The answer to this question is very simple once you get past the confusion often found online. To understand why a bank deposits its cash in the ECB’s deposit facility, you need to look directly at how a bank in the eurozone manages its cash. You probably have an account with a bank. Banks, in turn, have an account with the central bank, called a current account. A portion of a bank’s cash (also known as « reserves ») must be kept in this current account: these are called reserve requirements. The amount of reserve requirements is proportional to the deposits held by the bank: the more deposits it has, the more reserves it must hold in its current account. In the eurozone, the reserve requirement ratio has been 1% since January 2012. To put it simply, this means that 1% of a bank’s deposits must be held as reserves in its current account [1]. The rest, the excess reserves, can go into the ECB’s deposit facility. How does this work in practice?
The bank department that will handle this is the cash management department (often referred to as ALM). The treasurer will know that for a given month, say September, the average amount of reserves in the bank’s current account at the end of the day must be at least X. X is the amount of mandatory reserves, and is actually calculated on the basis of the amount of deposits (according to the 1% rule explained above) that the bank had two months earlier, i.e. in July in our example.
At the end of each day, the treasurer will therefore have to make choices: as transactions with the current payment system (Target 2) end at 6 p.m., the treasurer will have to ensure that the amounts in his bank’s current account are neither too low nor too high in relation to the amount required to comply with the reserve requirements [2]. Based on his forecasts of end-of-day transactions, prevailing interest rates, and other specific factors, the treasurer will decide either to do nothing and allow the bank to close its account for the day, or to increase or decrease the amount of cash he holds. If the bank anticipates that it will need cash at the end of the day, it will logically seek to borrow cash from other banks on the interbank market. If the bank anticipates that it will have too many reserves at the end of the day, it will logically seek to dispose of them under normal circumstances, as excess reserves in its current account do not earn any interest. It will therefore seek to make these reserves financially productive. It has two main options for doing so: lending them to other banks or placing them in the ECB’s deposit facility (under normal circumstances, amounts placed in the ECB’s deposit facility earn interest, known as the « deposit facility rate »)[3]. As the ECB normally adjusts the amount of liquidity so that there is only a minimum amount of excess reserves, the amounts placed in the ECB’s deposit facility are usually minimal and the amounts placed in banks’ current accounts correspond only to the level necessary to meet minimum reserve requirements. This can be seen in the chart below for the period prior to 2008.
Between 2008 and 2012, the ECB’s interventions led to an increase in excess reserves, which were logically directed towards the deposit facility, which is remunerated (in blue), while the amounts placed in current accounts remained at a « minimum. »
In July 2012, the deposit rate fell to 0%, which was effectively the same rate as the excess reserves on the current account (this parity has been maintained since then with the rate cuts in June and September 2014, affecting all excess reserves). This had the effect of making the amounts in current accounts and deposit facilities completely arbitrary. They are therefore irrelevant for drawing any conclusions about banking activity or economic conditions, as some people do.
Julien Pinter
Notes:
[1] In reality, things are more complex: some deposits are not eligible, and different terms apply depending on the type of deposit. These details are negligible in the context of our approach.
[2] To be more precise, since reserve requirements are calculated as an average amount over the month, the treasurer will be able to « average » the amounts left in their current account. They will therefore be able to leave very small amounts on certain days, which will be offset by very large amounts on subsequent days.
[3] Another option would be to purchase liquid securities, which would result in a transfer of cash to another bank, which in turn, if it considers that it has sufficient reserves in its current account, would have to choose between the two main options (lending cash or depositing it in the deposit facility).
