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Workshop: Indirect Tools for Monetary Operations –

Open Market Operations
Jhuvesh Sobrun
Monetary & Economic Department
Research & Policy Analysis
Bank for International Settlements (BIS)

Maputo, Mozambique
5 August 2009

The views expressed are those of the presenter and not necessarily those of the BIS


Part I
- Role of the Central Bank & Monetary Policy framework/scope
- Short-term interest rates as operating target: implications
- Rules-based instruments: direct instruments
- advantages v/s disadvantages

- Market-based instruments: indirect instruments

- Advantages over direct instruments
- Transition from direct to indirect instruments: conditions & phases

- Reserve requirements
- Demand for reserves (required (RR), settlement & voluntary reserves)
- Features (RR ratios, eligible assets, maintenance periods, lagged accounting)
- Remuneration v/s non-remuneration
- Reserves averaging (description & use)
- Functions & main problems

- Conclusion to Part I


Main roles of the Central Bank in the financial system

 Evaluate channels of monetary policy

 Plan scenarios, set the policy rate and communicate with other market

 Monopoly supplier of local currency

 Control liquidity & credit conditions (by using RRs, SFs & OMO)

 Carry out FX intervention to control relative value of local currency

 Lender of last resort to the banking sector

 Fiscal agent of the central government in the primary securities market

 Supervises banks (thru legal frameworks, regulatory ratios & sanctions)


Monetary policy framework and implementation

Operating Intermediate
Instruments Goal(s)
target(s) target(s)
Direct Financial stability
Base money Money supply
Market interest Inflation stability
Inflation rate
rates Growth
instruments: Exchange rate
Exchange rate Full employment
Lending/deposit Etc
facilities etc Competitiveness
Reserve etc
Disc. Mon. op.

Monetary policy framework and implementation (cont.)

To achieve its monetary policy goals (price stability, exchange rate
stability, growth, full employment, financial stability), the CB:

-sets its policy rate and

-uses instruments that it can directly control to indirectly influence its

operating targets (exchange rate, monetary base, market interest rates).

-These are often supplemented by data on intermediate targets (money

supply, inflation and exchange rate) for more visibility and timeliness (due
to lags in transmission channels (interest rate, credit, wealth, exchange

-Nowadays, most CBs rely on the money market to distribute liquidity

among banks at market interest rates


The scope of monetary policy

Commonly-used operating target

 Nowadays, most CBs conduct monetary policy via ST interest rates

 Well-functioning money market vital as formation of interest rates in interbank
market constitutes 1st step in transmission of monetary policy to financial
markets & real economy
 Exchange rate targets used by small open economies (HK, SG)
 Quantity targets (monetary base) used in some less developed countries

Implications of ST interest rates as operating target

 Advantages:
• They signal desired policy stance via the Policy Rate
• ↓ fluctuations in interest rates (pre-condition: transmission mostly
through interest rates and developed + efficient interbank markets)
• Can be used for Liquidity management operations

 Liquidity management operations are either:

• Supportive – influence ONLY the specific market rate targeted by
policy to keep it consistent with the policy rate
• Active – influence the specific market rate targeted by policy over and
above the impact of the policy rate –also called Balance sheet policy
• BSP implementable whatever the prevailing interest rate level

 Active liquidity management operations influence asset prices, yields &

funding conditions => substantial ∆ in size, composition and risk profile of
the CB’s balance sheet (more details in Part II & III)

Direct policy instruments (used in the good old times?)

 Rules-based: CB has regulatory power to set or limit prices (interest rate)
or quantities (credit)
 Aimed at balance sheet of banks

 They are:
 Interest rate controls
 Bank-to-bank credit ceilings
 Statutory liquidity ratios (hold % of bank’s liabilities as govt securities)
 Directed credits
 Bank-to-bank rediscount quotas
Use of direct instruments – 1998 to 2004


Case for direct instruments

 Best or only possible solution when:
• information is scarce (used to limit adverse selection)
• bank supervision & legal structures weak
• financial markets underdeveloped or at early stages of development
• Low market participation
• transmission mechanism of monetary policy is uncertain

 Relatively easy to implement & explain to politicians and the public

 Low direct fiscal costs (Statutory liquidity ratios)

 Easy to link with a monetary targeting policy (BUT monetary targeting relies on
strong & stable relationship over time between demand for money and supply of
money – not the case in reality)

 CB can more easily control flow of credit to banks or targeted sectors

 Supplemental instrument (to RRs) in transition periods or severe financial crisis

(help more distressed sectors)

Case against direct instruments

 Disintermediation (to circumvent them) => ↓ policy effectiveness & ↑ evasion

 Financial repression => ↓ bank-based savings & shifts from formal to

informal markets => Distortions

 Discourage development of interbank markets & secondary markets for


 Hamper & distort competition => ↑ costs in resource allocation

 Credit ceilings tend to ossify credit distribution & act as barrier to entry of
new players

 Over time, policies become less effective => multiplication of controls (↓

credibility) => complex, multi-tiered structures of interest rates and credit
controls which make situation worse


Indirect instruments of monetary policy

 Market-based instruments: they ∆ supply of banks reserves at
market-related prices

 CB determines overall systemic liquidity and market distributes it

 Roots: CB as monopoly supplier of high-powered money (i.e,

monetary base (M0),i.e, the MOST liquid and narrowest measure of
money supply)

 Aimed at the balance sheet of the central bank

 They are:
• reserve requirements
• Standing facilities
• discretionary monetary operations (OMOs, OMO-type


Advantages of indirect instruments

 Greater flexibility and larger choice of targets than direct instruments

 Encourage development and deepening of formal interbank markets

=> ↓ disintermediation

 => Financial innovation & technological developments => ↓

information & transaction costs

 Allow small, frequent changes in instruments & hence quick responses

to shocks & possibility to quickly correct errors

 Reliance on market forces => reinforce CB independence & credibility

 Improvement in investment and ↑ financial savings

 Indirect instruments & a well-functioning interbank market mutually

reinforce each other

Transition to indirect instruments: the conditions

 Stable macroeconomic environment, reduction of barriers to entry & elimination of
regulations restricting competition

 Sound and competitive financial system

• Otherwise, segmentation and heterogeneity => systemic crisis
• Well functioning interbank market & healthy banks assets => rapid
transmission of ∆ instruments to the banking system

 Modernized clearing & payment systems (to avoid volatility in reserves supply)

 Adequate supervisory and legal frameworks

• To foster prudent behaviour

 Requirements WITH proper enforcement on information disclosure

 CB autonomy (vital for its credibility) & sound fiscal policies

• Government should refrain from pressuring CB to keep interest rates low
to minimize fiscal costs

Transition to indirect instruments: the phases

 Phase 1
• a. Absorb any liquidity overhang (by using reserve requirements (RR))
• b. CB to help individual banks (to meet interbank settlement obligations)
• c. Creation of a credit facility to inject desired amounts of funds

 Phase 2
• Characterised by reduction of reliance on RR for sterilisation
• Introduction of primary market issuance (eg, OMO-type operations)
• Foundation stone for development of securities secondary market
• Adequate collateral important as:
• CB has to protect itself from incurring losses on its credit operations
• Without collateral, CB counterparties cannot obtain liquidity
• Combination with freer interest rates to facilitate money market development

 Phase 3
• Secondary market operations (OMO), use of standing facilities & further

Demand for Reserves (notes & reserve requirements)

Stylised CB balance sheet

Reserve money or
Base money or
Monetary Base

 Reserve demand = Currency + {required + voluntary + free (or settlement)

 Excess reserves = Settlement + voluntary reserves
 Voluntary (precautionary) reserves >0, if reserves are remunerated
 Free bank reserves = net foreign assets + net lending to government +
lending to banks + other items (net) – notes – required or contractual
(voluntary) reserves – liquidity draining operations

