3 Refinance Instruments: Lessons from Their Use in Some Industrial Countries
- Tomás Baliño, and Lorena Zamalloa
- Published Date:
- September 1997
Many central banks are gradually shifting from a system of direct controls toward the implementation of monetary policy through market-oriented instruments. However, often the central bank is constrained by the low level of development of market mechanisms and the absence of sound and competitive banking systems. Moreover, in many countries—particularly the former centrally planned economies—commercial banks depend heavily on central bank credit.
Indeed, in many developing countries and economies in transition, some traditional market-based instruments, such as outright open market operations, cannot be immediately used as the main instrument for monetary management because a number of prerequisites are not fulfilled, such as a competitive banking market, the availability of government or central bank paper and active secondary markets on these securities, and an efficient payment system. In the transition period, refinance instruments may be valuable for the flexible implementation of monetary policy. Moreover, a number of industrial countries also use these instruments.
Description of Refinance Instruments
The central banks in the selected sample use two types of refinance instruments: standing facilities and money market instruments. Both are collateralized operations.
Refinance instruments operate as modified rediscount windows. In a traditional rediscount operation, the ownership of the collateral is transferred to the central bank for its whole residual maturity. As a consequence, refinancing is granted for a period of time corresponding to the maturity of the collateral involved in the transaction. Because this is a source of rigidity for the daily management of liquidity, especially since the assets involved in rediscount operations are usually nonnegotiable, many central banks have adopted modified arrangements. In some cases, the refinance window operates as a collateralized loan (a repurchase operation), which allows the central bank flexibility in choosing the maturity of the refinancing, which typically is shorter than the residual maturity of the collateral.
Whereas a classic rediscount operation provides refinancing at a fixed rate for the remaining maturity of the underlying asset, collateralized lending does not. Therefore, the cost of refinancing a certain paper with a collateralized lending facility is uncertain. Since the remaining maturity of the paper will generally exceed that of the refinance operation, the cost of refinancing will vary because refinance operations have to be rolled over.1 Collateral is also used in the case of money market instruments as explained below.
Experiences vary across countries regarding which assets central banks accept as collateral for their refinancing. As shown in Tables 1 and 2, central banks of the selected countries admit one or both of the two main categories of collateral: government securities or prime quality private paper, which may or may not be marketable.2 When assessing the quality of assets, monetary authorities may rely on ratings published by private agencies or, if such ratings are unavailable, on their own assessment.
Penalty rate below short-term market rates.
|Not relevant.||Within limits fixed by the central bank.||Lower bound for market rates. Serves to mop up daily surpluses of liquidity.|
Rate below short-term market rates. It applies to collateralized loans.
|Private paper only.||Within rediscount ceilings.||Conveys policy signals to the market. Refinancing of private paper.|
|Special advance rate|
Penalty rate above short-term market rates.
|Government paper only.||Within limits fixed by the central bank.||Upper bound for market rates. Source of emergency funding.|
|France||5- to 10-day repo rate|
Penalty rate above short-term market rates. It applies to loans against collateral.
|Government paper, good-quality short-term credit (2 years or less) to enterprises.||Access at the initiative of banks. Collateral may be limited to government paper.||Conveys policy signals to the market. Upper bound for market rates. Source of emergency funding.|
Rate below short-term market rates. It applies to classic discount operations.
|Private paper and government paper (federal and local) with remaining maturity less than 3 months.||Rediscount ceilings according to capital, and portfolio of admissible paper.||Conveys policy signals to the market. Ceilings are entirely used.|
Penalty rate above short-term market rates. It applies to loans against collateral.
|Public paper, including liquidity paper and private paper lodged in advance with the Bundesbank in disposition accounts.||Access at the initiative of banks. or automatic if their account is overdrawn at the end of the day.||Conveys policy signals to the market. Upper bound for market rates. Source of emergency funding.|
Rate below short-term market rates. The same rate applies to classic discount operations and collateralized loans.
|Mainly government securities.||Rationing procedure. Lending may be withdrawn at any time.||Conveys policy signals to the market. Limits rate fluctuation.|
|United States||Discount rate|
Rate below short-term market rates. It applies to discount operations and loans against collateral.
|Securities of the U.S. government and federal agencies. Local government securities or private assets of acceptable quality.||Access strictly controlled by the Federal Reserve, and granted for very short term-periods.||Conveys policy signals to the market. Source of emergency funding.|
|Country||Instrument||Collateral||Auction System||Other Features|
The rate of volume tenders is one of the key rates of the central bank.
|Government securities and private paper.||Volume tender Rate known in advance.|
Interest rate tenderBoth multiple- and uniform-rate auctions.
|Amount and maturity fixed by central bank (in practice weekly auctions).|
|Forex swaps||Foreign currencies. Credit risk managed by credit lines.||Interest rate tender Banks are served ai rates they bid.||Occasional use.|
|Repurchase transactions||Mainly government securities.||On a bilateral basis at a market rate.||Instrument of fine-tuning.|
The rate is a key rate of Banque de France and the lower bound for short-term market rates.
|Government paper, good-quality short-term credit (2 years or less) to private enterprises.||Volume tender||Amount and maturity fixed by Banque de France. In practice weekly auctions of 1-week maturity.|
|Repurchase transactions||Government securities.||On a bilateral basis at a market price.|
Instrument of fine-tuning.
