4 Use of Central Bank Credit Auctions in Economies in Transition

Tomás Baliño, and Lorena Zamalloa
Published Date:
September 1997
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Auctions or tenders are used as means of allocating portions of central bank credit in many industrial and developing countries.1 In these countries, credit auctions are used in combination with other monetary policy instruments, including other central bank credit facilities, to manage bank liquidity or short-term interest rates. In a number of economies in transition from centrally planned to market-based systems, the central banks have begun to use credit auctions as part of broader packages of reforms to foster market-based monetary operations, promote money markets, and improve monetary control. However, while the monetary operations of central banks in market economies are supported by well-functioning interbank markets, adequate risk management—including the use of collateral—and effective banking supervision, these factors may be insufficiently developed in economies in transition.

This paper discusses ways in which credit auctions can be designed to reduce the negative impact of these deficiencies and presents the experiences of some countries in transition that have implemented credit auctions as one of their monetary policy instruments. It takes as its starting point the realities of many Eastern European economies, the Baltic countries, Russia, and the other countries of the former Soviet Union early in the transition process: economic and financial activity cannot be put on hold until enterprise restructuring is completed, commercial banks form the core of the financial system, and these banks are heavily dependent on central bank credit (Table 1). This dependence stems from the concentration of household deposits in the savings banks and of credits with the specialized commercial banks inherited from the monobank era and underdevelopment of interbank markets. These structural factors resulted in a need for central bank intermediation between banks and for extensive central bank financing of bank lending during the initial stages of transition (Sundararajan, 1991). However, as bank deposit mobilization has increased and interbank markets have developed, the authorities in many economies in transition have reduced the structural dependence on central bank credit over time.2 Nevertheless, policymakers are still faced with the challenge of designing central bank credit facilities that can ensure monetary control and at the same time foster a smooth transition toward market-based indirect instruments.

Table 1.Central Bank Credit to Commercial Banks, 1993–96
Eastern Europe
Czech Republic11.810.
Slovak Republic18.217.418.218.018.317.914.4
Former Soviet Union
Source: IMF, International Financial Statistics.Note: Share of central bank gross claims on deposit money banks over deposit money banks’ credit to the private sector and nonfinancial public enterprises.

Data starting in 1995 are based on a new classification and are not directly comparable to earlier data.

Source: IMF, International Financial Statistics.Note: Share of central bank gross claims on deposit money banks over deposit money banks’ credit to the private sector and nonfinancial public enterprises.

Data starting in 1995 are based on a new classification and are not directly comparable to earlier data.

Credit Auctions as an Alternative to Administrative Allocation

In most planned economies, credit was allocated administratively to specific sectors or borrowers at preannounced interest rates. The main disadvantages of this approach are that the use of directed credit is prone to misuse and abuse, the pricing of credit may be inefficient, and administrative allocation procedures tend to favor the state-owned sector and do not lay a foundation for more market-oriented financial systems. An auction-based allocation system can allocate credit transparently, based on objective criteria. In the absence of distortions, auction-based allocation mechanisms function efficiently; that is, they ensure that resources accrue to those that value them most highly and where they will be most productive (Feldman and Mehra, 1993). Furthermore, an auction-based system introduces market interactions and price flexibility, which can form a basis for further financial sector development.

When no restrictions are placed on the use of auctioned credit and on the interest rate in the auction, and when banks act rationally to maximize profits, central bank credit is expected to flow to banks that can make the best use of the available resources. Since the end use of funds will be determined by the commercial banks, the government will no longer be presumed to guarantee banks’ loans, and banks will be forced to develop their credit analysis capabilities. State-owned enterprises will be forced to compete with other bank customers in terms of both price (loan interest and expected project rate of return) and quality (reliability of returns).3

Furthermore, credit auctions can be an important component of the package of measures needed to liberalize and manage interest rates and improve monetary control in economies in transition.4 Regularly scheduled auctions introduce a market-based reference lending rate that can influence and guide the market as well as other central bank operations. Moreover, the central bank can control the volume of credit auctioned, taking into account other factors that affect bank reserves, and thereby influence either the level of bank reserves or the interest rate in the auction and in the interbank market.5

By introducing a flexible-price market in bank liquidity, auctions contribute to the development of the interbank money market and thereby pave the way for strengthening indirect instruments and phasing out any direct controls on credit and interest rates. Early introduction of credit auctions allows the central bank to gain experience in market-based monetary control and, as money markets develop, sets the stage for more sophisticated open market operations. As banks learn to assess liquidity conditions and price credit through participation in the auction, they will become more active in managing their reserve positions, thereby stimulating money market dealing. Furthermore, imposing uniform and transparent access to credit will force banks that have historically been supplied by directed central bank credit to look at other sources, including the interbank market.

However, some of the assumptions underlying the expected efficiency of an auction-based system may not apply in economies in transition. Possible impediments to the use of uncollateralized credit auctions in these economies involve deficiencies in incentives and information, which can increase the credit risk to the central bank and compromise the allocational efficiency of the auction mechanism. Credit risk may result from adverse selection—the tendency to attract banks willing to offer the highest bids but bearing the highest risks; and from moral hazard—the inability of the central bank to influence or monitor how the borrowing bank uses the funds.6 Collusion among auction participants or market dominance by a few large banks might also affect the efficiency of credit allocation.7 These problems could be more significant in economies in transition, where some banks may be insolvent, the banking system as a whole may not be competitive, banks’ accounting and reporting are insufficiently developed, and banks’ weak portfolios induce an inelastic demand for central bank credit, than in countries that use collateralized credit auctions in the context of well-developed banking systems and financial markets.8

Thus, there are potential advantages and disadvantages to using an auction mechanism for the allocation of credit in economies in transition. The next section will discuss how auctions can be designed to minimize the problems of adverse selection, moral hazard, and collusion.