Reserve requirements
 Required reserves (generally fixed by CB & binding (compulsory))
• Defined as requirement for a bank to hold minimum current account
balances with CB (usually a % of its unsecured cash deposits)
• Only INDIRECT influence of ∆ interest rates (i) on required reserves
• ↑ i => ↓ demand for deposits as economic activity slows down => ↓
the base used to calculate required reserves
• Enforcement thru penalty interest rate (usually the lending SF rate) or
restricted access to CB lending facilities

 Excess reserves (non-binding; settlement + voluntary reserves)

• Opportunity Cost: no interest return or banks earn interest < market rates
• Size = fn (uncertainty on payment outflows (+), institutional characteristics
of payment system (+ or -), expected costs of overdrafts (+), market interest
rates (-), uncertainty about OMO (+), expensive standing facilities (+))
• Higher excess reserves ↓ impact of changes in RR

Settlement (free) reserves: NON-binding reserve req

 Exist as interbank payments usually settled via accounts at CB

 Better CB technical capacity & payment & settlement systems => ↓ free

 Liquidity mgt problems & high overdraft penalties => ↑ free reserves

 If not remunerated (opportunity cost) => banks keep minimum free reserves

 Remunerated free reserves (usually at deposit SF rate, normally < policy rate)
=> ↓ opportunity cost => free reserves ↑

 ↑ free reserves => liquidity surplus => trigger CB to↑ policy rate

 Free reserves usually high when CB’s balance sheet asset-driven (eg, when
govt borrows abroad and sells FX to CB; when CB makes net purchases of
FX to manage a fixed exchange rate regime and capital flows)

Features of reserve requirements

 RR with Uniform or differentiated ratios
• Applicable to domestic and foreign currency (FC) liabilities with different
• Differentiation – to attract or to discourage FC deposit inflows (v/s LC
deposits) or ST v/s LT deposits
• Countries (among which many African) using differentiated ratios have in
general higher RR ratios => ↑ risks of disintermediation
• Uniform ratios (CB neutral with respect to currency / maturity of deposits)
• Equitable, easier to calculate RR & to monitor
• Avoid shifts in deposits, ST capital flows & exchange rate pressures

 Eligible assets?
• Include: usually, deposits with CB (demand, time, FC), vault cash
(debatable – estimation problems)
• Exclude: government securities & OMO eligible instruments =>to avoid ↓
efficiency of monetary policy thru increased complexity

Implications of using FC deposits as eligible assets for RR

 RR on FC deposits:
• Reflects balance sheet structure of banks, hence of customer
preferences and even distrust in local currency
• ↓ the bias on LC deposits & exposure to capital flows
• If exchange rate unstable => reserves demand unstable & unpredictable

 FC deposits (% of total deposits) very big in many EMEs (esp. Africa)

• Common practice: RR on FX deposits in the LC, while corresponding
liabilities are in FC => ↑ exposition to currency risk

 LC depreciation => Banks have to ↑ reserve balances at CB => demand for

liquidity ↑ as banks forced to sell FC for LC or borrow liquidity from CB (at
high penalty rates) => CB has to carry out policy expansion (for eg, by ↓
policy rate) to counter liquidity shortage problems
• ↓ policy rate may => more depreciation (vicious circle!)


Features of reserve requirements (cont.)

 Maintenance period (MP) – period over which banks’ average holdings of
reserves are assessed relative to requirements (US: 2 weeks, JP: 1
month; ECB: 28-35 days)
• Function of CB’s passivity/activity in intervention to monitor liquidity
• Long MP => ease requirement conditions => ↓ excess reserves
• For determination of end-dates of MP:
• avoid days of high liquidity uncertainty (eg, tax payment dates)
• avoid speculation & volatility: alignment with policy decision
announcement dates

 Lagged reserve accounting

• Calculation of RR for next MP can be done before end-date of MP =>
helps banks plan reserve holding pattern in advance & build-up

 Carrying over excess reserve holdings into next MP => more smoothing,
esp. last day of MP (when O/N rate volatility is higher)

No Remuneration or RR remunerated below policy rate

 Income source for the CB = tax on the financial system => disintermediation
 Less income for banks => banks may ↑ spreads between deposit & lending
rates to clients to compensate for loss
 Remuneration rate = usually the policy rate for RR and deposit SF rate for
excess RR
 High remuneration => ↑ excess (voluntary) reserves
 No remuneration but high RR => ↑ comparative disadvantage of banks relative
to non-banks (who are not subject to RR)
 No remuneration, high inflation & lower interest rate differential with other
countries => ↑ real opportunity cost (ie, implicit tax burden) on FX deposits =>
disintermediation & capital flight
• ↑ domestic interest rates => ↓ interest rate differential => partial
compensation (deposits earn higher returns), but ↑ opportunity cost of “non
remunerated” deposits subject to RR v/s deposits not subject to RR


Reserves averaging (cushion effect)

 Banks can postpone reserves accumulation to a later date of the MP, except
last day of the MP => binding RR ONLY on the last day of MP
=> banks are indifferent between holding liquidity on different days of MP
(before last day)

 Averaging acts as Buffer to stabilize cash flows & limit O/N int. rate volatility

 Buffer effect more effective if :

• Longer MP
• RR binding enough to affect marginal reserves demand
• Combined with frontloading (ie, CB injects surplus liquidity early in the
MP to mop up excess later on) => ↓ funding liquidity risk for banks

 Contributes to ↓ excess reserves by acting as an indirect liquidity injection

 Critique: By offering Greater flexibility => poorer liquidity mgt => prudential

Features of reserve requirements (cont.)

Reserve requirement with averaging
Varying elasticity over maintenance period

Start of maintenance During maintenance End of maintenance

period period period
Rmin<= RR <= Rmax Reserves demand Reserves demand
Maximum elasticity of still very elastic inelastic
Reserves demand

Features of reserve requirements (cont.)

Buffer function of reserves averaging
under calm market conditions

“With averaging, before last day of MP” No averaging or “With averaging, last day of MP”

 DT = inverse aggregate demand for reserves; ST = supply of reserves; R =

daily average RR
 Flat part of DT curve (highly interest-elastic), ie, supply shocks do not affect
ST interest rate => RR varies without affecting ST int rate
 Non-flat part of DT curve = reduced interest-elasticity of DT

Functions of reserve requirements

 Buffer – stabilize cash flows & limit O/N int. rate volatility

 Liquidity management (when averaged & lagged) – facilitate interbank


 Monetary control: as reserve market management tool & built-in stabilizer

 Unremunerated RR => Introduce a wedge bet. SFd and SFc to discourage over-
lending => ↓ too fast credit growth - not much used (tax => disintermediation)

 Income source for CB (if unremunerated or remuneration < market rates)

 Supportive role for OMOs (“crude” liquidity draining/injection device)

 Prudential instrument in developing countries – ensure that banks have

sufficient liquidity in case of withdrawal of deposits – prevent bank runs

 Provide “automaticity” when financial markets shallow (& secondary markets

inexistent) competition still too poor for more flexible operations (like OMOs)


Main problems with reserve requirements

 Unremunerated RR => tax on banking system => disintermediation

 High RR put banks under pressure (penalty attached to non-fulfilment &

comparative disadvantage relative to non-banks)

 IF liquidity uncertainty ↑, banks tighten targets on their daily accounts =>

weaken RR averaging => liquidity effects emerge on other days of MP =>
“flat part” of demand curve disappears

 Blunt measure to control liquidity, esp. in the medium term:

• ↓ RR when liquidity shortage: too low RR => buffering effect too small to
be still significant
• ↑ RR when liquidity surplus => high RR => ↑ tax on banking system (if
not remunerated) => cost of liquidity draining ultimately supported by the
• Frequent changes in RR => disruptive & ↑ costs for banks (may affect
client rates on deposits/borrowings)

Reserve requirements in selected countries

RR on RR on
Averag- Remuneration of
Carry-over Accounting MP domestic foreign
ing excess reserves
currency currency
China No No Lagged 10 days 0.1 0.04 Yes
India Yes No Lagged 2 weeks 0.06 0.06 Yes (for > 3%)
Korea Yes No Half-lagged 1/2 month 0-7% 0-7% No
Brazil Yes No Lagged 2 weeks 0-45% 0-45% Yes
Kenya 0.05 0.05 No
Tanzania 0.1 0.1 No
Mauritius Yes No 2 weeks 0.04 0.04 No
South Africa Yes 0.025 0.025 No
Eurosystem Yes No Lagged 28-35 days 0.02 0.02 Yes
Japan Yes No Half-Lagged 1 month 0.05-1.3% 0.15-0.25% No
UK Yes No Lagged 1 MPC month Voluntary Yes (within + - 1%)
US Yes Yes Lagged 2 weeks 0-10% No
Source: Central Banks.