The rate of volume tenders is one of the key rates of the Bundesbank.
|Government paper (including liquidity paper), securities listed at the stock market deposited at the Bundesbank.||Volume tender Rate known in advance.|
Interest rate tender Multiple-rate auctions.
|Amount and malurity fixed by Bundesbank. Weekly auctions (2- or 4-week maturity).|
|Forex swaps||Foreign currencies. Credit risk managed by credit lines.||Interest rate tender Multiple-rate auctions.||Infrequent use because of its effecis on the exchange market.|
|Japan||Bill discount window Market rates.||Bills (maturities 7 to 180 days) of good quality, and traded in the money market.||On a bilateral basis at a market rate.||Instrument of fine-tuning.|
|United States||Repurchase transactions||Government securities.||Transactions negotiated with primary dealers at a market rate.||Instrument of fine-tuning.|
The technique used to transfer the collateral to the central bank also differs across the selected countries. In Germany, for instance, in the absence of a book-entry system, accepted collateral must be lodged in advance with the central bank in disposition accounts. This allows the Bundesbank to extend funds automatically through the Lombard facility to finance end-of-day clearing imbalances. In France, by contrast, banks are no longer required to lodge collateral in advance with the central bank. When funds are extended against private paper, banks issue and sell to the central bank “mobilization certificates” representing eligible private paper given as collateral. If government securities are used as collateral, a book-entry system allows the transfer of ownership of each individual security through a payment-against-delivery arrangement.3
Refinance standing facilities are instruments offered by central banks to provide funds and have the following characteristics: (1) they are used at the initiative of individual banks, (2) they carry preannounced rates, and (3) in some cases, central banks also offer deposit standing facilities.
(1) Standing facilities are used at the initiative of banks, which determine the amounts used, although generally subject to some limits. Central banks tend to limit free access through the implementation of formal or informal ceilings, especially when they charge interest rates below market levels (Table 1).
(2) Refinance standing facilities provide funding at a preannounced rate. However, the importance of the guarantee of the cost of refinancing has shrunk with the growing use of standing facilities that provide short-term loans against collateral.
(3) Deposit standing facilities allow banks to lend surplus liquidity to the central bank. Belgium is the only country in the sample to use this instrument. Not only is interest on these deposits below market rates, but access is subject to limits: within a first quantitative limit, the interest rate applied is slightly below market rates; deposits exceeding this first limit are remunerated at a rate well below market rates.
Table 1 presents additional features of standing facilities in the selected countries.
Operations with Money Market Instruments
Over the last decade, monetary management in most industrial countries has increasingly relied on operations with money market instruments instead of standing facilities. Because those operations are initiated by central banks, operate through market mechanisms, and serve to manage the global amount of liquidity in the system, they are ideal tools for the central bank to manage monetary policy.
These instruments, whose main features are presented in Table 2, are repurchase transactions in domestic securities (purchase and resale transactions or repos), that is, loans backed by domestic assets; or repurchase transactions in foreign currency (foreign currency swap transactions), that is, loans backed by a foreign currency.
Operations with money market instruments differ from standing facilities on essential points. They are conducted in a competitive manner and at the initiative of the central bank. The central bank is likely to deal with any bank on the basis of a public offer or at the prevailing conditions of the market. Because interest rates applying to these operations are unknown in advance and are likely to be modified for each individual operation, they are often described as variable rate operations.
Although they are market-oriented operations, operations with money market instruments differ also from outright open market purchases and sales. Operations with money market instruments take place in the market for cash and thus affect this market’s interest rates directly. Although they involve securities as collateral, they do not affect the secondary market for securities. By contrast, outright open market purchases and sales directly affect the price of securities on the secondary market, and only indirectly the interbank market, through their impact on the amount of liquidity in the system. Thus, the latter transactions are especially appropriate for managing overall liquidity in the system, but may be less appropriate for fine-tuning short-term market rates.
Money market instruments used by the central banks in the sample of industrial countries take the form of purchase and resale transactions (repos). These comprise the purchase of assets by the central bank under a contract providing for their resale at a specified price on a given future date and are used to supply reserves. The mirror image, sale and repurchase transactions (reverse repos), are sales of assets by the central bank under a contract providing for their repurchase at a specified price on a given future date; they are used to absorb liquidity. Typically, the seller buys back the asset at the same price at which he sold it and pays the original buyer interest on the implicit loan on the buyback date. Repurchase agreements have been treated variously as a sale with an agreement to buy back, involving a change in the ownership of the asset, or as a collateralized loan. Most often they are treated as the latter. The borrower—who sold the security with an agreement to repurchase—remains the owner of the collateral, even though it may temporarily be in the lender’s possession. Thus, he retains the right to all coupon interest accruing on the collateral for the duration of the repurchase agreement. The precise status of a repurchase agreement, however, varies between countries.
The attractiveness of such operations stems first from the fact that they can be implemented quickly and have no significant effect on the price of the assets used in the operations. Second, the central bank retains the initiative in setting the amount, timing, and duration of the contract, and in deciding whether to renew it or to let it unwind upon maturity; hence, these operations give the central bank flexibility in the control of money market conditions. Third, because the added reserves in case of a repo, or conversely the subtracted reserves in case of a reverse repo, will automatically be extinguished when an operation matures, these arrangements are a flexible tool for managing highly variable bank reserves and for injecting or mopping up reserves on a short-term basis. Fourth, they are often less disruptive to the financial system than outright sales and repurchases of securities, because the ownership of the securities changes only temporarily under a repurchase agreement.
Repurchase transactions in domestic securities may be implemented according to a procedure available to all banks on the same basis. Typically these operations involve repo auctions or reverse repo auctions, whereby the central bank injects funds (in a repo auction), or absorbs funds (in a reverse repo auction).
Various auction procedures enable central banks to manage interest rates and/or volumes flexibly. With volume tenders, banks bid only for volumes supplied by the central bank at a preset interest rate. This rate may be preannounced when the auction is made public, or may be disclosed after banks have submitted their bids, and be part of the results of the auction.4 Interest rate tenders allow banks to bid for both the amount and the rate. There are two alternative ways of running these tenders: a multiple-rate auction, in which refinancing is allocated at the rates bid by banks, or a uniform-rate auction, in which all accepted bids will pay the cutoff interest rate (or marginal rate) at which the desired level of liquidity is injected.5 In practice, interest rate tender is used when the central bank is willing to let interest rates adjust to participants’ expectations. Volume tenders, in contrast, help to make monetary policy intentions (as regards interest rates) explicit and to stabilize market expectations.
