The Impact of Surplus Liquidity

Transcription

1 The Impact of Surplus Liquidity Garreth Rule CCBS PFTAC Course on Monetary Transmission Channels, Liquidity Conditions, and Determinants of Inflation Central Bank of Solomon Islands July 2012 The Bank of England does not accept any liability for misleading or inaccurate information or omissions in the information provided.

2 Overview Liquidity Position. Excess vs. Voluntary Reserves. Estimating Excess vs. Voluntary Reserves. The Impact of Surplus Liquidity. Channels of Impact. Quantifying the Impact. Other Impacts.

3 Liquidity Position The liquidity position of the financial system vis-a-vis the central bank can largely be determined by the structure and dynamics of the central bank s balance sheet.

4 Liquidity Position We often state that when a central bank s balance sheet is liability-driven, the economy has a demand for central bank liabilities, predominantly for payment purposes, and the central bank lends money to the banking sector. In this case we say there is a shortage of liquidity.

5 Liquidity Position Liabilities Notes Assets FX Government Required Reserves OMOs Free Reserves Capital Other

6 Liquidity Position Liabilities ( billions) 28-Jun-06 Assets ( billions) 28-Jun-06 Banknote Issue 38.0 Short term reverse repo 32.9 Reserve Account Balances 20.7 Long term reverse repo 15.4 Other Liabilities 17.5 Other Assets 12.3 CRDs, BoE Capital and Reserves Foreign Currency Denominated 6.0 Bonds and Other Securities Acquired 8.2 Liabilities via Market Transactions Ways & Means Advance 13.4 Total 82.2 Total 82.2

7 Liquidity Position Similarly when a central bank s balance sheet is asset-driven, an exogenous or policy-driven increase in certain asset items results in a balance-sheet expansion greater than apparently needed to accommodate the economy s demand for central bank liabilities and a central bank often needs to absorb money to offset this. In this case we say there is a surplus of liquidity.

8 Liquidity Position Liabilities Notes Assets FX Required Reserves Free Reserves Government Capital Other

9 Liquidity Position Liabilities Notes Assets FX Required Reserves OMOs Government Capital Other

10 Liquidity Position Liabilities (RM billions) 31-Dec-11 Assets (RM billions) 31-Dec-11 Currency in Circulation 61.9 Gold & Foreign Exchange Deposits by Financial Institutions IMF Related Assets 8.9 Deposits by Others 23.9 Malaysian Government Securities 2.0 Bank Negara Securities Other Assets 47.6 Other Liabilities 32.4 Capital 31.9 Total Total 473.0

11 Excess vs. Voluntary Reserves. Therefore to measure surplus liquidity do we need only to measure the quantity of free reserves present in the financial system? As noted previously free reserves are composed of two elements voluntary reserves and excess reserves. The distinction between these two elements is crucial not only to measuring surplus liquidity, but also to understanding its impact.

12 Excess vs. Voluntary Reserves Free Reserves Excess Reserves Voluntary Reserves

13 Excess vs. Voluntary Reserves Voluntary reserves are additional reserves held by commercial banks for precautionary motives. The demand for voluntary reserves arises from a desire to self-insure and can vary dependent on the uncertainty of payment flows. In addition in times of market stress, reserves are a highly liquid and safe asset, often in such circumstances counterparty demand increases.

14 Excess vs. Voluntary Reserves Excess reserves on the other hand are reserves that exceed commercial banks demand for them. Crucial to remember that in aggregate the quantity of reserves in the system is determined by the elements of the central bank s balance sheet. When a commercial bank makes a new loan or purchases an asset the reserves are merely transferred to another counterparty s account at the central bank.

15 Excess vs. Voluntary Reserves Determining the difference between holdings voluntary or excess reserves is not a trivial task. One method is to survey banks as to their intentions, however, this can be a slow and cumbersome task.

16 Estimating Excess vs. Voluntary Reserves An alternative method is to estimate econometrically whether the determinants of free reserve are factors related to voluntary or excess reserves. One model to do this was proposed first by Agénor, Aizenman and Hoffmaister (2004), when looking at the case of Thailand during the Asian crisis, and built upon by Saxegaard (2006), when looking at liquidity surpluses in Sub-Saharan Africa. Saxegaard s extensions mean that the model is also capable of decomposing the evolution of free reserves into voluntary and excess reserve factors.