 RR on FC are actually maintained in local currency in most countries

 Less developed countries
 do not remunerate excess reserves – tax! => disintermediation
 RRs are much higher - income for CB
 Other indirect insts less effective - inexistent or shallow secondary markets
 High RR with no remuneration can be dangerous (disintermediation)

Conclusion to Part I
Rules-based instruments (=> disintermediation, distortions in the
allocation of bank resources and loss of effectiveness by the monetary
authorities) incompatible with today’s developed financial markets,
international trade and and liberalised capital markets.

Reserve requirements, when averaging is possible, are a good but not

best way to smooth fluctuations in short-term interest rates, and by
spillover, to the rest of the yield curve. Their effects are however not clear
over the medium-term.

Recommended for CB to use flexible, market-based instruments of

monetary policy that allow CB to control the supply of liquidity quickly and
on day-to-day basis. This is best achieved through the combined use of
standing facilities and discretionary monetary operations….

Part II
- Liquidity supply & CB balance sheet
- Autonomous factors & importance of liquidity management
- Problems with liquidity surpluses

- Standing Facilities
- Definitions & uses
- Credit and deposit facilities
- Features (maturity, collaterization, eligible instruments)
- Corridor system & stigma

- Discretionary monetary operations

- Definitions & uses
- Conduct & implementation
- Types: primary & secondary market issuance, repos
- Permanent v/s temporary liquidity injection/absorption
- Features (maturity, frequency of operations, auction techniques)
- Associated risk control measures

- Conclusion to Part II

Supply of liquidity
 Net supply of reserves or liquidity influenced by:
• Autonomous factors, ie, Uncontrollable changes to the CB’s balance
sheet NOT the result of its domestic liquidity operations
• Policy factors – its controllable domestic liquidity operations
A Central Bank’s Balance sheet liquidity position
Assets Liabilities = net sum of
Net foreign assets Currency autonomous factors
Net securities Bank reserves
• Required reserves =  Net foreign assets +
• Outright
 Credit to Government
• Under repo • Excess reserves
+  Other net assets
Lending to banks Government deposits
–  Government
Credit to government Liquidity draining operations deposits –  Currency
Other items net Capital and reserves
Net policy position (+ means inject, - means withdraw)
=  Bank reserves – Autonomous liquidity position

Importance of liquidity management

 Good liquidity forecasting smooth undesirable liquidity fluctuations - vital for
efficiency of OMO and SFs

 By adjusting level of reserves balances, CB can offset or support permanent,

seasonal or cyclical shifts in supply of reserve balances => effect on ST interest
rates & rest of yield curve

 Excess liquidity => ST int. rates ↓

• if ST interest rates too low, banks tempted to make riskier loans in search of
yield or refuse to take customer interest-bearing deposits => ↓ savings,↑
consumption & ↑ inflation

 If liquidity level ∆ a lot => ST interest rate volatility ↑ => this impedes on devlt of
LT end of mkt => risk-aversion ↑ & banks reluctant to take positions

 Both shortage & surplus liquidity => weak secondary market for securities


CB as LOLR & liquidity surplus

Central Bank’s Balance sheet
Assets Liabilities
Net FX reserves Currency in circulation
Net lending to govt Reserve requirements (RR)
Lending to banks Banks’ current accts excl. RR
• OMO Deposits, CB bills (OMO)
• SFs Deposits (SFs)
LOLR & lending to Capital & Reserves
“priority” sectors Other items
Other items

 Liquidity surplus usually characterised by:

• Large amounts of OMO & SF liabilities, but little or no OMO & SF lending
• Excess reserves in banks’ current accounts
• ↓ ST interest rates ( => ↑ inflation)
• Weakening exchange rate (if speculating banks seek higher FX returns or
think that domestic inflation will rise soon)

Why is structural liquidity SURPLUS not preferable?

 Liquidity-draining is costly to CB => ↓ CB profitability & independence

 CB carry out liquidity-draining by ↑ policy rate => -ve effect on credit growth

 Interference with transmission mechanism of monetary policy => liquidity

forecasting & monetary policy implementation complicated & imprecise

 Market segmentation – big banks attract all deposits while small banks are
short of liquidity

 Collusion between big banks to ↑ pressure on small banks => ↑ risks of

losses for CB => ↓ CB independence

 EMES: weak market infrastructure, lack of competition & insufficient voluntary

participation => CB unable to carry out efficient liquidity-draining
 Issuance of same securities by both CB & govt (to drain liquidity) =>
confusion & competition bet. them => ↓ CB independence in case of losses

Main sources of surplus liquidity

 Net FX reserves
• Commodity exports
• Foreign borrowing by govt (who sells FX to CB to obtain local currency)
• FDI (FX receipts sold to CB for local currency)
• Donor Funds (esp. in Africa: Ethiopia, Ghana, Malawi, Mozambique,
Uganda, etc)
• Remittances (esp. countries with large emigrated citizens)

 Main source in fixed or managed exchange rate regimes, as:

• FX stability perceived as key anchor for low inflation expectations
• Export-competitiveness important


Main sources of surplus liquidity (cont)

 Monetary financing (= lending to government)
• May be detrimental to CB independence => coordination is needed
• Better be in the form of marketable securities as then CB can sell
them in the market to drain liquidity

 Reduction in reserve requirements

• Crude measure of liquidity management (costly & disintermediation)

 Bank rescue (LOLR) – the case with the recent financial crisis ?
• Crisis => ↑ demand for liquidity as:
• Banks want to ↑ precautionary reserves
• Banks are reluctant to lend to each other
• If CB bails out a bank =>↑ CB assets => surplus liquidity
• If CB makes losses => may endanger CB’s independence

Standing facilities (SF)

 Usually come after use of discretionary monetary operations, in liquidity mgt plans
 At initiative of the banking system => CB does not enjoy full control
 SFs are bilateral (v/s most OMOs are multilateral)
 INDIRECT form of liquidity management (OMOs: direct approach)

 When SF rates low => SFs used as permanent LOLR facility (ie, => over-reliance)
• Over-reliance => moral hazard => danger to development of interbank
markets (CB’s SFs acts as rough substitute to interbank markets)
• Need for penalty rate & regulation
• However, Penalty rate may lead indirect stigma & discourage use when
appropriate (eg, the US at beginning of current financial crisis)

 Functions & Use

• Enhance CB credibility (bears a pre-specified interest rate – a commitment)
• Safety valve or back-stop: ↓ volatility of ST int rates around the policy rate
• Rate-setting or rate-stabilising: keep ST interest rate close to policy rate
• Used more often when other indirect instruments not very effective

Credit Standing Facilities (SFc; also called Lending facility)

 Form of liquidity injection

 Help meet reserve deficiencies & avoid end-of-day overdrafts => limit
pressures on overnight rates
 SFc > Market rates => market-ceiling rate for market rates
• if market rates threaten to rise above SFc, banks tend to borrow more
from SFc than from the market=> limit rise in market rates
 High SFc = signal of tightening monetary policy

 Often used as the penalty rate on unfulfilled RR commitments at end of MP

 Use of SFc ↑:
• When current accounts are not monitored properly => banks don’t meet
their RR, esp on last day of MP due to liquidity forecasting errors
• With credit rationing, market segmentation, liquidity hoarding (during
crises); ECB (1st week Oct 08: daily avg use of SFc went from 0.5 bil
euros to 21 bil euros)


Deposit Standing Facilities (SFd)

 Form of liquidity absoption

 Facility for banks to deposit remunerated funds at CB

 SFd < market rates => floor-setting for market rates

 SFd > O/N interest rate = signal of illiquid interbank market (less dev. countries)

 Less widely used than SFc (esp in developed countries – more often
characterised by liquidity shortages)
 When market-wide liquidity surplus => SFd ≈ policy rate

 Often used as the remuneration rate on remunerated excess RR

 Frontloading (ECB since Aug 2007) => liquidity surplus at beginning of MP => ↑
use of SFd; ECB (1st week Oct 08: daily avg use of SFd went from 1.5 bil euros
to 43 bil euros)


Standing facilities (SF) – cont.

