Understanding Commercial Bank Reserves

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1 Understanding Commercial Bank Reserves Garreth Rule Monetary Policy Management, Analysis and Operation PFTAC / Reserve Bank of Fiji March 2014 The Bank of England does not accept any liability for misleading or inaccurate information or omissions in the information provided.

2 Overview Understanding Reserves Reserve Requirements Misconceptions Reserves to Lend Reserves and Other Assets Market for Reserves Achieving Policy Goals

3 Understanding Reserves Reserves are overnight balances that banks hold in an account at the central bank. As such, they are a claim on the central bank. Together with banknotes, reserves are the most liquid, risk-free asset in the economy. And they are the ultimate asset for settling payments; banking transactions between customers of different banks are either directly or indirectly settled through transfers between reserves accounts at the central bank..

4 Understanding Reserves Reserves also help banks to manage their liquidity risks, which arise as a natural result of banking activities. Banks either self-insure or are mandated by regulation to limit liquidity risks by holding a buffer of liquid assets that can be easily realised. As the most liquid asset of all, reserves often form a key component of such a buffer.

5 Understanding Reserves To understand the role that reserves play in the transmission of monetary policy we start with a very simplified model of a commercial bank. We generalise the representative commercial bank s balance sheet to the following:

6 Understanding Reserves Liabilities Assets Deposits Reserves Loans Interbank Capital Securities

7 Reserve Requirements Through time reserves and the justifications for requirements imposed upon them has changed. Today reserve requirements can be imposed for a variety of reasons: monetary policy purposes, liquidity management purposes, structural liquidity position purposes and sectorial behaviour purposes.

8 Reserve Requirements Reserve requirements can be applied for monetary policy purposes. This is the case if reserves are unremunerated or remunerated at a rate below prevailing market rates. The aim is to affect the spread between deposit and lending interest rates: higher reserve requirements will increase lending rates (discourage borrowing) and reduce deposit rates (discouraging deposits, and so reducing bank access to funding). Does this by creating a deadweight loss on commercial banks balance sheet (reserves tax).

9 Reserve Requirements Can also be applied for liquidity management purposes if remunerated at a rate such that there is no opportunity cost to holding reserves. The aim is to provide commercial banks with a means to smooth payment flows and hence reduce volatility in interbank markets. Changing the level of remunerated reserves can impact on the availability of collateral in the market.

10 Reserve Requirements Can be used to alter the structural liquidity position of the banking system vis-à-vis the central bank. Increasing (or imposing) reserve requirements will increase the liquidity deficit of the system (or reduce liquidity surplus). Applying reserve requirements at different levels across different forms of lending can be used to influence commercial bank behaviour (i.e. discriminating between foreign and domestic lending or between residential and commercial lending).

11 Misconceptions A fundamental misunderstanding of the nature of banking means that many people hold misconceptions regarding the role and nature of reserves. The two largest misconceptions is that banks need reserves to lend and that the quantity of reserves is determined by commercial banks (i.e. in aggregate that banks choose between reserves and other assets).

12 Reserves to Lend Central to undergraduate economic theory is the money multiplier. This posits that commercial bank credit creation is innately tied to the central bank s provision of reserves. In such a model the central bank provides reserves to commercial bank which in turn lend them out in decreasing quantities constrained by central bank imposed reserve requirements.

13 Reserves to Lend Two significant problems with this representation of credit creation: In reality the timing is the wrong way round. It does not accurately depict commercial bank s decisions regarding credit creation.

14 Reserves to Lend As noted by Gray (2011) most central banks around the world now apply reserve requirements in a lagged manner (i.e. requirements for the current period are calculated based on liabilities in a previous period). In addition as we will see the provision of reserves by a central bank is chosen solely to reduce market volatility by providing enough in aggregate for the system to satisfy reserve requirements and thus ensure payments can be made. Any stable multiplier relationship is actually in reverse, broad money expands and narrow money responds.

15 Reserves to Lend More fundamentally the money multiplier treats the banking system as a black box through which loans are made in a mechanical way constrained only be central bank provision of reserves. Commercial banks and their role in credit creation are far more complex than this. While many things determine commercial bank lending, availability of reserves is rarely one of them.