17 Estimating Excess vs. Voluntary Reserves In Saxegaard s model holdings of free reserves are regressed upon a range of variables thought important in determining holding of voluntary and excess reserves: In this specification EL t is the ratio of statutory excess reserves to total deposits, X 1 and X 2 are vectors of variables, v t is a well behaved error term and α j (L) are vectors of lag polynomials.

18 Estimating Excess vs. Voluntary Reserves The variables included in the vectors are set to reflect the factors thought to influence holdings of voluntary and excess reserves. For sub-saharan Africa, Saxegaard included the following variables.

19 Estimating Excess vs. Voluntary Reserves Where: RR is the ratio of required reserves to total private sector deposits. VOL Y and VOL CD are 5-year moving averages of the standard deviations of the output gap and cash to deposit ratio. VOL PS and VOL GOV are 5-year moving averages of the standard deviations of private and government deposits divided by the 5-year moving average of these series. PORT is the ratio of demand to savings deposits. Y is the output gap r D is the central bank discount rate.

20 Estimating Excess vs. Voluntary Reserves Where: DEP PS and DEP G are, respectively, private sector and government deposits as a fraction of GDP. CRED PS and CRED G are the ratios of private sector credit and credit extended to government to GDP. BOND is the ratio of securitised domestic debt to GDP. AID and OIL are the ratios of aid inflows and oil exports to GDP. POIL is the quarterly percentage change in the oil price. r L is the commercial bank lending rate.

21 Estimating Excess vs. Voluntary Reserves Because of the presence of several explanatory variables that are likely to be endogenous, OLS estimation would be inconsistent, instead the model is estimated using the instrumental variables estimator (IV). Estimation will only be valid if the variables are stationary. Results of the estimation should reveal which factors are the main drivers of holdings of voluntary and excess reserves.

22 Estimating Excess vs. Voluntary Reserves Saxegaard establishes a dynamic forecast for voluntary and excess reserves using the following formulae: Where ĉ, ά 1 ά 2 ά 3 are parameter estimates. EL P are precautionary reserves as a ratio of total deposits and EL I are involuntary reserves.

23 Estimating Excess vs. Voluntary Reserves There are a couple of drawbacks with this methodology. The estimation is clearly sensitive to the variables included in the vectors X 1 and X 2. Second only the sum of the two constants is identified. Note that any given value of a is consistent with the requirement that the sum of EL P and EL I equals total excess liquidity. The implication is that the level of voluntary and involuntary reserves is not identified, only the growth rate.

24 The Impact of Surplus Liquidity Under a liquidity shortage central bank operations have the following characteristics: Commercial banks are forced to transact with the central bank (potentially in standing facilities). Central bank can dictate the terms on which they interact with the market; including which assets back respective liabilities. Operations should earn a central bank money.

25 The Impact of Surplus Liquidity Liabilities Notes Assets FX Government Required Reserves OMOs Free Reserves Capital Other

26 The Impact of Surplus Liquidity When there is a surplus of liquidity its impact on the operations of the central bank will be determined by the extent to which free reserves are being held for voluntary or excess reasons.

27 The Impact of Surplus Liquidity Central bank attempts to absorb voluntary reserves may be ineffective unless the instrument used in draining operations is similarly desirable to the counterparty. However, holdings of voluntary reserves if stable are unlikely to impact on the central bank s ability to implement monetary policy or significantly impact on the transmission of monetary policy. Ultimately they can be modelled as an additional autonomous factor on the central bank s balance sheet.

28 The Impact of Surplus Liquidity Commercial banks holding excess reserves may be more willing to make use of draining operations if they offer a positive return. However, the presence of excess reserves in the financial system creates a deadweight loss for the commercial bank if they are left holding them. This will impact on the interbank market, lending by commercial banks and the deposit rates they offer.

29 The Impact of Surplus Liquidity Therefore the presence of excess reserves can influence the transmission mechanism of monetary policy. Despite surplus liquidity being a common feature of many economies around the world there has been surprisingly little work formalising either the channels through which excess liquidity impacts on the transmission mechanism, nor the scale of the impact.