 Sometimes, Credit available at subsidised rates, ie, SFc < Market rates
• May lead to Speculation on devaluation of LC => banks borrow funds (via
SFc) to purchase FX from CB, betting on speculative profits after devaluation
• May need additional supportive measures: rationing & CB close scrutiny

 Types of eligible instruments

• Short-term, mainly O/N (loans/deposits; repos/reverse repos, FX swaps,
outright sales/purchases of short-term securities or FX)
• Recent trends marked by broadening of eligible instruments

 Maturity of SFs
• O/N in most countries – serves “safety-valve” function
• Recent trends (financial crisis): ↑ maturity to ↓ rollover risks in interbank


Standing facilities (SF) – cont.

Quick overview of money market instruments & their uses


Collaterisation of SFs: floors & ceilings

 Hard floor: (no collateral needed) => SFd available to all banks without any
limit => (SFd < O/N rate)

 Soft ceiling: collateral needed for SFc => banks with non-eligible collateral
forced to borrow from the market => may cause market rates to ↑
=> (SFc < = O/N rate) – may pose problems during financial crises

 Physical location of collateral important as rapid access & transfer needed –

many SF settlements are “same-day”

 Use of collateral denominated in foreign currencies => micro- and macro-

prudential implications for > 1 country – need international cooperation

 Recent trends (financial crisis): broadening range of eligible collateral and

wider set of counterparties to facilitate effective distribution of CB funds
=> changes portfolio composition of CB’s balance sheet
=> CB more exposed to illiquid assets – risk control measures to protect
CB’s balance sheet against financial risks (haircuts, etc)

The Corridor Approach (SFc – SFd)

 Provides automaticity - CB can deal at both upper & lower bound

 Narrow corridor
• Use of SFd more attractive v/s interbank market for excess liquidity depositing
• Minimises interest rate volatility; best if stigma low or zero => ↓ need for
further fine-tuning operations
• Serves the rate-setting or rate-stabilising function
• Implies higher importance of RR averaging to contain rates within bounds
• Too narrow => ↓ incentive for banks to manage their liquidity via interbank
market & hamper its development
• Too narrow => moral hazard (no penalty) => over-reliance
• Necessary in financial crises with severely impaired interbank funding markets

 Wide corridor
• Safety valve: prob (market rates under-/over-shooting SF rates) ↓
• Encourage banks to fund themselves via interbank market instead of CB
• More room for interest rate volatility => ↑ need of fine-tuning operations
• => Lower use of SF as spreads between SFc and market rates ↑
=> ↑ holdings of voluntary reserves

Stigma negatively affects the effectiveness of SFs

 Banks go to interbank market even if more costly than to use SFs

 External: borrowing from CB is an adverse signal about creditworthiness as

SFs tend be associated with Emergency Liquidity (eg, US)
 Internal: if CB credit requires additional administrative procedures as SF seen
as deviation from normal routine
 High stigma & narrow corridor => ↑ prob market rates under-/over-shooting
SF rates
 Important for CB to communicate its actions clearly (eg, announcements
about liquidity operations should be separated from those about policy rate) =>
↓ stigma => SFs more effective

As of March 2007 Lending SF Deposit SF Ceiling Floor

Policy rate + 75 bp (since Policy rate - 75bp (since
Euro area Repo or collaterised credit Deposit
13/05/09) 13/05/09)
Indonesia Repo Deposit Policy rate + 300 bp Policy rate - 500 bp
Malaysia Repo or collaterised credit Direct borrowing Policy rate + 25 bp Policy rate - 25bp
New Zealand Repo Deposit Policy rate + 50 bp Policy rate
Singapore Collaterised credit Deposit O/N cash rate + 50 bp O/N cash rate - 50 bp
Taiwan Fixed rate loan Discount rate + 37.5 bp
Policy rate + 25 bp (since Policy rate - 25 bp (since
UK Repo Deposit
Oct 2008) Oct 2008)

Discretionary monetary operations

 Done at the initiative of CB with Voluntary participation of the banking
 Most flexible & widely-used tool by CB for liquidity management

 Can be used regularly or irregularly and in any quantity

 Influence interbank rates to ↓ volatility of ST rates, or to steer interbank

rates towards levels considered appropriate with the desired stance of
monetary policy & consistent with macroeconomic policies.

 Require a certain number of conditions to be effective

 Come with large choice of instrument-types, maturities, frequency of use

 Available thru various auction/tender formats

 Used in both primary markets (first-time instrument issue) and secondary

markets (trading of already issued instruments)

Conduct of discretionary monetary operations

 2 ways:
• Can be actively aimed at a given quantity of reserves, letting the
price of reserves fluctuate freely along with fluctuations in the
pressure on banks’ liquidity.

• Can be aimed at a particular market interest rate, letting the amount

of reserves provided at the central bank’s own initiative to be
determined passively as a function of demand at that price.

Conditions for implementation

 Well functioning interbank market & Liberalized interest rates
• No interbank market = NO issuance of securities & CB paper = no
discretionary monetary operation
• Interest rate controls => disintermediation

Conditions for implementation (cont.)

 Sound, competitive banks for rapid and efficient transmission mechanism

 Adequate book-entry, payment and settlement systems to build up confidence

& increase flexibility of operations

 Technical capacity of central bank – liquidity forecasting

• If a bank doubts quality of forecast, it will be reluctant to participate in an

 Effective banking supervision & CB autonomy (capital standards, doubtful

loans provisioning, collateral requirements, enforcement, financial reporting,

 Prudent fiscal policy: conflicts with debt management goals

• Monetary policy MUST be insulated from deficit financing & needs fiscal
discipline on the part of the government to be effective

Types of discretionary monetary operations

 Open Market-Type Operations (OMO-type)
• Issuance of CB paper or government securities in primary market => this
absorbs excess liquidity
• Direct borrowing/lending in interbank market with underlying assets as
collateral: eg, auctioning CB credit => this injects liquidity
• Difference with SFs which are at initiative of banking system (not CB)
• Transfer of fixed-term public entity deposits

 Open Market Operations (OMO)

• Outright purchases/sales of domestic currency assets in secondary market →
permanent (sales = excess liquidity absorption)
• Reversed purchases/sales of domestic currency assets (repos and reverse
repos) & foreign currency assets (FX swaps) → temporary (purchases =
liquidity injection)

Primary market issuance of CB paper & Govt. securities

 Risk-free => highly sought-after; Issuance to withdraw excess liquidity
 Most commonly-used OMO in developing countries and at initial transition
stages to use of indirect instruments – foundation for secondary markets

 Rough-tuning liquidity management

• Securities issued tend to have long maturities => not suitable for ST
interest-rate setting
• Banks may bid for liquidity management reasons not in line with CB’s plans

 Issuance of CB paper
• ↑ CB independence
• but in case of loss, may ultimately => ↓ CB independence
• Used when:
• separation needed bet. Monetary & fiscal policy goals
• CB more creditworthy than government or govt securities not available
• Coordination with Treasury needed to protect CB independence
• May be detrimental to development of active govt securities market

