What is Excess Liquidity Mop-Up and How to Avoid its Impact

The modern business landscape has become increasingly complex due to the accelerated trade globalisation, invention of new sectors and sheer economic growth. Liquidity is the backbone of the international and local economy, allowing businesses to take out loans and expand beyond their local markets. 

However, managing global or even local liquidity is much more intricate. It consists of numerous variables to consider, putting the central banks and commercial banks in a much tougher position than in previous decades. 

The banking system has developed numerous new techniques to control liquidity levels, determining the path toward sustainable growth and market equilibrium. However, some of these tactics, like excess liquidity mop-ups, can be a considerable challenge for market players who wish to grow their businesses. This piece will analyse liquidity mop-ups and their impact on the economy. 

Commercial banks operate with three potential reserve levels - the federal reserve, voluntary reserve and the excess liquidity reserve. Fed reserves, or mandatory reserves, are set by the central bank in each country or jurisdiction. This reserve is calculated by considering the country's market risks and economic conditions.

Fed reserves are designed for control, as commercial banks tend to increase their lending rate if they do not have any limitations. So, mandatory reserves serve as monetary policy to limit commercial bank activities and oblige them to keep enough cash to satisfy most deposit liabilities. 

The commercial banks themselves determine voluntary reserves, considering the market conditions. Voluntary reserves are a cushion against economic downturns and other crises that could emerge in the market. 

Commercial banks have the right to keep voluntary reserves, but the extent of liquid assets differs from country to country. Central banks also frequently change the size of acceptable voluntary reserves depending on economic factors.  

Finally, excess liquidity is anything that commercial banks keep after honouring the mandatory and optional reserves. In simple terms, excess liquidity is more money held by banks. But why are banks incentivised to keep extra cash when they can lend it out and reap profits through interest rates? In most cases, this happens because banks are waiting for a more profitable investment or want to avoid giving out risky loans. 

Excess liquidity and inflation are interconnected in both ways, as one could cause another and vice versa. However, in most cases, excess liquidity is the precondition to inflation if the commercial banks engage in aggressive lending practices. 

Suppose the commercial banks recently acquired excess reserves well beyond the minimum level. They could either decide to invest in secondary projects and markets or decrease interest rates, creating a larger money supply in the economy. Due to a reduced interest rate, more people and businesses will be encouraged to take loans and pursue aggressive spending strategies instead of being financially conservative. 

This will lead to more purchasing power and demand from the public without the corresponding boost in national production of goods and services. As a result, the economy might go into an inflationary period. 

Excess reserves can sometimes indicate a liquidity trap, a relatively rare occurrence in the economy. Unlike inflation, liquidity traps happen when individuals and businesses are motivated to save instead of spending more on investments, purchases or business growth. 

Liquidity traps occur when the general public is concerned about the future, expecting an upcoming depression or an economic crisis. Central banks decrease the interest rate to motivate larger spending, but the public stays conservative, avoiding any excess investments or expenses. 

Excess liquidity reserves could signal a liquidity trap since banks might be unable to issue new loans to clients in this period even if they offer astronomically low interest rates. 

For example, Japan was suffering from a liquidity trap, with loans going as cheap as 0% interest, but the public was still reluctant to increase their spending by taking debt. Liquidity traps harm the economy, halting economic growth and aggregate supply and damaging tradable markets like the stock market, bonds and forex. 

The excess liquidity in a vacuum is not necessarily a negative phenomenon, as it could sometimes be positive, signalling that the economy is growing without the need to take out excessive debt. 

However, as analysed above, excess liquidity can signal or follow a drastically adverse economic event. But why is excess liquidity terrible, exactly? 

The causes of excess liquidity could be liquidity traps and black swan events like COVID-19, and it could also lead to an economic crisis, depression or inflation. 

So, in practice, excess liquidity entails that the economy is not functioning correctly, and it requires a significant adjustment by the government or the market itself. 

However, if these efforts fall short, the local or even global economy might be headed into an extended period of recession and stagnated growth. When excess liquidity is not demanded on the market, liquid funds stay dormant in the reserves instead of stimulating the economy. 