16 Reserves to Lend In fact using a simple model developed by Martin, McAndrews and Skeie (2013) it can be shown if the central bank is able to control conditions in the interbank market then commercial banks lending decisions is independent of the quantity of reserves they are holding. Commercial banks ultimately will lend if it is profitable for them to do so. In the Martin, McAndrews and Skeie this is when the return on the loan is greater than the cost of funding (i.e. the market interest rate).

17 Reserves to Lend Increased reserve levels impact lending only to the extent that if the central bank is unable to control conditions in the interbank market then excess reserves push market rates lower and hence make more lending profitable to commercial banks.

18 Reserves to Lend The simple model of Martin, McAndrews and Skeie assumes that the only cost to lending is the marginal funding cost. In reality Carney (2012) notes there are significant additional costs and considerations for a commercial bank making a lending decision: Regulatory and capital requirements. Administrative and hedging costs. Credit worthiness and credit hungriness of borrowers.

19 Reserves to Lend The final element above is particularly pertinent. Commercial banks through history have shown that they are more than capable of expanding lending at times of high interest rates and contracting lending even when rates are low.

20 Reserves to Lend Specific to the Pacific region, work by Gorajek (2013) identified legal issues surrounding property and bankruptcy law along with weakness in collateral infrastructure as additional costs to commercial bank lending in Tonga.

21 Reserves and Other Assets At various stages of the global financial crisis coverage has focussed on the increasing quantities of commercial bank reserves, often such coverage has concluded that this is evidence of commercial banks hoarding money and not lending. The most prominent example of this was coverage of use of the ECB s deposit facility following the 3-year LTROs in late In addition significant liquidity surpluses in developing countries are often lead to fears of high inflation.

22 Reserves and Other Assets Such statements and reports make it out that commercial banks make a choice between holding reserves and other assets. While this is true for an individual bank, for the system as a whole the quantity of reserves is constrained as a balance sheet identity of the central bank.

23 Reserves and Other Assets This means that once reserves are in the system there are few places for them to go. Some could seep into cash in circulation or into government balances. But if a bank buys assets or makes a loan then reserves will return to the central bank at another bank.

24 Reserves and Other Assets The process of lending and creating deposits can lead to free reserves becoming re-categorised as required reserves as the balance sheet of commercial banks expand. However, the overall size of total reserves is not affected by such moves. This can be easily seen by adapting a model initially put forward by Keister and McAndrews (2009).

25 Reserves and Other Assets Bank A Liabilities Assets Deposits 100 Reserves 10 Due to CB 10 Loans 60 Due From Bank B 40 Capital 10 Securities 10 Total 120 Total 120 Bank B Liabilities Assets Deposits 100 Reserves 10 Due to CB 10 Loans 140 Due to Bank A 40 Capital 10 Securities 10 Total 160 Total 160

26 Reserves and Other Assets Bank A Liabilities Assets Deposits 100 Reserves 50 Due to CB 10 Loans 60 Capital 10 Securities 10 Total 120 Total 120 Bank B Liabilities Assets Deposits 100 Reserves 10 Due to CB 50 Loans 140 Capital 10 Securities 10 Total 160 Total 160

27 Reserves and Other Assets Bank A Liabilities Assets Deposits 120 Reserves 50 Due to CB 10 Loans 80 Capital 10 Securities 10 Total 140 Total 140 Bank B Liabilities Assets Deposits 100 Reserves 10 Due to CB 50 Loans 140 Capital 10 Securities 10 Total 160 Total 160

28 Reserves and Other Assets Bank A Liabilities Assets Deposits 80 Reserves 10 Due to CB 10 Loans 80 Capital 10 Securities 10 Total 100 Total 100 Bank B Liabilities Assets Deposits 140 Reserves 50 Due to CB 50 Loans 140 Capital 10 Securities 10 Total 200 Total 200

29 Reserves and Other Assets Bank A Assets Liabilities Reserves 15 Deposits 80 Loans 80 Due to CB 10 Securities 5 Capital 10 Total 100 Total 100 Bank B Liabilities Assets Deposits 140 Reserves 45 Due to CB 50 Loans 140 Capital 10 Securities 15 Total 200 Total 200

30 Market for Reserves Regardless of the operational target of the central bank, every day commercial banks manage their reserves account balance at the central bank using interbank markets. Such accounts are subject to three types of inflow and outflow: Flows between the private and public sector; Flows between reserves account holding banks in respect of customer payments; and Flows between reserves account holding banks in respect of interbank loans.