Design of Auctions to Control Credit Risk

Adverse selection and moral hazard may be addressed by requiring adequate collateral, formulating appropriate access rules for the auction, and setting limits on the volume of central bank credit that each bank is allowed to borrow.9 Ideally, central bank lending should be collateralized by government securities or other high-quality paper, but in economies in transition, banks’ securities holdings are often negligible, particularly in the early stages of reform. In these circumstances, the collateral requirement can be introduced only gradually. Since a program to develop treasury bills and other securities is typically part of the transition strategy, some requirement of collateral is feasible and desirable even if it covers less than 100 percent of the loan. In addition, the range of admissible collateral can be broadened to include such assets as foreign exchange and banker’s acceptances.10 As the volume of treasury bills and government securities in the market increases, the rate of collateralization can be increased, gradually transforming the uncollateralized credit auctions into a repurchase auction.11

Rules of access are particularly important in the absence of adequate collateral. They must be uniform and transparent and should include compliance with all mandatory prudential ratios, including foreign exchange exposure limits; compliance with reserve requirements; satisfactory repayment record for previous credits; compliance with reporting requirements; and satisfactory performance in clearing and settling payments. Even under uniform and transparent access rules, current uncertainties underlying the computation of prudential ratios may temporarily limit the effectiveness of these ratios in screening banks. In addition to access rules, credit limits as a ratio (or multiple) of each bank’s deposits or capital could be set. Whereas setting a limit in relation to deposits might encourage banks to compete for deposit resources in the market, a limit in relation to a bank’s capital might encourage prudent behavior. However, there is a trade-off between regulation and competition. The need to limit central bank credit risk must be balanced against the need to ensure fairly wide access by banks so as to permit adequate competition at the auction.

In many countries, the auctioneer retains the right to screen bids and reject any that are deemed inappropriate. However, the option to reject a bid must be exercised judiciously to avoid diminishing confidence in the fairness of the auction or interfering with the price discovery function of the auction. Frequently, central banks set a minimum auction rate to increase monetary control, discourage recourse to central bank lending, or coordinate the auction with other central bank facilities. Setting a floor below the interest rate could also prevent banks from colluding to bid a low interest rate. However, announcing the minimum rate in advance provides a focal point for collusive bidding. Even if the minimum rate is not announced, participants may guess the level and their bids may cluster around the assumed minimum rate. Although this outcome may appear to demonstrate collusive behavior, widespread bidding at the minimum rate may also indicate that there is excess liquidity at the floor price.

While the best insurance against collusion and uncompetitive behavior is a dynamic and competitive banking sector, some auction procedures may reduce the likelihood that collusive arrangements can be sustained. These include using sealed bids rather than an open outcry mechanism; awarding credit at a uniform price; limiting the postauction sharing of information with bidders; and limiting the share of total volume offered for which any one bank may bid (see Feldman and Mehra, 1993; Guasch and Glaessner, 1993).

Ultimately, the design of an auction cannot insure against all risks, from both the credit risk and monetary control perspectives. Credit auctions are typically initiated on a small scale, allowing central banks to gain experience in monitoring borrower behavior in conditions of limited total risk. In any event, the likely alternative—administratively allocated credit—cannot control for these risks either. Economies in transition have long records of nonrepayment of directed credit. Administered allocation of credit led to outstanding loans being serviced through additional directed credit, a form of adverse selection in that the borrowers were those who could not repay previous loans. In the early stages of transition, assets in the portfolios of the newly created commercial banks were largely loans carried over from the previous systems of administrative allocation; of these assets, nonperforming loans were estimated at 15–20 percent in Czechoslovakia and Hungary, 20–30 percent in Poland, and 40 percent in Bulgaria (Calvo and Kumar, 1993). Clearly, credit risk is significant under administrative allocation. Furthermore, the potential for collusion between enterprises, banks, and officials may be worse under a system that explicitly allows discretionary allocation than under a rules-based auction.

Experience with Credit Auctions in Economies in Transition

Credit auctions have been used in Eastern Europe, the Baltic countries, Russia, and the other countries of the former Soviet Union. The following discussion surveys the use of this monetary instrument in these countries, highlighting its role in paving the way for the development of interbank markets and more refined open market operations.

Eastern Europe

The central banks of Bulgaria, the Czech and Slovak Republics, Hungary, the former Yugoslav Republic of Macedonia, Poland, and Romania have used credit auctions both as a means to extend structural credit and as an instrument of monetary control (see Table 2). For example, the Bulgarian National Bank auctioned one-month interbank deposits to inject and redistribute liquidity in the system. The liquidity need arose in part because of a lack of collateral that could be used to borrow from the Lombard facility; the redistribution need stemmed from underdevelopment of the interbank market coupled with the commercial banks’ lack of a deposit base owing to the large concentration of household deposits in the State Savings Bank (see Mladenov, 1992). The auction allowed the Bulgarian National Bank to replace some refinance credit with a competitive funding instrument and enabled banks to become familiar with auction procedures and interbank trading of deposits (see Filipov, 1992). The National Bank of Macedonia also structured its refinancing auction to redistribute excess deposits among commercial banks.12

Table 2.Credit Auctions in Selected Eastern European Countries
Country (Auction Period)Purpose, Frequency, volume, and MaturityRules of Access and CollateralLimits on AccessAuction Procedures

Bulgarian National Bank (BNB) (1991–94)
Banks bid on a pool of 30-day deposits contributed by the BNB and by commercial banks with surplus funds. Contributions to the pool from commercial banks were rare in 1991–92; most banks lend surplus funds through the interbank market. In 1993, the biweekly deposit auction consisted entirely of BNB funds. In 1994, while the relative importance of BNB credit to commercial banks decreased, this instrument was replaced with Lombard loans. In May 1994, the BNB began to auction repurchase agreements.Banks must have repaid outstanding debt from the previous auction. No collateral was required for auctioned credit.

Lombard loans and repurchase agreements are fully collateralized with treasury bills.
The BNB maintains targets in terms of the percentage of capital that banks may borrow. However, such targets are applied flexibly depending on the liquidity situation of banks and the BNB’s currrent monetary policy.Volume was announced one week before the credit auction. The BNB sets a floor interest rate. Deposits were allocated at the average rate bid; this average interest rate was the only information released after the auction. Specific information on bids received was kept confidential.

Repurchase auctions use a multiple-price method. Banks offer repurchases and BNB selects those offering the highest prices until the BNB’s volume target is met.
Czech Republic

Czech National Bank (CNB) (1993–94)
The credit auction is used for liquidity management and monetary control. Weekly auction of 1- to 12-week maturities until January 1994 and 1- to 14-day maturities thereafter. In 1992, auctioned credit represented over 67 percent of total CNB refinance credit (or 7 percent of base money); however, since late 1993, auctioned credit has become virtually irrelevant.