Belgium, France, and Germany use volume tenders. In France, banks do not know in advance the interest rate preset by the central bank, whereas in Germany and Belgium, they do. In addition, the Bundesbank and the National Bank of Belgium use interest rate tenders: the Bundesbank implements the multiple-rate auction, whereas the Central Bank of Belgium uses the multiple-rate auction and, at times, the uniform-rate auction.
Experiences vary across the sample countries regarding the extent to which central bank operations are conducted with all market participants or with only a few intermediaries. In Belgium and the United States, the desire for operational efficiency has led the central bank to conduct most market operations with a few specialized counterparts. At times, the Bundesbank may also select a few participants for its Schnell-tenders,6 and the Banque de France may select a few large banks when it wishes to bring about a rapid change in market interest rates through fine-tuning operations. However, in France and Germany, regular repo auctions are conducted with all market participants to give all banks equal access to the refinancing of the central bank.
The Banque de France has, however, its own network of counterparts, called Opérateurs principaux du marché. These banks collect bids from all the banks each time the central bank conducts repo auctions and add them to their own bids before sending them to the central bank. After the results have been published, the central bank grants the refinancing to each individual bank, according to their bids. This mechanism allows the central bank to operate with all market participants while reducing the amount of information to collect for each operation.
Generally, the whole process of a repo auction takes two working days. However, when needed, both the Banque de France and the Bundesbank can operate a repo auction within one working day.
Foreign currency swap transactions (a combination of a spot and a forward transaction) may be used as an instrument of domestic money market policy. They are used at times in Belgium and Germany, in particular when the central bank wishes to sterilize the impact of large foreign reserve flows on domestic liquidity conditions. This instrument has also been used in France, even though it is not explicitly part of the set of instruments of the Banque de France. However, because these operations may have an impact on the foreign exchange market, they are not frequently used.7
Use of Refinance Instruments to Influence Short-Term Interest Rates
Despite differences in the way monetary policies are implemented, money market interest rates are an important target for daily monetary operations in all the sample countries. Moreover, increased resourse to market-oriented techniques in recent years has promoted convergence in the monetary instruments and procedures that central banks use to influence short-term market rates. In this context, refinance instruments play three roles: (1) they serve as indicators of the monetary policy stance; (2) they regulate the overall level of market rates; and (3) they are used to fine-tune the call money rate.
Indicator of the Monetary Policy Stance
When using indirect monetary policy instruments, central banks have to convey policy signals to the market to make explicit the stance of monetary policy. Usually they do so through their key interest rates. Changes in these rates will manifest a shift in the orientation of monetary policy: a cut will indicate a loosening, and an increase a tightening of monetary policy stance. The immediate response of market interest rates to a change (the announcement effect) will much depend on the extent to which the market anticipated the change: a move that is largely anticipated will probably have a limited impact, whereas an unexpected move or, even more, a move in the opposite direction to the one expected is likely to provoke a large reaction.
Some central banks rely primarily on a single key rate both to steer market rates and to give policy signals. Others use several rates that may give more flexibility both in conducting operations and in providing policy signals. In some cases, one rate provides an upper or a lower limit to market rates, while another serves to guide them. In other cases, two rates may set a band for short-term market rates.
In all the sample countries, central banks use the standing facility rate to convey policy signals. In addition, some central banks also use the money market refinance rate: Belgium, France, and Germany use the rate of volume tenders for this purpose. Because these rates apply to actual refinance operations, a move is likely to have a direct impact on the market.
Less notable shifts in the monetary policy stance would more likely be suggested through changes in market-oriented indicators: the Banque de France may modify its benchmark for the call money rate; the U.S. Federal Reserve may change its Fed funds target, although this could also signal changes in the stance of monetary policy; and so forth.8
Central banks can also indicate policy intentions by changing procedures, in particular, the auction procedure or the maturity of refinancing. For instance, the Bundesbank and the National Bank of Belgium can switch from interest rate tenders to volume lenders to stabilize market expectations. At other times, they may switch to interest tenders to give a greater weight to market forces in determining interest rate.
Regulation of Overall Level of Market Rates
Central banks not only give broad indications to market participants, but may also regulate the overall level of short-term money market rates. Refinance instruments play a core role in the management of money market rates. Table 3 gives some indication, as of the end of December 1995, of the position of short-term money market rates relative to key central bank rates.
|Country||Lower Bound||Money Market Rate||Upper Bound|
|Belgium||Discount rate 3.00|
Repo auction 3.80
|Call money rate 3.85||Overdraft facility 5.00|
|France||Repo auction 4.60||Call money rate 5.00||5 to 10 days repo 5.85|
|Germany||Discount rate 3.00|
Repo auction 3.80
|Call money rate 4.10||Lombard facility 5.00|
|Japan||Discount rate 0.50||Call money rate 0.53||No official bound|
|United States||Discount rate 5.25||Call money rate 5.60||No official bound|
With respect to the structure of refinance instruments, the countries sampled can be grouped as follows: (1) Japan and the United States, (2) Belgium and Germany, and (3) France.
(1) In Japan and the United States, the central bank maintains a unique standing facility (the discount window), whose rate is below market rates. When market rates rise, widening the spread, banks will tend to increase their borrowing; they will tend to curtail borrowing when the spread narrows. Thus, the call money rate cannot deviate sharply or for a long time from the level of the discount rate. However, because access to the discount window is not free, this mechanism has to be complemented by fine-tuning operations (see below).