31 Market for Reserves Failure by either the central bank or reserve account holding banks to manage these flows will lead to operational targets being missed or in extremis payments being unable to be made.

32 Market for Reserves Flows between the private and public sector, do not necessarily sum to zero. These flows cover transactions between the central bank and the private sector as well as changes in autonomous factors. The net effect of daily inflows and outflows on the banking sector s balance at the central bank is determined essentially by the degree by which changes in autonomous factors are offset by central bank transactions. From the central bank s viewpoint it is the aggregate flows generated by autonomous factors that are important.

33 Market for Reserves By definition flows between reserves account holding banks will sum to zero (one bank s credit is another bank s debit) and will therefore not impact on the aggregate reserves position of the banking sector. But, from the individual commercial bank perspective these flows, however, will impact on their own reserves account position. Therefore, commercial banks need to manage daily their own reserves account position, in the interbank market, even in the absence of net inflows and outflows from this market.

34 Market for Reserves Often will use the terms interbank market and market for reserves interchangeably. While there may be many participants in interbank markets that do not have direct access to reserves accounts as all transactions ultimately settle in reserves we can use the terms interchangeably. Therefore we can also say that the short-term market interest rate is ultimately the domestic price for reserves. Canonical model of interbank markets is that of Poole (1968).

35 Market for Reserves Problem facing commercial banks in managing their reserves account position is that they may not know with certainty their end of day position when engaging in money market trading. Shocks can occur with respect to both interbank trading and flows between the public and private sector. The presence of such shocks can lead to volatility in interbank markets Central banks will design their operational frameworks in an attempt to minimise such volatility as well as to achieve their policy goals.

36 Achieving Policy Goals A common framework utilised around the world to control short-term interest rates was the corridor system. In its purest form such a system is a one-day system, which does not require reserve requirements. Open market operations were used to ensure the optimal quantity of reserves was available to the system. The central bank relied on lending and deposit standing facilities charged at penal rates to create opportunity costs around its target rate

37 Achieving Policy Goals Lending Facility Reserves Demand Reserves Supply Policy Rate Deposit Facility 0

38 Achieving Policy Goals Assuming that the uncertainty faced by commercial banks around their reserves account positions is symmetric and the central bank is able to judge the scale of its intervention accurately, then the symmetric opportunity costs of holding excess reserves or being overdrawn should lead to interbank transactions converging around the centre of the corridor. In addition no profit maximising commercial bank will aim to hold an end-of-day balance other than zero on its account.

39 Achieving Policy Goals This result has a number of significant implications for central bank monetary operations: Open market operations should be used only to offset moves in autonomous factors (i.e. so flows between the public and private sectors sum to zero). The quantity of reserves required to ensure market rate equals policy rate is not affected by the level of the target rate or the width of the corridor. To change target rate the central bank needs only to move in tandem rates on the standing facilities.

40 Achieving Policy Goals If the corridor is not symmetric then to ensure that the market rate trades in line with the policy rate then the central bank may need to estimate a demand for reserves greater than zero. In reality many central banks who operated these pure corridor systems targeted a non-zero level for reserves balances. Often this was a small positive level of reserves. Reflecting that in reality the costs of the standing facilities are not truly symmetric.

41 Achieving Policy Goals The width of the corridor employed by central banks varies. No optimal width, choice trades off encouragement to trade against potential volatility in rate. In extremis a zero width corridor would likely see all trading gravitate to the central bank.

42 Achieving Policy Goals The successful implementation of a pure corridor system was therefore reliant on the central bank being able to accurately forecast every day flows between the private and public sectors. The addition of period averaging reserves reduced the need for the central bank to produce accurate forecasts from every day to only the last day of any maintenance period. Reserve averaging could be added to a corridor system or implemented in the absence of a symmetric corridor.