The CNB also conducts open market operations through one- to seven-day repurchase agreements on treasury bills.
Collateral on auctioned refinance credit was gradually increased from 40 percent of borrowing in 1993 to 100 percent in mid-1994; the collateral was structured as a repurchase agreement.

One- to seven-day repurchase agreements are fully collateralized.
Access is limited to the minimum of three times the paid-up capital of the bank and 20 percent of its credits to nonbanks.Banks may enter up to three bids in the credit auction. Credit is awarded to the highest bids, up to the aggregate volume desired by the CNB.

Repurchase maturities and rates are set by the CNB. and banks tender for an amount. Awards are prorated if the total requested exceeds the CNB target repurchase volume.

National Bank of Hungary (NBH) (1991–92)
The uncollateralized credit auction provided short-term refinancing to replace credit allocated based on banks’ capital. The biweekly auction of two-week credit was used as an instrument for short-term liquidity injection in parallel with central bank brokering of interbank deposits. Auctioned credit represented about 3 percent of central bank credit (0.5 percent of narrow money) at end-1991. The auction was discontinued in mid-1992 after failing to attract bids for several auctions. It was replaced by repurchase agreements in early 1993.1All backs and certain nonbank financial intermediaries were eligible to participate in the auction. No collateral was required for auctioned credit.The NBH reserved the right to exclude any institution from participation. In practice. the high minimum interest rate limited participation to the liquidity-starved larger banks.The uncollateralized auction was for a preannounced volume. A minimum interest rate was sel by the NBH so as to be above the interbank rate. Credit was awarded at the pnce bid (multiple price).
Macedonia, former Yugoslav Republic of

National Bank of Macedonia (NBM) (since 1993)
The auction was intended to replace the refinancing of directed credits at predetermined rates. An auction of deposits is held biweekly as needed; banks may offer deposits for resale through the auction, but in practice file funds have come only from the NBM. Initially, maturities offered were 14, 28, 56, and 84 days, but these have decreased to 1 and 7 days. The NBM has also purchased deposits. Selective credit refinancing was abolished in 1994. Auctioned credit volumes are determined by a reserve money program.Banks must meet reserve requirements and must be current on all auction-related obligations. Banks offering deposits for resale may specify banks with which they will not deal.

No collateral is required.
NBM Auction Committee sets limits on access based on each bank’s level of required reserves. Banks offering deposits for resale may specify limits on amounts they will sell to specific banks.The auction volume is preannounced. Banks submit sealed bids. Multiple bidding is permitted. A cutoff rate is set as the rate at which the volume offered and the volume bid come closest to matching. Credit is allocated to participants who bid above the cutoff rate.

National Bank of Poland (NBP) (since 1991).
A fully collateralized credit auction in the form of repurchase agreements was introduced for monetary control; in particular, the NBP sought to restrict banks’ access to funds provided passively by the NBP and to replace these with facilities operated at the initiative of the NBP. Initially, weekly auctions of repurchases with 14-day maturities were conducted to inject liquidity into the system. Since January 1993, reverse repurchases have also been executed; maturities of both instruments may range from 1 day to 14 days. The amount of auction credit outstanding has ranged as high as 7.5 percent of total refinance credit, but is generally much smaller.Repurchase transactions with the NBP are open only to primary dealers. These banks have current accounts at NBP and are dealers in the money market. Repurchase agreements are fully collateralized by NBP and treasury bills.The NBP reserves the right to reject some or all offers.The NBP announces the volume to be offered/ purchased and the discount rate to be used to value the securities. Banks bid a repurchase price. Expressed as an interest rate, the difference between this price and the discount rate is the criterion for ranking bids. Banks may submit multiple bids; awards are at the prices bid.

National Bank of Romania (NBR) (since 1992)
NBR conducts a weekly auction of one-week credits, which replaced directed credits. In the second half of 1992, because of a resurgence of directed credit the auction became inoperative. Short-term credit auctions were resumed in September 1993 at an initial volume corresponding to 14 percent of the outstanding NBR credit to banks. This share was 34 percent at end-1994, 27 percent at end-1995, and 29 percent at end-1996.The auction is open to all banks. Collateral has been required for all NBR facilities since August 1996.No formal limit is applied to a bank’s borrowing from the NBR. Initially, a limit was placed on the share of each auction for which any one bank could bid. The limit was nonbinding and has been removed. A ceiling on access to the Lombard (overdraft) facility was introduced in 1996.Auction volume and the minimum interest rate are preannounced one day ahead of the auction. Banks bid an interest rate for an amount of credit. The auction would use multiple-price allocation, but the tendency has been for banks to all bid at the cutoff rate except when there has been a significant change in the volume offered.
Slovak Republic

National Bank of Slovakia (NBS) (1993–94)
An auction of 30-day credits was held weekly, except when the NBS determined that no additional liquidity was required. At end-1993, refinance credit represented about half of NBS credit to banks, or about 8 percent of base money. In 1993 and 1994, during a brief period, Lombard and discount rates were set with reference to the auction rate. No auctions have been held since July 1994.

Since 1996, the NBS uses repurchase agreements with banks to manage short-term liquidity. These are arranged bilaterally with individual banks rather than on a tender basis.
Initially, no collateral was required. Since April 1994, 10 percent collateral in the form of treasury bills is required.Bids could not exceed 50 percent of the amount offered at that auction. There was no limit on NBS credit a bank could have outstanding.Volume was announced in the morning. By mid-day, banks submitted up to three bids by fax. Bids were ranked by interest rate; credit was awarded to the highest bidders at the cutoff rate.

State Bank of Czechoslovakia (SBCS) (1993–94)
Initially, an auction of 30- and 90-day refinance credit was held monthly. Maturities of one to seven days were introduced in January 1992. Short-term refinance rates were linked to the discount rate. During 1992, auction frequency increased to weekly, and 90-day credit was discontinued. In April 1992, refinance credit at a predetermined discount rate was discontinued, and the auction of refinancing credit became the primary indirect instrument of monetary control.No collateral was required.To ensure access by small banks, a bid limit was set at 50 percent of the volume offered in any given auction.Volume was preannounced. Interest rate determination was based on a uniform-price auction procedure at some times and a multiple-price auction procedure at others.
Sources: Central bank bulletins and annual reports; International Monetary Fund, Recent Economic Developments, various issues.Note: The information in this table was initially compiled in May-June. 1994 and updated in January 1997.