(2) The central banks of Germany and Belgium implement a mechanism that combines several windows. The Bundesbank uses two standing facilities: the discount window and the Lombard window. The discount window is a preferential refinance facility whose rate is below market rates and that functions as a lower bound for short-term rates. The Lombard window provides loans to bridge temporary reserve shortages. The rate applied to this emergency funding serves as an upper bound for market rates. The central bank in Belgium implements a similar mechanism, although limits apply to its overdraft facility.9 Thus, interbank rates in Germany and Belgium are bounded by the spread between the discount rate and the emergency funding facility. However, in practice, market rates fluctuate within a narrower margin. Both central banks implement repo auctions whose rate is between the discount rate and the emergency funding facility. As a consequence, money market rates tend to fluctuate between rates of repo auctions and of the emergency funding facility.
(3) In France, the central bank maintains a single standing facility whose rate is set above market rates.10 As with the Lombard window, it is used as an emergency facility that serves as an upper bound to short-term interest rates. The lower bound is set by periodic repo auctions.
Fine-Tuning of the Call Money Rate
The call money rate is a short-term market rate that central banks use as their operating target. They intervene on the money market to keep this rate within a desired range.
(1) Repo auctions are not appropriate for the fine-tuning of interest rates, because of the delay between the moment they are initiated and the settlement date (one or two days). Thus, the daily management of the market is operated through more flexible transactions, such as direct lending or borrowing on the interbank market, or repurchase transactions negotiated bilaterally.11
For instance, when the Banque de France conducts bilateral repurchase transactions in domestic assets, it makes no official announcement and operates with a few counterparts at prevailing market conditions. Because these transactions operate at the margin, they have an impact on the money market rate even though they involve small amounts of liquidity.
In the United States, the Fed repo transactions are similar to repo auctions in Belgium, France, and Germany. However, because there is a liquid repo market, repo operations can be used to fine-tune short-term interest rates. The Federal Reserve negotiates with primary dealers on the basis of a multiple-rate auction system and completes the entire transaction within a few hours. Such quick implementation allows the Federal Reserve to rely entirely on this instrument to regulate the Fed funds rate on a daily basis. In addition, its repo provides funds on a demand or an open basis, which allows either party to terminate the operation at any time up to the maximum number of days specified in the agreement. Thus, this procedure has the advantage of providing a self-correction mechanism when the Federal Reserve oversupplies liquidity because of forecast errors. In this case, the interbank rate (the Fed funds rate) would fall below the contracted repo rate, and banks would have an incentive to terminate their repos with the Federal Reserve; that liquidity withdrawal would help to raise interest rates.12 The Federal Reserve may use up to 15-day repos, but in practice it rarely effects transactions for periods longer than 3 days.
When market rates fall below their desired level, the Federal Reserve may use reverse repurchases to withdraw liquidity. With a reverse repo, the Federal Reserve offers to sell one or several bill issues to dealers at the prices at which these issues are trading in the market. It then asks the dealers to offer a price at which they will resell these bills. The dealers’ offered buyback (repurchase) prices determine the implicit interest rate they wish to earn on the money they lend. The Federal Reserve accepts those bids with the lowest implicit interest rate. These contracts are made only for fixed periods and cannot be terminated before maturity.
(2) The frequency of fine-tuning operations is in part related to the way reserve requirements operate. In particular, when banks are required to hold reserves in amounts larger than the average daily shifts in overall liquidity, the frequency of central banks’ interventions diminishes. In Germany, where reserve requirements play an important role in stabilizing the demand for reserves, the central bank typically intervenes only once a week through repo auctions and rarely operates between two repo auctions. In France, by contrast, partly as a result of recent cuts in reserve requirements, the frequency of central bank intervention in the market has tended to increase. In Belgium, owing to the absence of reserve requirements, the central bank makes frequent end-of-day transactions to absorb or provide liquidity to help banks square their position at the central bank. These transactions are, however, conducted at penalty rates to encourage banks to trade on the interbank market first.
The frequency of fine-tuning operations also reflects different philosophies of monetary management: infrequent operations tend to leave more room for market forces to play. In Belgium, France, and Germany, market rates fluctuate within the band framed by refinance instruments (as discussed above), whereas in the United States, the Federal Reserve closely manages the overnight rate for the Fed funds market.
(3) Legal arrangements, and typically the interdiction against the central bank’s remunerating banks’ accounts, also have an impact on the fine-tuning operating procedures central banks use. Because the Federal Reserve is not authorized to remunerate banks’ accounts, it mops up excess liquidity by conducting reverse repurchase agreements. In France, because such interdiction does not exist, the central bank usually operates through direct borrowing, although in the recent period reverse repurchase agreements have also been used.
Management of Banks’ Reserves
The quantitative importance of standing facilities has diminished in recent years. However, they play an important role as an instrument of emergency funding to finance end-of-day imbalances. On the other hand, central banks rely on money market instruments to regulate overall liquidity in the system.
Declining Quantitative Role of Refinance Standing Facilities
Refinance standing facilities, and especially the discount window, were for many years the prominent, if not the only, instrument central banks used to refinance the banking system. This quantitative role declined in the 1970s and 1980s in most of the industrial countries because of increased reliance on money market instruments. However, in some countries the discount window is used to provide subsidized refinancing.
Indeed, in Germany, and to a lesser extent Belgium, the central bank still provides significant refinancing to the banking system through a discount window.13 Because this refinancing is granted at below-market rates, it is a way to provide subsidized funding to banks.14 As a consequence, this refinancing is subject to ceilings.
In Germany, the discount window now accounts for about one-fourth to one-third of central bank refinancing. By comparison, in 1985 it provided more than half the refinancing. The spread between the discount rate and the money market rate has tended to narrow: it reached 110 basis points in December 1995, but rose to 220 basis points during part of 1991 and was above 100 basis points during most of the 1980s. Access to refinancing through the discount facility is entirely at the initiative of commercial banks but is bounded by each bank’s individual ceiling. In allocating the ceilings, the central bank takes into consideration the level of capital and the amount of eligible assets of commercial banks. In practice, commercial banks use all their allocations of refinancing.
