As this shows, the balance sheets of the Federal Reserve (Fed), European Central Bank (ECB) and Bank of England (BoE), represented as a percentage of GDP, are on the decline, but they’re still well above pre-covid levels. There’s little in the way of agreement on the “right” level of balance sheet or bank reserves in a system, so we expect central banks to adopt a trial-and-error approach as they continue to reduce their balance sheets.

Central bank balance sheets, as % of GDP

While exact figures are difficult to predict, we believe the Fed could settle at $2.75trn of reserves (equivalent to around 10% of GDP), the ECB at €3.5trn (30% of GDP) and the BoE at £400bn (16% of GDP). 

While looking at the size of balance sheets as a percentage of GDP is the commonest way of assessing liquidity in the system, we can also look at money supply. The below chart shows the percentage growth rates of money supply in the US, euro area and UK since 2007. Since surging during the pandemic, money supply has contracted. This is a result of banks creating credit more slowly and central banks running down their balance sheets.

Growth rates of money supply as % GDP

The M1 and M2 indices broadly move together, while the ‘Other Liquid Deposits’ (OLD) category within M1 makes up most of the money supply in the US. 3 shows the evolution of M1 and M2 (and their components) in recent years. We can see that there was a big increase in money supply during the pandemic, driven by fiscal and monetary stimulus, but that this trend has reversed, with money supply decreasing, largely due to a drop in OLD.

Changes within the components of money supply

The M3 and M1 indices generally move together, with overnight deposits making up most of the money supply in the euro area. Money supply in the euro area has not fallen to the same extent as it has in the US. The decline has largely been driven by a reduction in overnight deposits, which spiked during the pandemic against a backdrop of economic uncertainty, quantitative easing and increased fiscal spending, rising from an average increase of around €50bn per month in 2019 to around €105bn per month in 2020. Since policy tightening began, there has been a move away from overnight deposits – they were down by an average of €90bn per month in 2023. This is broadly in line with portfolios being reallocated towards longer-dated, higher-yielding deposits or other assets such as bonds and equities as the opportunity cost of holding overnight deposits shot up.

Deposits from households make up most of M4 in the UK. Changes in the level of money supply in the UKs tend to be volatile from month to month, mostly due to the actions of non-intermediate other financial corporations (NIOFCs) such as asset managers, hedge funds, securities houses, insurers and finance leasing companies.

In July 2023, money supply in the UK contracted for the first time since 2009. While lending growth to households is falling, it is still positive.

What about liquidity in the banking sector? By and large we still believe that banks’ balance sheets are robust, and that reduced deposits (in the US) and economic stagnation (in Europe) do not mean there is undue stress on banks’ funding or the sector’s stability. That said, the high-profile bank failures in the US and Switzerland in March 2023 made clear the weaknesses in the US regional banking model and led regulators and investors to focus more closely on banks’ liquidity metrics and how quickly bank runs can occur.

Bank balance sheet health

The largest banks across regions have historically high levels of capital and liquidity, and robust balance sheets. After the global financial crisis, regulators significantly raised minimum capital and liquidity requirements, and in practice many of the largest banks now operate with buffers on top of regulatory minimums. Given Basel 3 regulations and the lessons banks have learned from the events of March, we see little scope for banks to loosen their capital and liquidity significantly.

Conclusion: no need for concern just yet

From a macroprudential perspective, banking systems remain strong and well-capitalised. There are clear risks to profitability given rising funding rates and declining low-cost deposits, but the system is broadly well prepared. What is becoming apparent, particularly in the US, is a divergence within banking systems, with some participants appearing better positioned to face the new regime.

Meanwhile, market-based liquidity metrics remain robust. There aren’t cracks appearing in funding markets yet as the tremendous amount of liquidity that was pumped into the system in 2020 and 2021 is still providing support. That’s not to say there won’t be challenges in 2024 – the economy is slowing and central banks continue to run down their balance sheets.