30 Channels of Impact Agénor and El Aynaoui (2009) present one attempt to map the channels through which excess reserves can impact on the transmission channel. Using a simplified model of the economy they establish two elements of commercial bank behaviour that are distorted by the presence of excess reserves: Deposit Rates Lending Rates

31 Channels of Impact In the model, the presence of excess reserves leads commercial banks to respond asymmetrically when adjusting deposit rates following a change in monetary policy. Following a tightening of policy commercial banks will internalise the possibility that tighter monetary policy will lead to greater demands for deposits. This will compound the problems of excess reserves, and so banks will likely not raise deposit rates in step. For the opposite reasons banks are likely to be responsive to cutting deposit rates following a loosening of policy.

32 Channels of Impact Excess liquidity can also induce asymmetric pricing of loans by commercial banks. The overall presence of excess reserves may lead to commercial banks to weaken lending criteria in an attempt to increase returns. The extent to which commercial banks would do this is determined by the overall scale of surplus liquidity. If an increase in interest rates leads to an increase in excess reserves, then a commercial bank may loosen credit standards, making the impact of policy ambiguous.

33 Channels of Impact The results of Agénor and El Aynaoui formalise the channels through which surplus liquidity can impact on the transmission of monetary policy. In particular central banks facing the presence significant holdings of excess reserves may find their ability to tighten monetary policy compromised.

34 Quantifying the Impact Despite the establishment of these potential channels little work has been done on quantifying their effects. Partly as surplus liquidity is often found in economies where the transmission of monetary policy through the interest rate channel is limited by underdeveloped banking systems.

35 Quantifying the Impact One attempt to quantify the impact was produced by Saxegaard (2006). Looking once again at the Sub- Saharan Africa region. By comparing the impulse response in a Threshold VAR (TVAR) model that has two states, depicting the presence and absence of significant holdings of excess reserves.

36 Quantifying the Impact The TVAR model is specified as follows: Where v it Y and v it M are regime dependant vectors of non-policy and policy shocks. C i (L) is a regime dependant lag polynomial of autoregressive parameters. Finally EL I t is the threshold variable whose value relative to a threshold that determines the prevailing regime.

37 Quantifying the Impact The variables are split into a policy (Y t ) and non-policy blocks (M t ). In Saxegaard s analysis variables in the non-policy block are real GDP and inflation, whereas in the policy block are the nominal exchange rate and M0. For Nigeria the oil price is also included.

38 Quantifying the Impact Saxegaard finds that the in the cases of Nigeria and Uganda an unexpected contraction in reserve money lowers inflation more when involuntary excess liquidity is low than when excess liquidity is high. Though for the CEMAC region the results are not conclusive. The results of Saxegaard provide some evidence that the ability of a central bank to tighten monetary policy may be weakened by the presence of surplus liquidity.

39 Other Impacts There are other potential channels through which surplus liquidity can influence a central bank s interaction with financial markets. One such effect is that commercial banks have a greater influence the central bank s choice of policy instruments. Under such conditions the central bank faces temptation to introduce to use non-market tools. While these can have short-term benefits they can impede longer-term development of financial markets.

40 Other Impacts The presence of a excess reserves has influence of financial stability objectives as well as monetary policy ones. Under such a surplus of liquidity commercial banks have less incentive to manage their own liquidity well. However, under a surplus of liquidity failure of central bank operations to ensure that the optimal amount of liquidity available to the banking system will not lead to payments systems problems.

41 Other Impacts Operations under a surplus of liquidity can lead to the central bank incurring losses. Crucial to note that losses occur as a result of the mismatch between costs due on liabilities compared to income from assets.

42 Other Impacts Liabilities Notes Assets FX Required Reserves OMOs Government Capital Other

43 References and Further Reading Agenor, P, Aizenman, J and Hoffmaister, A (2000) The Credit Crunch in East Asia: What can Bank Excess Liquid Assets Tell us? NBER Working Paper No ( Agenor, P and El Aynaoui, K (2008) Excess Liquidity, Bank Pricing Rules, and Monetary Policy Centre for Growth and Business Cycle Research Discussion Paper no. 105 ( cgbcr/dpcgbcr105.pdf)

44 References and Further Reading Ganley, J (2003) Surplus Liquidity: Implications for Central Banks CCBS Lecture Series no.3 ( b03.htm) Gray, S (2006) Central Bank Management of Surplus Liquidity CCBS Lecture Series no.6 ( b06.htm)

45 References and Further Reading Saxegaard, M (2006) Excess Liquidity and Effectiveness of Monetary Policy: Evidence from Sub- Saharan Africa IMF Working Paper WP/06/115 (

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