The National Bank of Belgium abolished its discount window at the beginning of 1991 as part of a global reform of its instruments of monetary policy. In mid-1991, however, it decided to create a specific discount window to refinance private paper. It sets a global ceiling on the use of this window, which it splits among commercial banks according to deposits collected and the level of lending on the money market. Refinancing through this standing facility amounts to about 10 percent of global refinancing.15 The spread between the discount rate and the money market rate averaged 80 basis points by the end of 1995.
In France and the United States, refinance standing facilities occasionally contribute residual amounts to the refinancing of the banking system. The Banque de France used to operate a preferential discount window for medium-term export credits, which it began to phase out in 1986, and which will be totally eliminated shortly. As a result, it still holds a portfolio of pre-1986 rediscounted medium-term private paper; however, it has disconnected the interest rate subsidy it provides from the refinancing itself.16
Table 4 gives some indication of the quantitative importance of the net domestic assets of the central bank compared with the outstanding domestic credit of deposit money banks. In the United States, the net domestic assets of the Federal Reserve do not exceed 7 percent of domestic credit of the deposit money banks. In Belgium, France, and Germany, countries where the net domestic assets of the central bank are mostly direct refinancing of the deposit money banks, the ratio is even lower. Thus, the quantitative importance of credit from the central bank often extended at below-market rates is negligible compared with credit extended by deposit money banks. In Germany, for instance, credit extended to deposit money banks at the preferential rediscount window (about 25 percent of total credit from the central bank) represented only 1.5 percent of domestic credit extended by deposit money banks at the end of 1995.
|Domestic credit granted by deposit money banks||6,399||3,144||1,548||517||5,684|
|Net domestic assets of the central bank||360||166||35||5||398|
|Net domestic assets of the central bank/domestic credit granted by deposit money banks (in percent)||5.6||5.3||2.3||1.0||7.0|
The figures in Table 4 clearly show that refinancing windows at below-market rates in these countries are not intended to direct credit to given economic sectors as is usually the case in countries using such windows on a larger scale. In the sample countries, refinancing windows at below-market rates are a survival of past practices. In Germany, they can also be seen as a counterpart to high, nonremunerated reserve requirements.
Standing Facilities as a Source of Emergency Funding
As a source of emergency funding, standing facilities play an important role in smoothing fluctuations in market rates.17 When designing the technical aspects of an emergency funding facility to cope with temporary shortages of funds, it is necessary to take into consideration the degree of development of markets and payment system, the soundness of the banks, and the range of central bank instruments.
In countries with a liquid interbank market and a sound financial system, the global equilibrium of the market is also likely to entail an equilibrium at the level of each individual financial institution. In those cases, a central bank emergency lending facility may be just an overdraft facility to finance end-of-day clearing imbalances, with access limited by charging an interest rate above market rates. If the interbank market and the payment systems are underdeveloped or financial institutions are weak, a penalty rate just slightly above market rates may be insufficient to discourage illiquid banks from resorting to that facility, even when the system as a whole has sufficient liquidity. In those cases, ceilings may be indispensable, as well as penalty rates that increase with the frequency of use of the facility.18
In the sample countries, interbank markets are liquid and the financial system generally sound. Overdraft facilities typically carry a penalty rate slightly above market rates and therefore provide a ceiling to very short-term market rates. In addition, they are likely to give the central bank more freedom to use other refinance instruments and open market operations: a miscalculation in the amount of liquidity injected or to be mopped up may be corrected, in a way automatically, through overdraft borrowing. Nevertheless, the penalty rate prevents this facility from causing an excessive monetary expansion.
In the United States, the discount window may be used for very short periods, often overnight, to cover sudden and unforeseen deposit outflows. This adjustment borrowing, therefore, tends to be used mainly by institutions that have volatile checking account liabilities or that are heavily involved in relatively short-term lending. Access is, however, strictly regulated by the Federal Reserve.
The Lombard facility in Germany is typically an overdraft facility to finance end-of-day clearing imbalances. It provides funds usually for a short period of time, not exceeding a few days. Because banks have collateral permanently deposited with the Bundesbank, the latter automatically grants a loan whenever a bank’s account is overdrawn at the end of the day.19 Belgium and France use similar procedures.
Management of Overall Liquidity in the System
The financial systems in the sample countries permanently require the central bank to provide liquidity. Except in Japan and the United States, where outright open market operations prevail, repo auctions provide the bulk of the needed liquidity in all the selected countries.20 When they need to reduce overall liquidity, central banks will let the outstanding amount of their credit fall, for instance, when auctioned credits mature.
(1) The frequency and the maturity of repo auctions are tailored to give central banks sufficient control over bank reserves. Unduly large excess reserves have to be avoided, as does habitual recourse to central bank standing facilities or a frequent need for fine-tuning. In practice, the frequency and maturity of repo auctions take into account the monetary programming capacity of the central bank, the amplitude of overall liquidity movements, and the design of reserve requirements.
The monetary programming capacity of the central bank refers to its capacity to forecast changes in the composition of its balance sheet, especially foreign reserves, currency in circulation, and net credit to the government. Such forecasts are indispensable for an accurate estimation of the amount of liquidity the central bank has to offer at the auction. Forecasts must cover at least the time between two repo auctions, which links the frequency of auctions to the horizon of the forecasting exercise.
