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Liquidity and Money Market Operations

by C.A.E. Goodhart

Four main problems have been highlighted by recent crisis:-

(1) Stigma effect of ELA/LOLR

Most Central Banks (CBs) have run a version of a ‘Corridor’ system, whereby policy rate is maintained by a variety of market operations. Misses, and other pressures, limited by upper band, standing facility or discount window, and lower band, paying a positive interest rate on deposits at CB. But use of upper band, and LOLR, compromised by stigma, reputational effect.

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(2) CBs only control one price (interest rate); can they affect two, or more, points on the yield curve?

No problems arose in providing banks with as much cash as needed since the turmoil arose. Overnight money market awash with cash. Problem was overnight rates consistent with policy rate also consistent with one month/three month LIBOR rates at emergency levels.Can CB carry out Operation Twist, i.e. lend (Term Auction Facilities) at longer maturities, while withdrawing funds overnight?

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(3) Bank liquidity ratios have been continuously declining. Can/should this be reversed?

Commercial banking systems have been ‘putting’ the management of liquidity onto the shoulders of CBs. A worse ‘put’ than the Greenspan put.

(4) CBs saw credit crunch coming, but did nothing

Failure of will, or lack of instruments?Instruments:

(i) interest rates; predicated to price stability;(ii) CARs; procyclical.

Devise a scheme to improve issues (1), (3) and (4). The preferential access scheme (PAS).

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The Preferential Access Scheme

Objectives

1. to get rid of stigma problem;

2. to provide an instrument which can be varied over time to affect liquidity;

3. to give banks an incentive, especially in normal times, to hold adequate liquidity.

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Method

To have a corridor for each bank individually which is initially zero (i.e. free liquidity, apart from opportunity cost of using collateral) and widens out in a series of (probably equally sized) steps to the common corridor of plus, or minus, 100 b.p. (1%).

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Each step of length X would be X% of bank j’s £ (sterling retail deposits in UK bank) from a base (3? 6?) months ago. It is assumed that £ retail deposits can be legally identified. Why that base? Because those are the fragile depositors, and it protects UK located banks. Why back-date the base? To generate frictions to prevent gaming and artificial creation of £ deposits.

Borrowing, and deposits, could be at length up to 30 days, at rates shown per tranche. Not more than 30 days, since the size of tranche X could be varied by BoE at one month notice, (though normally left unchanged). Borrowing would need to be secured by collateral in normal way.

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Why does this help?

(1) The first, zero spread tranche is free liquidity, apart from opportunity cost of using collateral. Banks should normally borrow to get that advantage. So all UK retail banks would, almost always, be borrowing from BoE. The total amount borrowed, and marginal rate of borrowing, would remain secret, but should be easier to keep it thus. So the stigma effect should be much curtailed, if not eliminated, at least for UK retail banks.

(2) The choice of X is a policy variable (bounded between 0 and 100%). It could be raised in liquidity shortage periods and lowered during booms. This would also be a useful signal. (N.B. if adopted, the current choice of X would have to be worked out.)

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(3) The PAS has been drawn symmetrical. That is simple but not necessary. The length of borrowing steps could be shorter (or longer) than length of deposit steps.

(4) Why not flood UK (retail deposit) banks with free liquidity by making X huge? Indeed possible to do so in a crisis, but NZ recent experiment showed that risk averse banks will just sit on CB deposits, if there is little penalty of doing so. As UK banks get more liquidity, they must have an increasing incentive to spread it around.

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Long-run incentive to hold liquidity

The above deals with objectives (1), removing stigma, and (2), giving BoE an extra usable instrument, but not yet (3) an incentive to hold adequate liquidity.

Objective 3 can be tackled by stating that, once normal times have been restored, or by end 2008, whichever is sooner, X will be calculated as a % of each bank’s £ retail deposits, interacted with a variable which is a function of each bank’s prior assessed liquidity. My proposed liquidity variable would be the average of the coverage ratio (say at 1 week, 1 month and 3 months) at two prior dates (say 1 and 2 years previously). The aim would be to allow banks to run down their liquidity in crises without completely eliminating their future access to PAS.

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It would be important that each bank’s relevant coverage ratio (for the appropriate horizons) should be published and known, and that each bank’s access to PAS should also therefore be public knowledge. This should provide an incentive for all UK retail banks to keep adequate liquidity in normal times.

Banks without access to PAS, or those who had exhausted their PAS, could still access the normal upper band facility.