Primary market issuance of CB paper & Govt. securities (cont)

 Issuing government securities- coordination with govt debt manager
necessary as govt securities also used in fiscal policy
• Reserve neutral: CB reinvests proceeds of maturing securities into new
• Reserve draining: CB redeems maturing securities

 Coordination with government debt issuance

• 1 possible coordination solution: govt issues for structural liquidity
purposes & CB for temporary liquidity purposes, with pre-agreed limits
• If CB engages on LT structural issuance, advanced planning rather than
ad-hoc better (avoid uncertainties & disruptions)
• Makes sense to harmonise securities’ specification (same registry,
discount yield, collateral, etc)


Open Market Operations (OMO): Secondary market operations

 More flexible and larger choice of operations/instruments than primary market
• permanent (outright sales/purchases of securities & foreign exchange)
• temporary (repos/reverse repos, FX swaps, deposits & collaterised lending)
• Final impact on liquidity depends on depth of secondary market & CB has to
have adequate stock of marketable assets

 Even If No govt securities available or held by LT investors => secondary mkts

still allow CB to carry out OMOs by using private sector paper, CB bills and FC

 Permanent operations: best for basic/structural liquidity needs & if CB seeks to

impact on market price of specific asset => permanent ∆ in reserve balances

 Outright transactions: assets are bought or sold up to their maturity

• May hinder market development when secondary market thin


Open Market Operations (OMO): Secondary market operations

 Foreign exchange outright transactions
• Widely used in developing & transition economies
• Problem: spillover effects => better use repos of FX swaps instead
• In dollarised countries: FX transactions (permanent) may affect exchange
rate while FX swaps will not
• CB more exposed to settlement risk

 Temporary operations (reversible and more flexible): best for fine-tuning & if CB
does not want to influence market price of specific asset

 Collateral in reversed operations

• CBs tend to accept long lists of collateral to avoid endangering monetary
policy => risk control measures needed (more later)


Repurchase agreements (repos)

 Defined as ST collaterised loans (usually < 2 weeks & often O/N) arranged by
selling securities to an investor with an agreement to repurchase them at a fixed
price on a fixed date => no aggregate impact on price of individual securities

 Difference with collateralised borrowing: ownership of the securities is not

retained by the seller

 Repo = liquidity injection; reverse-repo = liquidity-draining

 Most flexible and common OMO

 Good for offsetting seasonal/cyclical fluctuations & when immediacy of response


 Play crucial role in reallocation of liquidity among banks (during normal times)

 Act as a safety net for smoothing interbank cashflows (in turbulent times)


Liquidity management options for the CB

 Permanent Liquidity Shortage (Surplus)
• Buy CB bills or government securities before they expire in the primary
market (issue new government securities or CB bills)
• Outright purchase (sale) of foreign exchange in the secondary market

 Temporary Liquidity Shortage (Surplus)

• Provide short-term collaterised loans (SFc) to banks (invite banks to deposit
short-term remunerated deposits; SFd)
• Purchase (sell) short-dated outright bills or foreign exchange
• Offer repo (reverse repo) transactions where the CB BUYS (SELLS)
securities from banks
• Purchase (sell) FX from banks and sells (buys) domestic currency to swap
them at a specified price at a given date (FX swaps) in the near future


Maturity of discretionary monetary instruments

 Short-term operations best if CB wants to affect ST interest rates or
the exchange rate and help liquidity management (market needs

 Long-term operations best (outright transactions) if CB wishes to

adjust market’s structural liquidity position

 LT operations not suitable to influence interest rates, as they can:

• Dilute the impact of monetary policy decisions
• => speculation
• Confuse the yield curve
• => pivoting, i.e, ST rates ↓ => distortions in yield curve
• if CB wants to drain liquidity => banks reluctant to participate


Frequency: Regular and irregular operations

 Regular (Eg: ECB’s MROs & LTROs)
• Operations conducted according to an indicative calendar
• Steer interest rates & signal policy stance
• Function of : Reserve averaging, OMO maturity, volatility & size of flows
of autonomous factors v/s size of RR, CB’s commitment to interest rate
• Eg: ECB: weekly Main Refinancing Operations (MRO)

 Irregular: at short notice & to react to unexpected shocks, with usually

much smaller group of banks (sometimes 1-to-1)
• Operations much faster than regular OMO; eg, fine-tuning operations
• To smooth effects on interest rates caused by unexpected liquidity ∆
• No standardised maturity; no indicative calendar
• Freq of use has ↑ significantly during recent financial crisis


Frequency: Regular and irregular operations (cont.)

 Frontloading and fine-tuning operations (FTOs) during the MP
• Frontloading: CB allots above benchmark (creates surplus liquidity) at
beginning of MP & gradually withdraws surplus until end of MP.
• Goal: generate expectations of interest target close to Policy rate on last day
of MP because:
• ↓ prob (banks would have to borrow in unsecured market at high rates if
they cannot use SFs)
• ↑ prob (banks fulfill their RR early in the MP)
• Problem: more volatility of ST interest rates on other days of MP

 Problems with irregular bilateral operations

• May not be visible, equitable and not distribute liquidity efficiently
• Signaling effect: 1 counterparty knows about the CB’s actions – competitive
advantage over other banks who might be less willing to participate as they
judge situation unfair

Auction techniques
 All discretionary monetary operations are conducted via auctions

 Standard tenders
• Regular; publicly announced by means of wire services; eg ECB’s MRO &

 Quick tenders
• Irregular; fine-tuning; little counterparties; may not be announced publicly in

 Most auctions characterized by allotment uncertainty; exception = full allotment

tenders (ECB since Oct 2008)

 Fixed rate or Volume tenders

• CB acts as signal receiver
• banks bid only for volumes supplied by CB at a pre-set interest rate
• If the aggregate amount bids received exceeds total amount of liquidity to
be allotted, submitted bids satisfied pro-rata
• => overbidding by banks which expect their bids to be pro-rated

Auction techniques (cont.)

 Variable rate or Interest rate tenders (Eg: ECB’s weekly MROs)
• CB acts as signal transmitter
• banks bid for amount and rate.
• CB charges the rates offered (multiple-rate auction) or the cutoff rate
(single-rate auction).
• Bids listed in descending order of offered interest rates. Bids with highest
interest rate levels are satisfied first

 Single rate auction (Dutch auction)

• Same rate applied for all successful bids – the last winning offer’s rate
becomes the current interest rate of auction
• Allotment interest rate commonly called the stop-out rate

 Multiple rate auction (American auction),

• Allotment interest rate is equal to the interest rate offered for each individual
bid => different rates on allotted bids


Auction techniques (cont.)

 Bid-to-cover ratio: number of bids accepted / number of bids that were
properly submitted in relation to the auction
• Gauge of the current level of desirability for the issue auctioned
• High ratio => high level of investor desire for the issue => high likelihood
that another similar auction would have good results
• In a full allotment tender (eg, ECB since Oct 08) => ratio =1
• Feature of full allotment tender: aggregate liquidity purely demand-driven
(no longer determined by CB)

Risk control measures with SFs & discretionary monetary operations

 Initial margins (used frequently with reversed transactions)
• Initial Margin = a % of the theoretical value of underlying assets
• Counterparties have to provide underlying assets with a value >= to
liquidity provided by the CB + value of the initial margin


Risk control measures with SFs & discretionary monetary operations

 Valuation haircuts
• Underlying asset value = market value of asset - a certain % (haircut)

 Variation margins (used for marking-to-market)

• haircut-adjusted market value of underlying assets used in liquidity-
providing reverse transactions have to be maintained over time, via
margin calls

 Valuation markdown
• CB applies a reduction of the theoretical market value of the assets by
a certain % before applying any valuation haircut

 Separate tranches of OMO for different classes of collateral (Fed)

 Limits in relation to issuers/debtors or guarantors and Exclusion

• To mitigate correlation risks

Use of discretionary operations in selected countries (up to March 2007)


Conclusion to Part II
Today, most CBs use some sort of OMO and to a lesser extent SFs in the
conduct of monetary policy. Differences are more on type & maturity of
instruments used, collateral used and frequency of operations. These are
influenced by the regime, the economic structure & openness, degree of
development of primary and secondary markets for securities, credibility &
independence of the CB as well as its’ expertise in managing liquidity and
the accuracy of its’ liquidity forecasts.