In 1993 and 1994, the NBH offered fixed rate repurchase agreements in practically unlimited amounts. In 1995, it selected volume limits to restrict the liquidity injected through this mechanism to the banking system. Repurchase agreements are fully collateralized with government securities.

Sources: Central bank bulletins and annual reports; International Monetary Fund, Recent Economic Developments, various issues.Note: The information in this table was initially compiled in May-June. 1994 and updated in January 1997.

In 1993 and 1994, the NBH offered fixed rate repurchase agreements in practically unlimited amounts. In 1995, it selected volume limits to restrict the liquidity injected through this mechanism to the banking system. Repurchase agreements are fully collateralized with government securities.

Most Eastern European countries have continued to allocate credit according to objective or administrative planning criteria in parallel with their credit auctions, sometimes to the detriment of the auction. For instance, the National Bank of Hungary began in 1991 to offer some refinancing loans at regularly held auctions. Over the next few years, an increased proportion of short-term refinancing loans was awarded through auctions, replacing allocation based on banks’ capital. However, long-term refinancing loans continued to be allocated for priority projects (Balassa, 1992). Similarly, the National Bank of Romania (NBR) began to auction some of its credit to banks in January 1992. In the latter half of 1992, government directives resulted in a shift of NBR lending to direct allocation of subsidized credits (for on-lending to the agricultural sector), and the auction became inoperative. In July 1993, government deposits were shifted to the National Bank of Romania to force banks to resort to it for liquidity, and the auction of short-term NBR credit was reactivated in September 1993.

Auctioned credit has been used as a monetary control instrument both through direct liquidity effects and through interest rate transmission mechanisms. For example, the use of auctioned credit allows the National Bank of Romania to retain short-term control over a significant portion of bank liquidity and to effect a tightening or loosening of its policy stance on a week-by-week basis. In a number of countries, Lombard and other central bank rates have been pegged to the refinance auction rate. The State Bank of Czechoslovakia linked the rate on its daily refinance facility (one- to seven-day maturity, allocated on the basis of bank capital) to the auction rate in 1992. In April 1992, the State Bank of Czechoslovakia phased out refinancing credit offered at the discount rate and made auctions of refinancing credit the primary indirect instrument of monetary control. The National Bank of Slovakia reintroduced lending at the discount rate; credit auctions were dormant for a period, but by mid-1994 auctioned credit accounted for about 40 percent of the bank’s refinance. No auctions have been held since July 1994 in light of its drive to absorb liquidity caused by capital inflows. In 1993–94, during a brief period, the National Bank of Slovakia linked the discount and Lombard rates to the refinance auction rate. Interest rates on its auctioned credit have generally been below the Lombard rate and above the treasury bill rate, while interbank rates have hovered around the auction rate. The National Bank of Hungary used to set its minimum rate for the uncollateralized auction above the interbank rate to encourage banks to participate in the interbank market.13

Interest rates on loans and deposits have tended to track the auction rate in most countries. The behavior of interest rates has not suggested that the auctions have attracted banks willing to pay any price with the expectation (or intention) of defaulting. Interest rates in the credit auctions have been responsive to changes in volumes auctioned and general liquidity conditions. For example, Romanian commercial banks have responded in the expected direction to central bank signals conveyed through the minimum acceptable bid rate (set by the National Bank of Romania) or the auction volume. In December 1993, the volume was cut for one week, resulting in a jump in the average interest rate. The National Bank of Romania raised its floor rate before the next auction, and banks raised their lending and deposit rates.14

In general, banks must comply with prudential and reserve regulations (to the extent that the central bank is capable of monitoring) to participate in auctions.15 In addition, some countries have introduced restrictions to widen participation and encourage competition in the auction or to prevent excessive credit risk exposure to particular banks (former Yugoslav Republic of Macedonia, Romania, and Slovak Republic).

There has been a trend toward increasing collateralization of bank borrowing from the central banks. The Czech National Bank gradually raised the level of collateral required for auctioned credit from 40 percent in late 1993 to 100 percent in June 1994, effectively becoming a repurchase facility. At the same time, banks holding bills of exchange had access to a rediscount facility at a rate generally below the rate of auctioned credit. The Bulgarian National Bank has not required collateral for the credit auction, but the increased availability of suitable collateral has reduced the need for credit auctions and increased the use of Lombard (backed by government securities) and discount (backed by bank letters of guarantee) operations at the bank. Moreover, it began using repurchase agreements in 1993 and during 1994 relied increasingly on this instrument, winding down the uncollateralized credit auction.16 Poland is an unusual case in that the National Bank of Poland moved directly to repurchase agreements soon after introducing treasury bills; the auction facility was thus fully collateralized from the start.

Uncollateralized credit auctions have diminished in importance as interbank markets have developed and commercial bank dependence on central bank credit has declined. The Bulgarian auction’s initial structural importance in intermediating between the State Savings Bank and other banks with less developed deposit-taking networks diminished as the interbank market developed. This, together with the introduction of treasury-bill-based open market operations for monetary control, allowed the outstanding volume of auctioned credit to be reduced from the equivalent of 17 percent of broad money at the end of 1991 to less than 1 percent at the end of 1994. At the same time, outstanding central bank credit to banks relative to domestic credit to the private sector declined to 9 percent from 21 percent. In Hungary, as the interbank market and other monetary operations developed, commercial bank dependence on credit from the National Bank of Hungary declined from over 40 percent at the end of 1991 to 30 percent in 1992, and the auction became unattractive, in part because of the high minimum bid rate in relation to interbank rates. In 1994, the Czech refinance auction mainly served small banks that lacked sufficient rediscountable collateral and that had limited access to the interbank market. As collateral requirements on refinance credit increased, this facility fell out of the reach of small banks. Czech interbank rates were at times well below the auction rate, reflecting liquidity problems experienced by a number of small banks and indicating adverse selection in the auction.

