems to be trivial for some, is a huge surprise for others. For instance, it has still not sunk in that banks cannot lend out reserves to the private sector, as described by a recent publication by Standard&Poors. Just in case there are still people around who believe that a central bank controls the quantity of reserves: no, it doesn’t. Not even in the euro zone.

The ECB writes on its own website (my highlighting):

Standing facilities aim to provide and absorb overnight liquidity, signal the general monetary policy stance and bound overnight market interest rates. Two standing facilities, which are administered in a decentralised manner by the NCBs, are available to eligible counterparties on their own initiative.

Marginal lending facility

Counterparties can use the marginal lending facility to obtain overnight liquidity from the NCBs against eligible assets. The interest rate on the marginal lending facility normally provides a ceiling for the overnight market interest rate.

Deposit facility

Counterparties can use the deposit facility to make overnight deposits with the NCBs. The interest rate on the deposit facility normally provides a floor for the overnight market interest rate.

With ‘liquidity’ the ECB means reserves, which is a central bank liability and an asset (in a central bank account) for the banks. With the deposit facility, banks can ‘park’ reserves that they don’t use for anything else. This is called ‘deposits’ by the ECB. Taken together, this means that banks – on their own initiative – can reduce the amount of reserves by depositing them in the deposit facility or expand the amount of reserves by borrowing overnight (given eligible collateral) at the interest rate set by the ECB. If that is so, banks have a say when it comes to the amount of reserves in circulation. It is not controlled by the ECB, which can influence the amount of reserves but not force banks to hold or borrow them. The ECB does control the (short-term) interest rates on deposit and marginal lending facilities as well as the main refinancing operations. It also controls the rules on what is eligible collateral and can, through manipulations of banks’ balance sheets, achieve other targets. However, it cannot determine the amount of reserves in the banking system.

Of course, one wonders why the ECB is not clearer by using proper vocabulary. But then, how much discretion do you have in policy-making if everybody understands your game?