The current financial crisis has shown that having highly developed &
liberalised interbank markets and being able to use all sorts of instruments of
monetary policy available do not guarantee success. Enforcement through
regulation and cooperation with government debt management policy are
crucial, together with the need for the CB to make good forecasts of
autonomous factors and take necessary measures early enough to counter
any adverse shocks…

Part III

Financial crisis development stages

Major CB operations in advanced countries

Unconventional Monetary Policies (UMP)

Effects on Emerging markets

Effects on African countries


Main features of the current financial crisis

 Unprecedented in its global reach (main difference with past banking crises)
and Reactions of CBs (monetary policy easing to provide ample liquidity) & by
govts (fiscal stimulus and bank rescue packages)

 Consequences:
• Many advanced economies CBs have used up the usual tools of mon pol
(like policy rate cuts (cut to almost 0 in US & UK)) – had to resort to
unconventional monetary policies to provide liquidity => huge ↑ in size of
balance sheets & ∆ in composition (=> ↑ risks of losses for CB)
• Government interventions to restore confidence in banking systems &
safeguard flows of credit have affected public finances & raised questions
on their sustainability => large ↑ in sovereign credit risk, fiscal debt &

 Exit strategies (timing & scale), adequate legal & institutional frameworks,
disclosure of information by involved parties & differentiated resolution (to
minimize moral hazard) VITAL for success of interventions
• Success => direct effect on confidence & future credibility of policies

Development of the crisis (Aug 07 to mid-July 2009)

Stage 1 (8/07 – 3/08): funding liquidity shortage, bank losses & writedowns
 US subprime mortgage problems=> Loss of confidence & investor retrenchment
=> ↑ uncertainty => ↑ concerns about counterparty & credit risk => ↑ volatility =>
↑ Libor – OIS spreads (measure of liquidity risk) => 1st CB coordinated action &
introduction of USD swap lines

 Mounting writedowns & fears of downgrades => forced sale of assets in thin
markets => ↑ deleveraging & insolvency

Stage 2 (3/08 – 15/09/08): insolvency concerns & Lehman failure

 ↑ insolvency concerns => ↑ liquidity hoarding & more concerns over counterparty
risks => further ↑ in CDS spreads (meas. of counterparty risk) & ↓ equity markets

 Tightening collateral conditions => ↑ pressure on investment banks => failure of

Lehman Brothers (15/09/2008) => Turning Point (until then, CBs were concerned
with persistently high inflation & thus resisted cutting policy rates (except Fed)) =>
sudden escalation of fears of disinflation => drastic policy rate cuts to
almost 0 by May 09 in many industrialized countries

Development of the crisis (Aug 07 to mid-July 2009, cont.)

Stage 3 (15/09/08 – 10/08): market turmoil becomes a global crisis
 Lehman failure (LF) => crisis of confidence & ↑ mutual funds’ exposure to LF-
issued notes => forced liquidation of assets => ↑ demand for USD interbank funds

 LF => Use of Unconventional Monetary Policies by CBs & massive govt

intervention (guarantees, recapitalisation/nationalisation, asset purchases)

Stage 4 (10/08 – 03/09): Global economic downturn

 Questions arising about scope of govt intervention & impact on debt holdings =>
big pricing differences across capital structure => ↑ sovereign CDS spreads

 Fiscal stimulus plans to stimulate demand & growth

Stage 5 (since mid-March 09): signs of improving situation

 Unprecedented policy actions => stabilization of financial conditions & ↓ in
systemic risks
 ↑ optimism; ↓ volatility; ↑ asset prices; ↓ LT ylds; equity prices ↑ => ↓ Libor-OIS
spreads & CDS spreads
 Lending conditions still very tight, esp, cross-border lending

Spreads, equity prices and distressed conditions

LF => large ↑ in Libor-OIS spreads, writedowns & CDS spreads; big ↓ in equity prices
LF=> ↑ capital injections (esp. Q4 08 & Q1 09); ↑ govt share in Q4 08
Deteriorating credit quality => ↑ writedowns => ↑ deleveraging => ↓ credit growth
Domestic official support (=> ↑ Home bias) & FX swap market impairment =>
↓ cross-border funding => ↑ cross-border deleveraging affecting EMEs a lot
Concern over fiscal sustainability & tight lending conditions => CDS spreads still higher
than pre-crisis levels

Credit standards and bank loan growth

“Too” accommodative conditions from 04 to mid-07 (negative)

Severe liquidity hoarding but recently loosening lending conditions but still tight
compared to pre-crisis period
Significant slowdown in loan growth (US & XM) – signs that confidence still wary &
after-effects of deleveraging & home bias affecting cross-border lending
JP exception – helped by cheap cost of capital (almost 0 interest rates)

Volatility indicators

 Significant ↓ in equity & exch rate volatility after all-time highs after LF
(Sep 08); levels almost back to pre-crisis levels
 Bond volatility still high => effects of aggressive government intervention
(purchases of securities)

Major CB operations to counter the crisis (industrial countries)

 So far, 3 kinds of CB responses, by targeted objective:
• Achieve official stance of monetary policy (conventional liquidity easing)

• Influence wholesale interbank market conditions (conventional liquidity

easing, but unconventional in range & magnitude)

• Influence credit market and broader financial conditions (UMP)

• Credit (CE) – growth of asset side of CB balance sheet
• Quantitative easing (QE) – growth of liability side of CB balance sheet (∆
in bank reserves)
(UMP = Unconventional Monetary Policy)

 Results:
• Improvement recently (lower spreads & volatility & ↑ asset prices)
• huge ↑ in CB’s balance sheet & ∆ in composition
• => greater risk exposure for CB => ↑ threats to CB independence
• => ↑ importance of more coordination with fiscal authorities

Main characteristics of CB actions during the crisis

 Higher freq of fine-tuning operations (for more sensitive responses)

 More favourable SF lending facilities (help cap ST interest rates)

 Increased supply of LT funds (accommodate demand for term funds)

 Wider range of collateral & set of counterparties (improve access &

distribution of CB funds)

 Increased securities lending (underpin market liquidity)

 Increased reserves cushion (dampen fluctuations in reserves demand by

remuneration of RR & increasing tolerance range around target RR)

 Increased international cooperation (facilitate cross-border distribution of

liquidity, eg. FX swap lines)

 Direct funding & purchases (reduce systemic risks from impaired to

unimpaired markets)

Achieve the official stance of monetary policy (conventional MP)

 ↑ instability of reserves demand =>↑ flexibility (& volatility) in supply of

 Narrower corridor => ↓ interest rate volatility & ↑ use of SFs – safety valve
 Liquidity-draining operations:
• issuance of CB bills (BoE, SNB)
• Accept more ST deposits & Treasury deposits
• ↑ remuneration rate on RR to ↑ their attractiveness
 In line with CB’s LOLR to banks; difference on range & magnitude

Influence wholesale interbank market conditions (conventional MP)

 In line with CB’s LOLR fn; diff on wider range & magnitude v/s trad. levels
 Main goal: ↓ interbank market spreads to:
• Provide more term funding & Smooth distribution of reserves
 FX swap lines = facilitate FC provision; main balance sheet expansion factor
 Lending highly liquid securities against less liquid assets & doubtful collateral
=> ↑ credit & market risk for CB


Influence credit market and broader financial conditions (UMP)

 Main goal: alleviate tightening non-bank credit conditions – CB as LOLR Mostly at

stages 3, 4 & 5 (intensification before better conditions)
 Securities purchases – quasi-fiscal element => need more careful coordination
with debt mgt operations!!!
 QE when CB cannot ↓ int rates further as they are at 0!!! – assets purchase => ↑
deposits at CB => ↑ excess reserves that could be used for lending purposes
 CE focuses on mix of loans & securities held by CB => ∆ asset composition

How do UMPs feed into the real economy?