The developments in the countries surveyed suggest that, in the absence of adjustments in auction design, the riskiness of the credit auction may increase as the financial sector develops because the worthiest counterparties will seek financing in the interbank market. The central bank may in fact be assuming the intermediation credit risk that the market refuses to bear; while this may be justified in the early stages of market development, it is not a sustainable position. A decline in participation in the auction coupled with significantly higher interest rates in the auction than in the interbank market may signal a need to review the purpose and structure of the auction.17

The trends in Eastern Europe also suggest that certain aspects of credit auctions can diminish in importance as the banking system develops. In some countries, the auction may continue to fulfill a structural function in that it redirects some amount of credit toward banks that do not have the collateral necessary to participate in the other facilities and are not considered appropriate counterparties for interbank lending. In countries where conditions have improved, the focus of the auction has moved to short-term monetary control. The trend toward increased collateralization of borrowing from the central bank and increased recourse to interbank markets indicates that the use of an auction allocation mechanism is indeed in conformance with, and has probably helped foster, the development of these features of market-based financial systems.

At the same time, it should be noted that credit auctions have often been used side by side with direct instruments of monetary control; for example, even though Poland instituted a repurchase facility in 1991, bank-specific credit ceilings were not removed until 1993.18 A credit auction should be implemented as part of a carefully designed financial program. The case of Romania, where government-dictated credit allocations superseded auctions and led to monetary control problems, highlights the fact that commitment to the overall financial program matters more than the design of any one instrument. The early implementation of market-based institutions can support, but is not a substitute for, consistent and well-formulated macroeconomic policies; even well-designed monetary instruments will not prevent the loss of monetary control if political commitment to appropriate policies is absent.19

Baltic Countries, Russia, and Other Countries of the Former Soviet Union

Banking systems in the Baltic states, Russia, and the other countries of the former Soviet Union have been, in general, more fragile than those in Eastern Europe. Thus, the ex ante concern about moral hazard and loss of monetary control has been greater. Nevertheless, in recent years, many countries in this region, including Kazakhstan, the Kyrgyz Republic, Moldova, and Russia, have relied (or are relying) partially on central bank credit auctions to allocate credit and determine interest rates (see Table 3).20 Particular attention has been paid to elements of auction design, including collateralization, limits on participation, and the use of sealed bids.

Table 3.Credit Auctions in Selected Baltic Countries, Russia, and Other Countries of the Former Soviet Union
CountryPurpose, Frequency, volume, and MaturityRules of Access and CollateralLimits on AccessAuction Procedures

Central Bank of Armenia (CBA) First auction held in July 1993
Maturity of credits decreased from 9 months in 1993 to mostly 28 days in 1996. Initially, auctions were held irregularly, but now they are held twice a week. In 1994, few banks participated in the auction owing to a lack of secure lending opportunities. However, in 1995, credit auctions became the primary instrument for the CBA to manage liquidity in the banking system. After full collateralization was imposed, credit auction volumes dropped sharply. However, the rapidly developing interbank market had taken over many of its functions by end-1996. The CBA also participates in the interbank market.Participants must meet prudential norms. Since January 1996, central bank credit is fully collateralized.Initially, banks could bid for only up to 10 percent of the volume auctioned, but this regulation is no longer in effect. Credit obtained through the auction can be rolled over three times before it is repaid.The minimum interest rate was eliminated in 1996. Initially, a multiple-price auction method was used, but a uniform-price method is now being used.

First auction held in March 1995
Interbank credit auction. As of February 1997, held twice a month with maturities varying from 3 to 180 days. Earlier auctions were held less frequently. Amounts sold have usually been consistent with central banks’ credit policy. In late 1996, about 50 percent of total refinance credits were allocated through the auction.Participants must meet prudential norms; two largest banks are normally excluded from the auctionOpen outcry method used; auctions are conducted at Baku Interbank Currency Exchange (BICEX). The supply of credit is adjusted dynamically as the auction proceeds.

National Bank of Belarus (NBB) First auction held in February 1993; auctions were discontinued a number of times
Authorities planned to gradually replace directed credit with auctioned credit and to use the auction rate as the basis for setting the refinance rate. Auctions were held irregularly. Maturity of credits varied between two weeks and three months. In late 1995, the share of auctioned credit in total NBB new credit reached 83 percent. However, in 1996, almost all credit extended was directed to the agricultural and housing sectors.Interbank lending is collatoralized with a promissory note.Banks may bid up only to 100 percent of their paid-in capital Overall liabilities of a commercial bank may not exceed 20 times its capital.Credit auctions were conducted at the stock exchange The auction proceeded by gradually increasing the interest rate until only one bidder remained.

National Bank of Georgia (NBG) First interbank credit auction held in May 1995
In January 1996, the NBG expanded the range of maturities from 7-day credits to 30-, 60-, and 90-day credits, and increased the frequency of auctions from twice a month to twice a week. The NBG has started to use (interbank) credit auctions to influence liquidity conditions.Since July 1996, up to 90 percent of required reserves may be used as collateral.Bids are submitted before the auction, but banks may modify their bidding price at the auction. An auctioneer states a minimum interest rate for each lot, and then the auction proceeds by gradually adjusting the rate to equate supply and demand.

National Bank of Kazakhstan (NBK) 1992–96
The authorities gradually replaced most directed credit with auctioned credit. Initially, the maturity of credits was three, six, and nine months, but since 1995 maturity has varied between one and three months. Frequency increased from monthly in 1993 to thrice-weekly in 1995, However, in 1996, only three auctions were held.Participants had to meet prudential norms and repay previous borrowed credit on time. The NBK used treasury bills and fixed assets as collateral.Auctioned credit granted to a bank could not exceed 20 percent of auctioned volume, or more than twice a bank’s paid-in capital. Also, the overall amount of credit granted to a bank could not exceed five times its paid-in capital.Bids had to be submitted in sealed envelopes. The number of bids submitted by any one bank was limited to three. The NBK moved from a uniform-price auction method to a hybrid method and subsequently to a pure multiple-price auction method. The NBK used a floor price (refinance rate minus 5 points), which is known to commercial banks.
Kyrgyz Republic

National Bank of the Kyrgyz Republic (NBKR) 1993–96
The authorities gradually replaced directed credit with auctioned credit in two years. Initially, auctions were held irregularly, but from 1994 to September 1996 they were held weekly. Maturity of credit was mostly three months. Participation by mid-1996 had dwindled because sound banks had excess liquidity. The NBKR discontinued credit auctions in the fourth quarter of 1996.

