Bank reserves (“liquidity”) are deposits that financial institutions hold with their central bank. They are created when the central bank purchases securities from, or provides loans to, its counterparties. Since the launch of quantitative easing programmes and long-term refinancing operations, particularly after the Great Financial Crisis, the volume of reserves has risen considerably, generating a liquidity surplus far exceeding banks’ needs. This surplus has pushed interbank rates down to their lower bound, which in the euro area corresponds to the deposit facility rate (DFR) and in the United Kingdom to the Bank Rate (the rate applied to reserves). This operational framework is known as a “supply-driven floor” system, where the central bank steers rates at floor level through an excess supply of liquidity.
In the current macroeconomic environment, marked by the repayment of long-term loans (TLTRO III in the euro area) and quantitative tightening, the stock of liquidity is declining amid uncertainty surrounding aggregate demand for reserves. Most central banks have opted to keep their policy rate at the floor, as this provides greater precision in rate control. However, this required adjustments to their operational framework. The US Federal Reserve has chosen to maintain a “supply-driven floor” system, providing just enough liquidity to anchor rates near the floor. Conversely, the BoE is transitioning to a “demand-driven floor” framework in which banks can obtain financing at the same rate applied to reserves. In its new operational framework announced in March 2024, the Eurosystem has adopted an intermediate approach, though it leans closer to the BoE’s model, as refinancing operations will become the main instrument for adjusting liquidity conditions.
The rise in STR uptake as part of the BoE’s transition to demand-driven steering
Introduced by the BoE in August 2022, the STR consists of repurchase agreements with a one-week maturity, allowing banks to obtain fixed-rate full-allotment sterling refinancing against high-quality collateral, mainly UK government bonds (gilts). It was intended to become one of the main mechanisms for steering interest rates, and uptake of the facility has increased sharply (from GBP 2.2 billion in January 2024 to GBP 41.0 billion in December 2024), driven by shifts in reserve supply and demand dynamics, as well as the facility’s relatively attractive pricing. On the one hand, the BoE has implemented an active quantitative tightening policy, ceasing the reinvestment of maturing securities and launching a gilt sales programme. On the other hand, reserve demand remains structurally high due to prudential liquidity requirements introduced under Basel III in 2015.
This is placing upward pressure on money market rates. The spread between SONIA (Sterling Overnight Interest Average, the unsecured overnight benchmark) and the Bank Rate has narrowed by 2 basis points since January 2023, while the overnight secured rate (RFR Sterling) has exceeded the Bank Rate, currently standing 2 basis points above it – compared with 16 basis points below during Q1 2023 (see Chart 2). Meanwhile, STR lending is priced at the Bank Rate, encouraging banks to increase their reliance on BoE funding during auction days due to its competitive price, while also helping to reduce the stigma historically associated with borrowing from the central bank.
The BoE has reinforced this trend though proactive communication, explicitly stating that STR is a standard financing tool within the new operational framework. Furthermore, it aims to promote a more sustainable approach to liquidity management, encouraging banks to increase their reliance on longer-term refinancing operations, which is becoming crucial as excess reserves in the UK financial system continue to decline.
Chart 2: STR volume & RFR Sterling-Bank Rate spread