43 Achieving Policy Goals On the final day of the maintenance period, the situation is almost identical to that of a one-day maintenance period. If a symmetric corridor is implemented in addition to the reserve averaging (and other prior assumptions hold); the result for the final day differs only in that commercial banks instead of targeting a zero balance will target their residual reserve requirement.

44 Achieving Policy Goals Lending Facility Reserves Demand Reserves Supply Policy Rate Deposit Facility b

45 Achieving Policy Goals On days prior to the end of the maintenance period, if the commercial banks believe that the central bank will ensure that the that the optimal quantity of reserves is available and market rates will be in line with policy rate on the final day then they should be indifferent as to what proportion of their reserve requirements they satisfy on pre-settlement days. Such a result is often referred to as the martingale principle. In its purest form any pre-settlement day s demand curve will be completely horizontal.

46 Achieving Policy Goals In reality, however the presence of a no overdraft policy at many central banks means that the arbitrage is never perfect. Instead, what is found is there is a range of reserves balances on pre-settlement day that banks are indifferent between holding. However, bank s will aim to avoid going overdrawn on a specific day and will also aim to avoid exceeding their total reserve requirements (as they cannot go overdrawn on subsequent days)

47 Achieving Policy Goals Lending Facility Reserves Demand Reserves Supply Curve Policy Rate Deposit Facility R

48 Achieving Policy Goals A further type of system used by some central banks and detailed by Bernhardsen and Kloster (2010) is a floor system. Similar to a corridor system, but target rate set equal to deposit rate at base of the corridor. To do this central bank provides or allows a large quantity of reserves in the system. No formal reserve requirements, however, all excess balances remunerated at deposit rate.

49 Achieving Policy Goals Reserves Supply Lending Facility Reserves Demand Deposit Facility Policy Rate

50 Achieving Policy Goals Floor systems can completely disconnect the quantity of money in the system from monetary policy. Any quantity of liquidity supply large enough to push rates to the floor of the corridor is sufficient to implement policy rate. However, floor systems reduce the need to trade from interbank markets. The two countries that operated a floor system as their standard policy framework (Norway and New Zealand) have both placed upper limits on the amount of reserves they will remunerate commercial banks for as a means to stimulate interbank trading.

51 Achieving Policy Goals Ultimately the exchange rate is the value of the domestic currency in terms of another currency. As the central bank has the ability to influence the supply of the domestic currency, by adjusting the supply of reserves it can influence the price. Mundell Flemming suggests that in the absence of capital controls a central bank looking to fix its exchange rate must sacrifice monetary policy autonomy.

52 Achieving Policy Goals This often leads to a perception that central banks targeting an exchange rate will employ vastly different instruments and frameworks to those targeting an interest rate. In reality as discussed by Disyatat (2008) there is often only slight differences between the tools employed.

53 Achieving Policy Goals One of the perceived key determinants of bilateral exchange rates is the interest rate differential between countries. Money would be expected to flow from a lower interest rate country to the higher interest rate country. Under an interest rate target with flexible exchange rates, we would expect an appreciation of the higher rate country s exchange rate to neutralise the flow. Under an exchange rate target managing the interest rate differential is a means of maintaining the desired exchange rate.

54 Achieving Policy Goals The operational framework for a central bank under such a policy can take any of the forms discussed above. The only difference is that the targeted interest rate is chosen in response to changes in another countries interest rate as opposed to underlying conditions in the domestic economy.

55 Achieving Policy Goals A central bank may choose to intervene directly into currency markets to influence the value of an exchange rate. Either by selling domestic currency to buy foreign currency or selling foreign currency to buy domestic currency Such intervention will impact on the availability of reserves to the market. Can be treated as an additional flow between the public and private sector.

56 Achieving Policy Goals At the extreme an exchange rate policy can be implemented through the means of a currency board. Under a currency board all of the monetary policy functions of the central bank are focused on guaranteeing direct convertibility between domestic and foreign currency at the desired policy rate. In essence a currency board is the equivalent of a zero corridor system for interest rates.

57 References and Further Reading

58 The End Any questions? The Bank of England does not accept any liability for misleading or inaccurate information or omissions in the information provided.