The reduction of the maturity of auctioned credit in Germany at the time of the 1992 foreign exchange crisis of the exchange rate mechanism (ERM) of the European Monetary System (EMS) illustrates the impact of the amplitude of the shifts in overall liquidity on the frequency of repo auctions. At that time, the Bundesbank shifted the maturity of auctioned credit from two to four weeks to one to three weeks, in order to cope better with large inflows of funds in the system resulting from an increase of its foreign reserves. The reduction in the maturity made it easier to adjust the amount of Bundesbank refinancing to changes in banks’ liquidity resulting from the interventions of the central bank in the foreign exchange market.
The reduction of the maturity of auctioned repos from two to three weeks to one week in France in 1992 illustrates the link between repo auctions and reserve requirements. At that time, the significant reduction in the amount of required reserves drastically diminished the latter’s stabilizing action on the volatility of bank reserves and, therefore, increased the volatility of short-term market rates. In order to stabilize money market rates, the central bank had to increase the frequency of its market interventions, which required an increased frequency in repo auctions and a shorter credit maturity.
(2) The Bundesbank introduced a new instrument at the beginning of 1993 to reinforce the structural dependence of the banking system on central bank refinancing. On March 1, 1993, the Bundesbank began to auction liquidity paper with three-, six-, and nine-month maturities, using an interest rate tender.21 In legal terms, this paper took the form of treasury discount paper of the Federal Republic of Germany, while the Bundesbank had to meet all interest and redemption commitments.22 Because these operations were open to all investors (banks and nonbanks, domestic and foreign), they allowed the central bank to influence nonbanks’ cash holdings directly.
The introduction of this new instrument was directly connected with a significant relaxation of reserve requirements.23 It enabled the Bundesbank to extend its scope for influencing financial flows by giving it an instrument to mop up liquid funds, not only from banks but also from nonbanks at home and abroad.24
(3) Following the 1992 ERM crisis, which resulted in large inflows of funds in the country, the National Bank of Belgium started using foreign exchange swaps on a large scale. This measure was designed to neutralize the impact of these inflows on domestic liquidity and maintain the dependence of banks on the credit of the central bank.
The declining quantitative role of standing facilities and the consequent shift toward market-based refinance instruments resulted in increased importance given to interest rate management in the conduct of monetary policy. As a consequence, monetary policy conduct also requires the use of fine-tuning instruments. The design of instruments must also take into consideration the exchange regime. Some additional conclusions related to the design of instruments are presented.
Interest Rate Management
The credibility of monetary policy is critical in the conduct of monetary policy with market-based instruments. Part of the credibility of a central bank depends on its capacity to take corrective measures and to make clear to markets the stance of its monetary policy. Moreover, market interest rates serve as an indicator of the daily management of liquidity in the system.
Need for Central Bank Rates
In all the countries in this paper’s sample, refinance instruments provide central banks with at least one official interest rate, whose level they decide. The publication and changes in official rates are used by central banks to make their intentions known. This practice has developed because of the increasing role financial markets play in allocating financial resources. It is also a consequence of a greater volatility in monetary aggregates, which has eroded confidence in them, because of shifts in financial assets resulting from disintermediation and financial innovation. As a result, central banks often prefer to indicate their intentions through changes in their official rates.
Use of Short-Term Interest Rates in Daily Monetary Management
Central banks often use market interest rates—typically, the call money rate in the sample countries—as an instantaneous indicator of the overall amount of liquidity in the system. In normal circumstances, an increase in market rates will indicate a tightening of liquidity, whereas a drop will indicate an easing. These indications will guide the central bank in fine-tuning the market.
However, interest rate fluctuations may also indicate anticipations that the central bank may or may not want to offset. To be able to discern whether fluctuations are the consequence of anticipations, or if they indicate a liquidity problem, the central bank must look at other indicators, such as the inflation rate, the balance of payments, the growth rate of monetary aggregates, and the exchange rate. Among them, the exchange rate is the one providing an instantaneous indication.
The manipulation of official rates, along with the management of short-term money market rates, helps make monetary policy intentions explicit and gives central banks the means to stabilize market expectations, thus reducing interest rate volatility.
Need for Fine-Tuning Instruments
Frameworks in which a short-term money market rate is the operational target for monetary policy require the use of fine-tuning instruments with which the central bank can influence market rates. Authorities can turn to such instruments either because they want to convey a new policy signal to the market without having to change their official rates, or because errors in the liquidity forecasts result in undesirable fluctuations in market interest rates. In addition, central banks need instruments designed to provide the system with the bulk of the liquidity it needs.
The experience of the countries sampled suggests that a single instrument cannot serve both needs. Fine-tuning instruments, to be effective, must be flexible, with an immediate and direct effect on a targeted interest rate. Instruments designed to provide the secular amount of central bank refinancing may operate with a lag period; they do not necessarily need to have a direct impact on the interest rate the central bank uses to monitor the market, and they can operate more indirectly than fine-tuning instruments. Typically, outright sales and purchases of securities on the secondary market or repo auctions are instruments designed to provide the secular refinancing, whereas repo operations and lending or borrowing by the central bank on the interbank market are used as fine-tuning instruments.
Influence of the Exchange Regime on the Use of Refinance Instruments
Refinance instruments are adapted to the exchange regime. In Belgium, France, and Germany, because of a fixed exchange regime, the central bank stands ready to buy or sell whatever amount of foreign currency is needed to stabilize the exchange rate. However, often the central bank wishes to offset the impact of foreign exchange market intervention on reserve money. For that, the central bank needs flexible instruments, either to mop up liquidity or to provide funds, and thus to compensate for the effect of its foreign exchange interventions. Repo auctions are used to this end, with the maturity of auctioned credit likely to be modified when necessary.
Because of limited liquidity and the depth of the securities markets in these countries,25 outright purchases or sales of securities on the secondary market would not cope with these flows with the same flexibility.