The NBKR also provides 14-day credit through a standing facility that is fully collateralized.
Banks had to comply with prudential norms and reserve requirements and to present their balance sheet regularly. Initially, banks with overdrawn correspondent accounts were excluded from the auction. From April 1995 to end-1996, the collateral requirement was 50 percent of the credit granted.The cumulative amount for which a bank was allowed to bid could not exceed 50 percent of the auctioned amount. The overall amount of credit granted to each bank could not exceed 20 times its capital.Banks submitted sealed bids. The number of bids submitted by any one bank was limited to five. In July 1994, the auction method was changed from uniform to multiple price. Initially, the minimum interest rate was the clearing rate at the previous auction, but it was eliminated in July 1994.

First auction held in November 1993
The Bank of Latvia gradually replaced most refinance credit with auctioned credit. Auctions were held weekly. Maturity of credits was two months.

In October 1995, the Bank of Latvia replaced uncollateralized credit auctions with repurchase auctions Since December 1995, they are held daily and their maturity decreased from one month to one or two weeks.
Participants are required to meet prudential norms. No collateral was required.

Repurchase operations are collateralized with treasury bills.
The overall amount of credit granted to a commercial bank may not exceed 50 percent of the banks’ capital and reserves plus 5 percent of its deposit liabilities.Bids were submitted in sealed envelopes. A multiple-price auction method was used. The minimum rate is not preannounced.

In repurchase auctions, the Bank of Latvia announces the volume and the minimum acceptable rate.

First auction held in April 1993; auctions were terminated with the introduction of a currency board in April 1994
The Bank of Lithuania conducted auctions for structural and monetary purposes. In April and May 1993, the auction facility was used to provide credit to banks with reserve deficiencies. It was also used to extend credit to the agricultural sector. By March 1994, about 10 percent of the flow of credits was auctioned. Maturity of credits varied from one to two weeks.Banks were not required to meet prudential norms.Each bank was only allowed to bid up to 5 percent of its deposits (net of time deposits at the central bank). At times, the Bank of Lithuania relaxed this limit to extend additional credit to the agricultural sector.Bids were submitted by fax. A multiple-price auction method was used. Mo minimum rate was preannounced.

National Bank of Moldova (NBM) First auction held in August 1993
Since early 1995, almost 90 percent of the flow of credit is auctioned. Frequency of auctions increased from monthly in 1993 to biweekly in 1995, Maximum maturity of credit extended decreased from six months to three months in the same period.

The NBM also has a short-term standing facility at a penalty rate, but it is seldom used by banks.
Banks must meet prudential norms to access the auction. Since mid-1996, auctioned credit is fully collateralized.Each bank is only allowed to bid for up to 50 percent of the auctioned amount.Sealed bids are used. Commercial banks state the amounts desired and the interest rates offered. A uniform-price method is used. No minimum rate is predetermined.

Central Bank of the Russian Federation (CBR) 1994–96
Initially, auctions were held monthly. They were subsequently held in response to the CBR’s assessment of market conditions. The last auction was held in September 1996. Maturity of credit decreased from 3 months in 1994 to 7. 14. and 30 days in 1996. The CBR provides overnight and Lombard credit through a standing facility at a penalty rate.From late 1995, mostly primary dealers participated in the auction. Participating banks were required to observe CBR regulations on bookkeeping and prudential requirements, to have no outstanding overdraft or arrears with the CBR, and to have been registered for a minimum of one year in the CBR’s bank registry. Banks had to provide 100 percent collateral; acceptable collateral included government securities, hard currency deposits, and balances in correspondent accounts.Initially, no bank could borrow more than 25 percent of the amount allocated to the relevant regional center, but this restriction was subsequently removed.

Banks were subject to an overall borrowing limit equivalent to twice capital or to 10 percent of assets, whichever was lower.
Initially, each regional center was assigned a volume to be offered at the auction, but this restriction was subsequently removed. Bids were submitted only by banks’ head offices, to the appropriate regional center Participants submitted written bids. While a multiple-price auction method was used in 1994 and 1995 with a floor price equal to the CBR refinance rate, a uniform-price method was then used, and the minimum rate was eliminated.

First auction held in May 1993
The National Bank of Ukraine held one auction in May 1993 and one in May 1994. While in 1993 the auction was discontinued to provide directed credit, in 1994 it was stopped owing to a lack of secure lending opportunities for commercial banks. In 1995, targeted credit auctions were widely used to provide funds for directed credit. In 1996, general credit auctions were held as directed credit was phased out during the year.Since 1996, collateral is required for all auctions. Acceptable collateral includes treasury bills, municipal securities, and real estate.Bids were submitted in sealed envelopes. A multiple-price auction method was used. The minimum interest rate was the refinance rate.

Central Bank of Uzbekistan (CBU) First auction held in 1994
Interbank credit auction. Since early 1995, all refinancing credit from the CBU to commercial banks is extended through the interbank credit auction. (On occasions, the CBU has borrowed in the market to manage liquidity.) Daily auctions.Participants must meet prudential norms and must have paid overdue credits to participate in the auction. No collateral is required.Open outcry method is used.
Source: International Monetary Fund, Recent Economic Developments, various issues.Note: The information in this table was initially compiled in May-June 1994 and was updated in January 1997.
Source: International Monetary Fund, Recent Economic Developments, various issues.Note: The information in this table was initially compiled in May-June 1994 and was updated in January 1997.

The introduction of credit auctions for monetary management has been associated with a phased reduction in directed credits and in the structural dependence on central bank credit. Although initially the amounts auctioned were relatively small (generally less than 20 percent of the flow of credits), subsequendy, many countries gradually increased their use of the auction mechanism. By 1995, Armenia, Kazakhstan, the Kyrgyz Republic, Latvia, and Moldova had replaced most central bank refinance credit at fixed interest rates with credit auctions.

The auction mechanism has provided some flexibility in the implementation of monetary policy in this region. In Lithuania, the auction facility was activated at a critical time to provide liquidity at a penalty rate to banks with reserve deficiencies.21 Given the volume of directed credit dictated by the government in the Kyrgyz Republic, the net domestic assets target of the central bank was achieved by reducing the amount of auctioned credit. In Azerbaijan and Kazakhstan, during 1995–96, central banks substantially reduced the volumes auctioned in response to foreign exchange inflows. In Russia, before abandoning credit auctions in September 1996, the central bank activated them in response to its assessment of market conditions. In Georgia, the central bank has started to use the (interbank) credit auction to influence liquidity conditions. For instance, it increased the credit supplied at the end of 1996 in an attempt to drive down interest rates.