Businesses are not expanding, stock and bond markets are falling short of general KPIs, and the entire commercial space is stagnating. This status quo can often be crippling for the economy, as the absence of growth could lead to a beginning of depression, with companies going out of business and individuals losing their jobs. 

So, whenever excess liquidity is believed to be a precursor of concerning developments like downturns and crises, central banks employ various means to combat it. Central banks usually mop up excess liquidity by raising mandatory reserves and forcing commercial banks to store extra funds instead of lending. 

The liquidity mop-up has ripple effects in virtually every industry, as commercial lending is connected to almost every industry. Nearly every prominent sector needs some sort of borrowing to expand and reach its goals in a feasible timeframe. In simple terms, loans are the lifeblood of the modern economy, and their absence hurts every aspect of global commerce. 

Startups, manufacturers, distributors, foreign exchange platforms, trading venues, digital companies and many other sectors take a hit in this environment. 

Growing and investing becomes exponentially more complicated for everyone as the total supply of lendable funds is smaller, and the corresponding interest rates tend to get higher because of the supply and demand dynamic. 

While liquidity mop-ups serve a higher purpose of stabilising the economy in the long, the short picture might become very tough on small and mid-sized businesses and individuals, as they will be cut off from expected lending or will have to deal with unusually higher interest rates. 

For a business that relies heavily on borrowings to develop new products and expand its scope of operations, excess liquidity mop-ups might be a death sentence, effectively eliminating the chance to grow through loan credits. 

With the global excess liquidity becoming increasingly unpredictable, it is prudent to have several safeguards in place to prepare for such an event. Otherwise, your commitments and liabilities might catch up with you, leading to unfortunate consequences like bankruptcy or insolvency. 

For businesses that are involved in brokerage and exchange services, there are alternative sources to acquire liquidity and continue operations despite the increased cost of borrowings. Liquidity providers can effectively supply your business with enough liquidity to maintain a high level of services without increasing spreads on price quotes. 

Having a long-standing relationship with LPs will guarantee that your expenses will not suddenly increase due to liquidity mop-ups going on in the industry. As a result, your brokerage practices will remain intact during this challenging period, giving you the opportunity to stay above the break-even point. 

Needless to say, it is important to become conservative during liquidity mop-ups, as seeking borrowings in this climate could lead to insolvency. Higher interest rates might not appear challenging initially, but you must consider the overall economic climate during mop-ups. 

All companies and individuals become less trigger-happy when it comes to purchasing or investing, which will probably affect your business as well. When the buying power vs excess liquidity is in action, consumers tend to save more and avoid unnecessary expenses, which might include anything beyond food, utilities and rent. 

If you take out a loan in this environment and your margins suddenly decrease, you might experience problems with paying back the principal and interest rates in due time. While expansion is not prohibited during mop-ups, it certainly becomes a high-risk activity you should avoid by any means necessary. 

If your business has a variable interest rate on its loan, excess liquidity mop-ups could lead to a significant increase in the rate. In these cases, it is possible to swap your loan contract with a counterparty if you manage to find a favourable deal. 

Companies with higher fixed interest rates might be interested in exchanging the agreement with you to acquire a less costly loan, even for a while. 

Naturally, you can also use this strategy in reverse and acquire a cheaper loan with a variable interest rate, but you have to consider the risks of the worst-case scenario. 

Both sides of these agreements could suffer opportunity costs if they make the wrong choice, but the loan swaps might be a lifesaver in a recession period where even the small funds matter. 

The meaning of excess liquidity in the financial landscape is quite complex. It could signal both positive and negative impacts on the economy. However, the influence tends to be primarily negative, with consumers and companies having trouble acquiring new borrowings. 

Excess liquidity mop-ups are an excellent mechanism for long-term economic health, but in the short run, they make it much harder for businesses to meet their commitments and pay their suppliers in time. 

So, if you are running a business, here's an extra variable to consider. While it might seem that excess liquidity is an endgame scenario for a small business, it can be planned for and offset with prudent business decisions. 

So, it is advisable to have substantial liquidity provider partnerships and a good grasp on complex financial mechanisms like loan swaps to weather the storm, which will most probably reverse within a calendar year.