A pegged exchange regime, with a liberalized capital account, imposes also a strong constraint on the management of interest rates by the central bank. Because the exchange rate is not allowed to adjust, interest rates have to be flexible. This requirement for interest and exchange rate consistency reduces potential risks that could be associated with volume auctions, which allow the central bank to set both price and volume. Therefore, central banks in Belgium, France, and Germany must set the interest rate applying to the volume auction at a level consistent with the exchange rate they want to defend: their apparent freedom is actually constrained by market forces.26
Design and Interplay of Monetary Instruments
The sample countries have designed their refinance instruments in such a way as to provide an incentive to trade funds first on the interbank market and to prevent the central bank from taking a credit risk. Moreover, standing facilities play an important role in support of money market instruments. They also enhance the transparency of the central bank’s interventions and reduce their frequency. Finally, in some countries, reserve requirements also play a significant role in supporting other monetary instruments.
Incentives to Trade Funds First on the Interbank Market
In the sample countries, the interest rate on refinance standing facilities whose access in normal circumstances is not subject to a ceiling is above market rates.27 As a consequence, banks experiencing a shortage of funds will have an incentive to trade funds on the interbank market first, and to go to the central bank only after they have fully exhausted the possibilities offered by the market. Thus, commercial banks can access additional reserve money only when there is a global shortage of liquidity.
Different arrangements can be worked out to encourage banks to trade funds first on the interbank market. The Banque de France uses two instruments to allocate funds: an overdraft facility with a penalty rate provides funds to cover end-of-day clearing imbalances, and a repo auction provides the bulk of refinancing at a market rate. The Bundesbank uses three channels: a standing facility at below-market interest rates provides a fixed part of the refinancing, a repo auction provides the residual and variable refinancing at a market rate, and an overdraft facility with a penalty rate provides funds to cover end-of-day clearing imbalances.
Need for Collateral
All central bank refinance instruments are based on the temporary or outright purchase (or sale) of assets of indisputable quality, government paper as well as private paper. This practice not only protects the quality of the central bank’s assets, but also enhances financial discipline in the system.28 Equally important, it is a necessary condition to operate a repo auction: the interest rate of the auction should not be affected by different credit risks applying to different banks taking part in the auction.
Standing Facilities in Support of Money Market Instruments
Money market instruments are most effectively used as an instrument of monetary control when they are well coordinated with other instruments of monetary policy, in particular reserve requirements and standing facilities. The need for money market instruments to be supported by standing facilities is evidenced by the combination of these two instruments in all the countries reviewed.
Money market instruments cannot be effective if access to a refinance standing facility is unrestricted. If, however, the refinance facility is effectively shut, its safety valve function is lost, and the financial system could be subject to excessive shocks. Thus, the discount window can usefully supplement money market interventions by allowing enough access to provide some cushion against unexpected day-to-day liquidity shortages, but not so much as to offset the basic policy thrust or, at a more micro level, to hamper the necessary development of interbank markets. The use of standing facilities avoids throwing the whole burden of adjustment to unexpected money market shortages in the interbank market or to money market interventions of the central bank.
The support function of standing facilities is limited in countries with liquid money markets. Unexpected liquidity developments can easily be offset through discretionary operations of the central bank in the market. When the capacity of the central bank to forecast liquidity developments is limited and the money market is not liquid, the role of standing facilities is likely to be greater.
Standing Facilities: Transparency and Frequency of Central Bank Interventions
The central bank’s operations must be transparent, so as to put all its potential counterparts on an equal footing. Moreover, transparency enhances the central bank’s credibility. When standing facilities provide a “corridor” for interbank market rates, the central bank’s interventions are transparent. This consideration may be important when the interbank market is thin or when instruments and procedures for the use of money market instruments are inadequate. For instance, in nascent money markets, it may be difficult for the central bank to conduct outright sales or purchases of securities on the secondary market in a transparent manner.
Also, in nascent money markets, frequent—that is, daily—discretionary interventions of the central bank can be harmful to money market development. A constant presence of the central bank on the market could inhibit market participation because participants would be more willing to transact with the central bank than with other participants in order to avoid a credit risk exposure.
With liquid money markets, money market interventions can be conducted with transparency, and the need for standing facilities diminishes. The central bank becomes a participant in the market like any other participant, although its interventions, because they indicate the stance of monetary policy, will be closely scrutinized by participants. Provided that the central bank’s operations are not out of proportion with the market turnover—that is, they do not dominate the market—they can be used to influence market interest rates.
Use of Reserve Requirements
Central banks in most countries rely on reserve requirements as supporting instruments to complement or reinforce their open market interventions. Because required reserves are held on an average basis, they play the role of stabilizer of the money market, as explained above. When there are no reserve requirements (Belgium) or when their level is low (France), central bank interventions tend to be more frequent. In these countries, a continuous central bank presence on the market does not impede the smooth functioning of the market. However, in countries where commercial banks are not used to central bank interventions, such a continuous presence could well reduce market liquidity, because participants may prefer to transact with the central bank rather than trade funds in the market.29
Bids Proposed by Banks30
- Minimum rate accepted: 8.50 percent
- Global amount of liquidity to be allocated: 4,640
- Percentage of accepted bids to be allocated: 80 percent = (4,640/5,800)
|Bank A||Bank B||Bank C||Bank D|
|Accepted bids (interest equal to or greater than 8.50 percent)||2,100||2,000||1,500||200|
|Refinancing granted (80 percent)||1,680||1,600||1,200||160|
|Interest rate changed (percent)||8.50||8.50||8.50||8.50|
Interest Rate Preannounced
In this case, bids are supposed to be proposed at the preannounced rate. Banks will receive a certain percentage of their bids, corresponding to the ratio between the global amount of liquidity to be allocated and the total of bids presented by banks.