In countries where credit auctions played, or continue to play, a significant role in the conduct of monetary policy, the functioning of credit auctions was or has been enhanced through increasing the frequency of auctions and reducing the maturity of auctioned credit. Initially, auctions were generally held monthly, and the maturity of auctioned credits was about three months—relatively long for monetary control purposes, but shorter than directed credit had been. Subsequently, the frequency of auctions increased to more than once a week—for example, to three times a week in Kazakhstan and twice a week in Moldova—and the maturity of credits decreased to about one month. These steps increased monetary control and interest rate flexibility. However, if central bank credit auctions are too frequent, such as daily, they may actually hinder the development of the interbank market, because excessive intervention may prevent market participants’ direct interaction.

In a few cases, auction rules have been circumvented to provide additional auctioned central bank credit to a specific sector or bank. For instance, the Central Bank of Azerbaijan has often waived its own access rules with regard to large state-owned banks, and admission criteria have sometimes been applied discretionally. The Bank of Lithuania deviated at times from its own limits on access in order to provide additional credit to the agricultural sector. These procedures reduce transparency at the auction by mixing monetary and directed credit objectives; it would be preferable to use an administered window to provide such specific credits.

In some countries, such as the Kyrgyz Republic, Lithuania, and Russia, a minimum interest rate was established for the auction. For instance, the Bank of Lithuania rejected all bids at its first auction, indicating that the interest rates offered were too low. Bids at higher rates were offered and accepted at subsequent auctions. While in principle this may prevent low interest rates that are attributable to collusion, it may also reduce interest rate flexibility. For this reason, the Kyrgyz Republic and Russia eliminated the use of minimum interest rates.22

As noted earlier, collateralized lending and carefully defined access criteria reduce the potential for adverse selection in the auction process. In the absence of sufficient stocks of acceptable collateral in economies in transition, central banks in a number of countries initially introduced partial collateralization to limit the credit risk they faced. For example, in 1994, the Kyrgyz authorities required collateral equivalent to 10 percent of the loan.23 In addition, the range of admissible collateral in most countries was broadened to include, in addition to treasury bills, foreign exchange holdings, promissory notes, and some less liquid assets. Subsequently, as treasury bill holdings of commercial banks have increased, the quality of collateral has improved and the percentage of the loan collateralized has increased. For instance, auctioned credit in Armenia is now fully collateralized with treasury bills and Latvia now holds repurchase auctions.

In the absence of adequate collateral, it has also been desirable to limit commercial banks’ access to the credit auction. Countries have restricted access by requiring banks to meet prudential norms. For instance, in Kazakhstan, of 200 banks, only 50 met prudential norms in 1994 and were thus allowed to participate in the auction.24 In addition, to manage the credit risk exposure of the central bank, the central banks of some countries in this region have placed limits on individual banks’ access to central bank credit. For example, in the Kyrgyz Republic, the total amount of credit granted to each bank may not exceed 20 times its capital. In Russia, commercial banks are subject to an overall borrowing limit equivalent to the lower of twice capital or 10 percent of assets.

These safeguards appear to have achieved their purpose. Low participation in the Moscow region of Russia suggests that the central bank auction did not attract high-risk borrowers that had been barred from accessing the local interbank market. Although commercial banks in Kazakhstan and Uzbekistan defaulted on central bank credits, their central banks tightened credit auction regulations to prevent further losses. For instance, in Kazakhstan, in the context of a systemic bank restructuring program and even though the National Bank of Kazakhstan required full collateral for its credits, it experienced severe losses in 1995, which had to be written off. As a result, in 1996, credit auction regulations governing defaults became even more rigorous by introducing a penalty rate of 1.2 times the refinance rate and by suspending the defaulting party from future auctions. More important, these losses have not resulted in excessive monetary growth.

In some countries of this region, as in countries of Eastern Europe, uncollateralized credit auctions have diminished in importance as interbank markets have developed and commercial bank dependence on central bank credit has declined (Table 1). In Russia, for example, appropriate access rules coupled with excess liquidity in the emerging interbank market actually discouraged participation in the auction. This was observed in Russia in 1995, particularly in the Moscow region, as interbank market rates were substantially below the credit auction rates, which were representative of emerging regional interbank markets. While repurchase auctions are held daily in Latvia, there is frequently no demand for such credit, reflecting the high level of excess bank reserves and the ready availability of funds in the interbank market, where interest rates fell below the refinance rate in 1996. In the Kyrgyz Republic, the interbank money market started to play a larger role in bank financing in 1995, although its growth was hindered by bank solvency problems. At the same time, the use of central bank credit facilities (credit auctions, Lombard credit, emergency credit) has been constrained by the need to reduce credit growth while financing a sizable budget deficit. As explained above, in other countries, such as Azerbaijan and Kazakhstan, credit auctions have diminished in importance because of foreign exchange inflows.


This paper has examined the use of auctions as a means of allocating central bank credit. Central bank credit in economies in transition has often served both a structural and a monetary role and has been sizable in volume. The structural need for central bank credit has been reduced over time by commercial bank deposit mobilization, the development of interbank and money markets, and the development of securities markets to provide enterprise financing from outside the banking system. However, it was unrealistic to expect a rapid reduction in the dependence on central bank credit. Both administered and market-based allocation mechanisms have coexisted in most countries, even those that have depended primarily on indirect instruments for monetary control. Thus, at least some portion of central bank credit in economies in transition can be extended using a market-based allocation mechanism that will facilitate the subsequent shift to market-oriented instruments of monetary control; this can usefully be done early in the transition process.

Credit auctions can be effective as a monetary instrument; central bank determination of volume and access procedures allows control of liquidity expansion and influence over interest rates. However, unless the stock of central bank credit provided to banks through the auctions is already large and of relatively short-term maturity, the possibility of using credit auctions as a liquidity withdrawal instrument will be rather limited. Nevertheless, operated flexibly, auctions have the potential to allocate credit in an economically efficient manner and to provide the basis for the further development of money markets and more refined indirect instruments such as repurchase facilities. The price discovery process inherent in an auction provides a market-based reference rate that can be used both inside and outside the central bank. Elements of auction design regarding access rules, collateralization, and auction procedures can ameliorate or prevent some of the problems associated with information and incentive deficiencies.

