Since the global financial crisis of 2007-2008, which rocked the world economy and prompted a reevaluation of monetary policy frameworks, the European Central Bank’s approach has undergone significant changes. One of the most notable shifts has been the increasing centrality of the Eurosystem deposit facility rate (DFR) in steering monetary policy, noted Gaston Reinesch, governor of the Luxembourg Central Bank (BCL), in a recent . He explained how the DFR has become the primary tool for guiding euro area monetary policy by the ECB’s governing council, particularly in maintaining price stability amid fluctuating economic conditions.
Pre-crisis era
Before the 2007-2008 financial crisis, the euro area banking system operated in an environment characterised by a structural liquidity deficit. This deficit arose primarily due to the demand for banknotes and banks’ obligations to meet reserve requirements. Reinesch explained that during this period, the euro area’s banking system relied on refinancing from the Eurosystem. The majority of central bank liquidity was provided to banks through main refinancing operations (MROs), conducted weekly by national central banks in the Eurosystem. These operations had a one-week maturity and were designed to ensure that banks could meet their liquidity needs smoothly. The total liquidity available to the banking system was determined by the Eurosystem, and euro area banks typically held only small amounts of excess reserves.
The interest rate applied to these MROs became the primary tool for determining refinancing conditions for credit institutions in the euro area. Reinesch noted that the MRO rate also had a direct impact on broader financing conditions, influencing households’ saving, spending and investment decisions, and ultimately affecting inflation. The overnight money market rate, measured by the Euro overnight index average (Eonia), closely followed the MRO rate, underlining the crucial role this policy instrument played in shaping the monetary policy stance.
Financial crisis
However, the global financial crisis led to a dramatic change in the financial landscape. Elevated uncertainty, counterparty risk and market fragmentation disrupted the smooth functioning of money markets. Banks faced significant challenges in obtaining liquidity and the effective allocation of funds became increasingly difficult. In October 2008, the ECB’s governing council, its interest rate-setting body, introduced a fixed-rate tender procedure with full allotment for MROs, allowing participating banks to bid for liquidity at a fixed rate set by the Eurosystem. The total amount of liquidity allocated was based on the bids, as long as adequate collateral was provided.
This new system marked the shift from a structural liquidity deficit to a situation of ample liquidity in the banking system. Reinesch observed that in the aftermath of the crisis, some banks opted to keep excess central bank reserves rather than lend them out, fearing counterparty risk. To stabilise the transmission of monetary policy, the ECB introduced measures such as large refinancing operations at attractive terms and large-scale asset purchases.
Post-crisis landscape
The shift to ample liquidity significantly altered the relationship between the ECB’s key interest rates and overnight interbank rates. As excess liquidity in the banking system grew, unsecured overnight rates began to follow the DFR more closely than the MRO rate. With ample excess liquidity, banks had little incentive to borrow at higher rates in the interbank market. As a result, the DFR, which provided a floor for overnight money market rates, became the effective tool for signalling the ECB’s monetary policy stance, Reinesch claimed. The DFR thus emerged as the focal point of the monetary policy framework, guiding short-term money market rates.
Eonia to €STR
In addition to changes in liquidity management, the financial landscape evolved further. Reinesch noted that the volume of unsecured overnight interbank transactions, measured by Eonia, dropped dramatically after the crisis. From a daily average peak of nearly €48bn in 2007, the average trading volume declined to under €2.5bn by 2019. This shift raised concerns about the reliability of Eonia as a benchmark, leading to its replacement by the euro short-term rate (€STR) in 2019. The €STR, recommended by the working group on euro risk-free rates, includes a broader range of transactions, including trades between banks and non-bank financial entities, such as money market funds and insurance companies.
Since its introduction, the €STR has generally tracked the DFR closely, with the spread between the two rates varying over time. Reinesch pointed out that excess liquidity in the euro area has ranged between €1.7trn and €4.7trn since the publication of the €STR, and this liquidity surplus continues to influence money market conditions. “Changes [in] the DFR therefore continue to transmit reliably to the overnight wholesale borrowing costs and the wider financing conditions, the saving, spending and investment decisions of households and firms, and, ultimately, the inflation rate,” Reinesch stated, emphasising the central role played by the DFR in steering economic outcomes such as inflation, investment and spending in the euro area.