Bids Proposed by Banks31
- Global amount of liquidity to be allocated: 4,640
- Weighted average rate of bids: 8.84 percent
- Range of accepted rates: 8.50-9.00 percent
- Percentage of bids accepted at the cutoff rate (8.50 percent): 27.50 percent
|Bank A||Bank B||Bank C||Bank D|
|Bids at 9.00 percent||1,000||500||500||100|
|Bids at 8.75 percent||1,000||500||500||100|
|Bids at 8.50 percent32||28||275||137||—|
|Weighted average rate (percent)||8.87||8.79||8.83||8.87|
- Global amount of liquidity to be allocated: 4,640
- Rate of the auction (cutoff rate): 8.50 percent
- Percentage of bids accepted at the cutoff rate: 27.50 percent
|Bank A||Bank B||Bank C||Bank D|
|Bids at 9.00 percent||1,000||500||500||100|
|Bids at 8.75 percent||1,000||500||500||100|
|Bids at 8.50 percent33||28||275||137||—|
|Interest rate charged (percent)||8.50||8.50||8.50||8.50|
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Note: The author is grateful to several colleagues in the Monetary and Exchange Affairs Department for their most helpful comments and assistance in preparing this paper, in particular, Tomás J. T. Baliño, for his support and assistance during the project.
This point is of particular importance in the case of refinance operations backed by medium- or long-term assets.
Because assets accepted as collateral are not usually traded by central banks, the comparative advantages of a marketable collateral are not really crucial.
Before 1987, commercial paper accepted as collateral had to be deposited in advance with the central bank. To streamline administrative procedures, this technique was abolished and replaced by the present system of mobilization certificates representing eligible paper.
In the case of a volume tender with no preannounced interest rate, participants bid for both the amount and the rate. However, only bids proposed at or above the preset rate are accepted by the central bank.
The multiple-rate auction is also called the American auction whereas the marginal-rate auction is also called the Dutch auction. See Appendix I and Appendix II for an example of a repo auction according to each of these techniques.
Schnelltenders, or “quick tenders,” are used by the Bundesbank to provide liquidity for a short period to a few selected banks the day the operation is announced.
In the United States, changes in the discount rate often follow changes in the Fed funds rate and are used to establish a new floor for this rate.
Belgium’s overdraft facility is subject to a ceiling. Above the ceiling, banks may get funding at a higher rate, well above market rates.
The Banque de France no longer has a real discount window. It offers five- to ten-day repurchase agreements available at the initiative of banks.
These transactions do not require a delay between the negotiation of the transaction and the settlement of funds.
A similar mechanism applies in Japan.
The Bank of Japan is still rediscounting bills. Although in the past, the balance of rediscounted bills accounted for almost 60 percent of total credit outstanding, at the end of 1995, it accounted for a mere 0.4 percent.
In some countries (e.g., Germany), this could be considered a counterpart to a high, non-remunerated reserve requirement.
The level of subsidies granted by the central bank can be estimated by considering the spread between the discount rate and the market rate, and the share of refinancing granted through the discount window.
In practice, operations carried out under this facility are 15- to 60-day loans against collateral.
Eligible credits are rediscounted at a preferential rate (4.5 percent, 6 percent, or 7.5 percent), but the liquidity thereby allocated to the banks has to be immediately deposited at the central bank, in a blocked account bearing a market-related interest rate.
Facilities to assist banks experiencing a shortage of funds are called lender-of-last-resort facilities. This terminology may be used to refer both to instruments designed to finance end-of-day clearing imbalances and to arrangements designed to support problem banks. This section refers to the former.
Moreover, additional measures (such as intervention of the banking supervision authorities) may be appropriate in cases in which the demand for credit is highly interest inelastic, for instance, because banks and enterprises face soft budget constraints.
Commercial banks have to give prior authorization to the Bundesbank.
However, in Germany, and, to a lesser extent, Belgium, the rediscount window comprises a significant share of the refinancing. In France, outright open market operations contribute an increasing share of refinancing (30–40 percent).
Because these issues are designed to mop up liquidity for a period of time longer than the usual maturity of refinance operations, they reinforce the structural dependence of the banking system on central bank credit, provided mostly through repurchase auctions.
Section 42 of the Deutsche Bundesbank Act prevents the Bundesbank from issuing its own paper.
The effect on liquidity of the release of minimum reserves (DM 32 billion) was slightly greater than the impact of issuing liquidity paper (up to DM 25 billion at the first issue). The remaining liquidity surplus has been eliminated by reducing the volume sold at repurchase auctions.
The impact of these operations on central bank profits is not straightforward. Because the Bundesbank is at the same time providing refinancing for a short-term period (one month) and mopping up liquidity for a longer period of time, the maturity mismatch produces an interest rate exposure. When the first operations were initiated, the mismatch was profitable because of the profile of the yield curve at that time.
In a liquid market, a customer entering the market to buy a security can find a ready seller at the lowest ask price, whereas a seller entering the market can find a ready buyer at the highest bid price, and the highest bid and lowest ask prices are close to one another. The market for a security is said to be deep if a large amount of that security can be bought (sold) at a price close to the lowest ask (highest bid).
A similar argument could be developed in countries where the capital account is not liberalized. In this case, inconsistencies between interest rates and the exchange rate are likely to result in pressures on the balance of payments or the development of a parallel market. This outcome may motivate an increase in interest rates. However, the process may be faster in countries with an open capital account: inconsistencies between the exchange rate and the level of interest rates will induce capital outflows in the short run.
The interest rate applying to deposit standing facilities is below market rates.
In most central bank laws, central bank lending must be collateralized.
Additional reasons, such as a poor payment system and prudential considerations, may also recommend the use of reserve requirements in countries in transition. However, such an issue is beyond the scope of this paper.
All bids are in units of the domestic currency.
All bids are in units of the domestic currency.
Bids at the cutoff rate are prorated using the percentage of bids accepted at this rate (27.5 percent).
Bids at the cutoff rate are prorated using the percentage of bids accepted at this rate (27.50 percent).