The evolution from uncollateralized credit to fully collateralized indirect instruments and from excessive dependence on central bank credit to greater use of interbank markets requires an appropriate transition strategy. The experiences of countries in Eastern Europe, the Baltic countries, Russia, and the other countries of the former Soviet Union suggest that credit auctions can be part of such a strategy, providing a suitable instrument to effect monetary control and at the same time to promote the use of market-based indirect instruments. However, although auctions can serve as a catalyst for further market development, they also have their limitations. The central bank should not allow auctions to become a permanent substitute for an interbank market or to become the refuge of uncreditworthy banks after the other banks have moved on to interbank or deposit-based sources of funds.25 Use of a rule-based allocation procedure does not relieve the authorities of the need to implement consistent and well-formulated macroeconomic policies.

The early use of auctions should be associated with a phased reduction in directed credits and in structural dependence on central bank credit, as well as with further development in other areas of the central bank’s responsibilities, notably bank supervision and the payment system. As part of such packages of reforms, credit auctions in several Eastern European countries appear to have successfully paved the way for the development of interbank markets and more refined open market operations and do not appear to have resulted in excessive credit risk or monetary expansion. Similarly, in the Baltic countries, Russia, and many other countries of the former Soviet Union, commercial bank dependence on central bank credit has decreased over time as deposit mobilization has increased and interbank markets have developed. In these countries, too, the uncollateralized credit auction has paved the way for more refined instruments of monetary policy, such as repurchase auctions. In most cases, safeguards to limit central bank credit risk seem to have been effective in achieving their purpose. Moreover, the auction has provided an institutional basis for further market-oriented development in these countries.


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Money market operations in Belgium. France, and Germany can be described as credit auctions (see Chapter 3 in this volume). The central banks of Indonesia and Israel conduct daily auctions of reserves, while the central bank of Malaysia auctions government deposits, and the Bank of Norway auctions central bank deposits and short-term deposits at the central bank (Klein, 1994; Carting. 1994: Norges Bank, 1993). Credit auctions have also been used to on-leno multilateral development funds in countries such as Bolivia and Chile (Guasch and Glaessner, 1992).


In some countries, the authorities converted part of the outstanding central bank credit to long-term loans to be repaid in installments (e.g., former Czechoslovakia, former Yugoslav Republic of Macedonia, and Poland). The remainder was extended as short-term loans (including credit auctions) for monetary control purposes. In other countries, credit was gradually phased out as outstanding credits were repaid.


The increased responsibility of banks will also put them in a position that will both require and permit an increased level of monitoring, which could be expected to result in improved corporate governance.


Bredenkamp (1993) presents arguments in favor of the liberalization of interest rates in the Baltic countries. Russia, and the other countries of the former Soviet Union early in the transition.


At the same time, however, auctions must be viewed as part of a broader package of monetary control instruments. Although variations in the volume of credit auctioned can be used to withdraw liquidity from the system, effective monetary management may require other instruments to reduce excess liquidity when necessary.


Moral hazard arises because, to attain higher profits, the bank will feel compelled to lend for riskier projects or investments at higher rates, thereby increasing the probability of default (Guasch and Glaessner, 1993)


Although this by itself would not be expected to increase the credit risk to the central bank, the efficiency of resource use and the value of the auction rate as a reference rate would be diminished.


For further discussion of these issues, see Mathieson and Haas (1995).


While adverse selection in the auction can be addressed directly, the fungibility of money implies that the risk of moral hazard must also be addressed through improved bank supervision.


However, the use of foreign exchange as collateral could encourage banks and enterprises to hold liquidity in foreign exchange and may provide further incentive for dollarization.


This process will also create demand for collaterizable assets, reinforcing reforms in government finance such as the introduction of treasury bills and other government paper.


Through mid-1994, commercial banks had not offered funds through the National Bank of Macedonia. It is not clear whether banks perceive the National Bank of Macedonia as providing any implicit guarantee for interbank lending.


In mid-1992, the credit auction was discontinued and replaced with repurchase agreements at fixed interest rates. The National Bank of Hungary had difficulty controlling the volume of liquidity injected into the banking system through this mechanism, particularly during 1994, and as a result, in 1995, it set volume limits on this facility (National Bank of Hungary, 1995).


However, its minimum bid rate has provided a focal point for bidding, and possibly for collusion. In the first quarter of 1994, all bids tended to be at the minimum rate. As explained above, this may also indicate excess liquidity at the floor price.


The process of putting in place a supervisory regime need not be extremely lengthy and has in some cases been accomplished within the first few years of transition. Fully ensuring compliance may require further development of supervisory skills as well as restructuring of some banks.


However, in 1995 and 1996, in the context of a banking crisis, the volume of unsecured lending (at fixed interest rates) increased because weak banks lacked sufficient collateral.


It may also indicate that the auction is functioning as a lender-of-last-resort facility, suggesting the need to evaluate the condition of the banks still participating in the auction.


For a discussion on the joint use of both direct and indirect instruments in transition economies, see Hilbers (1993).


The establishment of an auction can provide a benchmark for comparison of actual behavior (e.g., use of the auction relative to use of directed credit) with professed commitment to market mechanisms. Even if the auction is not operated ideally, it can give reformist groups (as well as bilateral and multilateral donors) an opportunity to point out backsliding.


For example, in Georgia and, in particular, Azerbaijan and Uzbekistan, the central bank participates in the interbank credit auction, providing most of the funds More recently, in Georgia, commercial banks have started to supply their excess funds to the auction


While interbank rates ranged from 7 percent to 9 percent a month, the rate at the auction was about 13 percent.


In Lithuania, auctions were terminated with the introduction of a currency board in April 1994.


Although credit auctions were fully collateralized in Russia, the effective rate of collateralization could have been lower. Legal constraints limited the effectiveness of collateralization, because in principle, Russia’s legislation on collateral permitted the pledger to retain control (and possibly dispose) of the assets until the loan was actually in default.


After the authorities implemented a systemic bank restructuring program during 1995–96, the number of banks eligible to participate in the auction was further reduced to 19.


One way to avoid this is to increase the rate of collateralization.

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