 Communication: conditional CB statements on future path of policy & objectives
=> ∆ inflation expectations & risk premia
• To avoid misinterpretations, CB to give broad info also in normal times about
factors expected to influence upcoming OMOs => ↑ familiarisation

 Quantitative easing (QE): ↑ reserves via pre-specified outright purchases of

government or government-guaranteed securities from banks
• Kicks in when policy rates = or close to 0 – instrument of mon. policy shifts
towards the quantity of money provided rather than int. rate
• Goal: ↓longer-term int. rate independently of risk & control inflation
• Affect market for risk free assets, typically longer-term govt bonds
• Problem: LT yields are already very low!!! Why lower them more?
• Example: Japan (03/01 to 03/06) – flood the market with excess yen liquidity
to ↑ inflation to +ve levels, while committing to zero int. rates.

How do UMPs feed into the real economy? (cont.)

 Credit easing (CE): ↑ credit flows via purchases of private assets in
specific sectors/markets or direct financing to corporate borrowers
• Problems: Credit risk & resource reallocation issues => “blurring” of
line between fiscal & monetary policy => danger to CB independence

 CE affects risk spread across assets between well-functioning markets

and those that are impaired

 Many CBs don’t distinguish QE from CE

 Endogenous credit easing (ECE): lending to banks at longer maturities,

against collateral that includes assets whose markets are temporarily
impaired via fixed rate tender procedures with full allotment (ECB)


Quantitative easing in Japan (March 01 – March 06)

 19/03/01: shift of operating target from O/N call rate to level of current acct
balances (reserves) at banks (changed 9 times until 09/03/06)
 Accompanied by outright purchases of LT JP govt securities
 Results:
• ↑ in BOJ’s balance sheet
• Lowering of term-structure of govt securities
• ↓ uncertainty about future funding & pickup in economic activity

Inflation (Y/Y % change) CAB (tr. Yen) Policy rates


Risks and challenges posed by UMP

 Inadvertent credit allocation to inefficient markets => constrain financial
sector restructuring in ST=> impair future economic growth

 Replacement of high-quality liquid assets with illiquid claims on CB

balance sheets => constrain monetary management

 Quasi-fiscal nature blurs distinction between monetary and fiscal policies

=> potentially compromise central bank independence

 Inflation potential of ↑ reserve money => ↑ inflation expectations in

response to some announcements of UMP
• Ongoing and detailed communication can help to reduce the risks


Effects on CB assets and repos

 UMP => large ↑ in CB balance sheet (Fed’s & BoE’s assets almost X3, by end-08)
 Reflection of aggressiveness of easing & nature of financial system
 Liquidity injection X4 for BoE & more than tenfold for Fed
 Highly volatile use of LT repos (from 0 to 100 %) – reflects high freq of LT fine-
tuning operations and their irregular nature

Effects on Central Bank asset composition (billions of national currency)

Fed & BOJ more active in
buying govt & private
securities than BoE & ECB

Stigma attached to use of

discount window in US
(before end-08) limited use
until then.
TAF => increase in use of
lending facilities

ECB & BoE use lending

facilities more intensively
than securities’ purchases
(more temporary v/s
permanent liq mgt)

Use of FC ↓ compared to
end-08, esp with BoE –
replaced by direct lending

Effects on interest rates & OMO in the US

 Policy rate almost 0

 Improving signs…
TAF has helped in
easing money market
 Massive liquidity
injections => Funding
spreads now very low
at all maturities &
less volatile => sign
of improving funding
 Bid-to-cover ratio ↓
=> urgent need to
borrow ↓
 Stop-out rate no
longer > min. bid rate
– growing investor

Effects on interest rates & OMO in the euro area

 Unlike US, policy rate >
0 (1% on 22/07/09)

 Funding spreads very

low at all maturities, but
still high volatility

 Fixed-rate MRO with full

allotment (since
15/10/08) to restore

 7 May 09: plan to

purchase covered bonds
=> ↓ spreads &
Fixed-rate MRO with full
allotment period
encourage LT funding

 Problem: instead of
lending, banks ↑ use of
deposit facilities…


Effects of government bank-rescue packages on 5-year CDS spreads

Unweighted average; in basis points

 Spreads have ↓ from peaks, everywhere

 Banks with govt support not doing better than those without support (Europe & UK)
 Consistency of govt guarantees important as lack of clarity slows banks’ efforts
to secure funding & dampen investor interest


Performance of major banks until late July 2009

 Mixed feelings, but
on the whole still in
 Uk and esp. US
banks in very bad
shape, in spite of
gov & private
support (except GS)
 Asia-based banks
globally in better

 Still high CDS

spreads – threat to
investors’ viability

Going forward: difficulty with assessing real impact of UMPs

 New “untested” environment (lack of experience) => calibration problems

 Assumptions based on past experience may not be a good guide for the future

 Transmission channels are impaired & unconventional: directed measures =>

distortions & interactions between standard & non-standard elements

 Lags & Durability of impact – is it going to last? How to unwind positions smoothly?
When to do so?

 Communication: misunderstood decisions => negative effects on economic agents

 Success depends on design & magnitude of the measures but also on the
willingness and ability of creditors to lend & of borrowers to borrow

 Density of different measures & international dimension of certain measures (FX

swaps lines) => uncertainty on which effects attributable to which measure?

Going forward: exit strategies

 Needed to give borrowers an incentive to return to interbank markets
• Should include retightening of funding conditions, traditional
liquidity-draining operations & RR readjustment

 Liquidity-draining options:
• Sale of securities outright; reverse repos ;↑ attractivity of bank
reserves holdings; Issue CB bills

 ST operations CAN be allowed to expire and rising interest rates will

act as a disincentive to continue to use the CB as counterparty

 LT assets- more difficult to offload

 More important for exit: TIMING of exit & NOT the unwinding of
balance sheet size


Going forward: exit strategies (cont.)

 Why? Because:
• Tightening “too early” => with low inflation, ↑ interest rates => ↓
inflation, investment & consumption
• Tightening “too late” => high inflation => large imbalances =>
another cycle of ↑ leverage & ballooning asset prices (base of
current crisis)

 Communication & clear explanation of policy decisions

• Very important for CB credibility
• Bad communication => ambiguous reaction to news & stigma
• Clear separation of monetary & fiscal policies to maintain
operational independence of CB


What about emerging markets?

 Pretty resilient until late 2008 (less developed financial markets, banks
with lower leverage ratios, strong domestic demand, high level of FX
reserves, lags in contagion effects)

 Downside risks materialize in early 2009

 ↓ trade volumes (& receipts) & ↓ commodity prices => ↓ macroeconomic

 Deleveraging (=> sale of EME subsidiaries & net capital outflows (home
bias & higher regulatory capital charges due to currency risks) => ↓ FDI
& credit-rationing => ↑ refinancing problems & insolvency pressures

 High external debt refinancing needs => EMEs very exposed to financial

 Strong & coordinated policy actions needed from EME policymakers


EME asset classes’ Heat map

 Pretty resilient until late 2008

 ↓ consumption in earlier-hit advanced economies => ↓ exports, production & sales
as revenues in EMEs ↓
 Spillover effects creeping in through the financial system (banks and corporates
facing funding problems)
 Downgrades & crowding-out effects affecting Sovereign spreads
 Growing uncertainty & loss of investor confidence affecting equity markets as
domestic conditions worsen

Emerging market high-frequency indicators

 Financial markets take full toll in Q4 08 => large depreciations to support exports
 Liquidity hoarding & fiscal stimulus sustainability uncertainty => ↑ sovereign
 ↓ equity prices & CDS spreads ↑ as confidence drops
 Bond yields ∆ a lot as uncertainty grows over authorities’ actions

Emerging market exposure to spillover risks from advanced countries

and CB balance sheet

 EMEs’ dependence on advanced economies ↑ in recent years – more exposed

to spillover effects due to lower demand in advanced countries (=> falling prices
and trade flows), liquidity hoarding, home bias, capital retrenchment (=>lower
FDI), lower donor and remittance revenues
 Large policy rate cut impact mitigated by ↓ inflation (=> real int rates constant) +
tighter funding conditions (more cautious banks & ↑ risk premiums)=> ↓ private
credit growth => need for UMP (=> ↑ CB assets)

Policy actions
 ↓ policy rates, RR and SFc↓ => expand liquidity provisioning

 OMO: ↑ repos => inject liquidity; OMO-type: US$ swaps or outright sales of FC
to local banks to counter ↓ cross-border bank funding
 Establishment of swap lines with advanced country CBs for some EME CBs

 International lending facilities (IMF’s Flexible Credit Line, modernization of

conditionality & simplification of lending terms)
 UMP: Directed private sector credit support (purchase of LT corp bonds &
deposit insurance schemes) => ↓ LT yields & ↑ confidence in local banks
 Govt support: guarantees to bank lending & spending on infrastructure (less on
personal tax reliefs)
• Problem: most packages currently programmed to wind down in 2010 &
levels below model-based baseline scenarios


Policy actions (cont)

 Limited effects so far: still tepid flows into EME assets & severely strained funding
& credit markets => deteriorating credit quality

 EME CB balance sheets have not ↑ like those of advanced countries

• reflection of tighter constraints on EME liquidity easing (higher external
vulnerability, shallower financial markets, conflicts between macroeconomic
and systemic stability objectives, and less firm CB independence)

 Firmer govt commitments on fiscal stimulus needed as EMEs do not have

extensive “automatic stabilizers” like in advanced countries (like unemployment
insurance, etc)

 Road ahead:
• More policy rate cuts & UMP (liquidity injection & credit flow support measures)
• more govt commitment to support banks & corporates (for liquidity and credit
needs), regulatory measures to facilitate creditor coordination
• Rely less on exports & promote domestic consumption/demand while avoiding
protectionist behaviors

Characteristics of Sub-Saharan African financial markets

 Shallow or undeveloped financial markets (CBs do not have many alternative
means to counter liquidity squeezes) => significant exposure to counterparty
risk, lack of collateral, deficiencies in the payment system, etc; this feature has
also limited contagion thru interbank markets & lower liquidity pressures
 Substantial liquidity buffers: large share of T-Bills & other liquid assets in CB
balance sheet
 Certain direct instruments & RR still widely used compared to other indirect
instruments & other regions
 RRs generally high, uniform across maturities & unremunerated
 Differentiated RR ratios between LC & FC deposits & Large share of FC
deposits as % of total deposits => destabilizing shocks on the money multiplier
are amplified => complicate CB liquidity management
 Weak & unstable domestic currencies; High & volatile interest rates & inflation
 High corruption, weak or non-existent CB independence & Heavy reliance on
revenues from export of commodities & raw materials, remittances, donor funds
& FDI from developed countries governments

Effect of the crisis on African countries (cont)

 So far, pretty resilient- limited integration with global fin markets, relatively high
bank liquidity, low leverage & limited reliance on foreign funding

 Like other EMEs, Africa exposed to spillover effects of financial crisis to real
economy & deleveraging from developed countries

 Oil exporters & financially more developed countries hardest hit initially

 Main concerns: Tightening of global credit => Capital & FDI inflow, tourism,
textiles & remittances revenues ↓; too thin domestic markets may not be able to
accommodate demand for credit =>↑ credit & liquidity risks

 Last hour: Outlook slowing improving (recovery in commodity prices & growth
prospects + return of risk appetite =>resumption of foreign portfolio inflows) –
Africa will benefit from these with delays, though…

 Risks remain: confidence still fragile, weak bank balance sheets, lower than
expected global growth, constrained international bank lending & questions on
fiscal sustainability of public sector support & exit strategies adopted in
developed countries that may have adverse effects on EMEs & Africa…

Sub-Saharan Africa : easing monetary & fiscal policies

 SSA countries have fewer & less effective policy instruments: fiscal multipliers are
lower, financing constraints more binding, debt sustainability issues more
pressing, monetary policy options limited by currency arrangements
 Countercyclical monetary policies:
 1st half: high commodity prices => tightening of monetary policies
 Since 2nd half: ↓ commodity prices => loosening of monetary policies
 Exchange rate depreciations may ↑ export-competitiveness, but may ↑ inflation


Effect of the crisis on African countries

 Less developed fin. markets => delayed crisis effects via ↓ commodity prices,
liquidity hoarding & capital repatriation by foreign banks & investors
 ↓ in commodity prices & demand and lower capital & FDI and remittances => ↓
trade flows => ↑ current account deficit & fiscal deficit & ↓ GDP
 Tighter global funding conditions => spillover effects => ↓ money supply
 Sovereign spreads back to pre-crisis levels after peaking around end-08
 Conditions in equity markets improving, but still a long way to go

Policy challenges within Africa

 No single recipe - circumstances differ so much across countries

 Priority for all countries : protect the hard-won improvements in

economic fundamentals - more sustainable debt levels, lower inflation,
liberalized trade and structural reforms & ST preventive measures to
minimize contagion
 ST priorities should not detract govts from the need for LT reforms to
build & diversify financial systems
 Fiscal stimulus MUST be used judiciously for countries enjoying
macroeconomic stability & sustainable debt levels
 Countries with deteriorated terms of trade: depreciate real exchange
rates to preserve macroeconomic stability while keeping fiscal and
monetary policies sufficiently tight to avoid a devaluation-inflation spiral


Policy challenges within Africa (cont)

 Early risk detection measures (stress-testing of banks)

 Closely monitor the balance sheets of financial institutions and be

prepared to act promptly if necessary
 Strengthen banking sector regulation, recapitalization of banks and
pursue prudent capital flow management
 Contingency plans => ↓ potential runs on banks & cross-border crisis
 Regional cooperation: implement emergency assistance programmes
(AfDB - Emergency Liquidity Facility, the Trade Finance Initiative and
other ways of support to low-income countries)

Conclusion to Part III

 Signs of improving situations indicate that unprecedented monetary easing
conditions & massive govt intervention are being successful in restoring
confidence & normalizing interbank transactions, although credit conditions
still remain largely impaired, esp, LT
 Current financial crisis has shed light on importance of:

 Good liquidity management by the CB, both in calm & turbulent times –
good & timely forecasting + ability to carry out operations with the necessary
tools independently & to communicate clearly its intentions (esp on UMP &
exit strategies)
 Need of close coordination between monetary & fiscal policies & the role of
govt support & UMP when conventional monetary policies reach their limits
 CBs to understand better asset-price & credit boom formation & associated
risks & take necessary measures to counter them in a timely & smooth

Conclusion to Part III (cont)

 Supervision & legal frameworks that prevent build-up of excessive leverage

 Contagion & spillover effects of crises stemming from developed financial

markets to EMEs
 Need for monetary & fiscal authorities in EMEs to come up with measures
to support local financial markets & corporates – shifts in production
patterns from export- & leverage-led growth models to more balanced &
diversified ones
 Strong policy commitments that resist protectionism & encourage an orderly
adjustment, by striking a balance bet. ST stimulus & exit strategies that
ensure LT sustainability
 System-wide macroprudential policies able to tackle procyclicality inherent
in the financial system & identify all risk sources & having the means to
counter/reduce them to ensure global financial stability

Thank you….


Supportive charts…

Investors confidence up: global risk appetite returning….

(based on survey data on risk appetite, investment time horizon, and cash position)

Source: Merrill Lynch.


Indicator of liquidity conditions (eg, depth of markets, narrowness

of bid-offer spreads, ease of execution, etc) = back to normal?

Source: Merrill Lynch.