Central Bank

Week 3 – EC-304
Central Bank
• A central bank is a financial institution given privileged control over the
production and distribution of money and credit for a nation or a group of nations.
In modern economies, the central bank is usually responsible for the formulation
of monetary policy and the regulation of member banks.
• Central banks are inherently non-market-based or even anti-competitive
institutions. Although some are nationalized, many central banks are not
government agencies, and so are often touted as being politically independent.
However, even if a central bank is not legally owned by the government, its
privileges are established and protected by law
Functions of CB
• A central bank can be said to have two main kinds of functions:

(1) macroeconomic when regulating inflation and price stability and

(2) microeconomic when functioning as a lender of last resort
Backbone of Economy
• A central bank is a financial institution that is responsible for
overseeing the monetary system and policy of a nation or group of
nations, regulating its money supply, and setting interest rates.
• Central banks enact monetary policy, by easing or tightening the
money supply and availability of credit, central banks seek to keep a
nation's economy on an even keel.
• A central bank sets requirements for the banking industry, such as the
amount of cash reserves banks must maintain vis-à-vis their deposits.
• A central bank can be a lender of last resort to troubled financial
institutions and even governments
Current Trends
• https://www.elibrary.imf.org/display/book/9781557750570/ch03.xml
State Bank of Pakistan & Monetary Policy
• It is mainly through money and foreign exchange market that SBP implements
its monetary policy stance. To implement its monetary policy, SBP
operationally focuses on controlling short-term interbank interest rate –
overnight money market repo rate – through the use of various monetary policy
tools (OMOs, Interest Rate Corridor, Reserve Requirements, FX Swaps, etc.).
• The short-term rates translate in to other longer-term market interest rates, such
as KIBOR, that are used as benchmark for lending to businesses and
households. In the transmission mechanism, efficient financial markets
increase the efficiency and effectiveness of monetary policy transmission by
reducing various uncertainties and improving translation of short-term interest
rates to pricing of longer-term loans.
Monetary Policy Tools
• 1- Open Market Operations
Open Market Operation is a tool used by a Central Bank (or monetary authority) to
inject or mop-up funds, based on the liquidity requirements, from the banking
system via the purchase or sale of eligible securities.
OMO
• - Operationally, in case of OMO (Injections), SBP lends funds to banks/PDs against eligible collateral to address
liquidity shortage in the system. In OMO (Mop-up), SBP sells MTBs to banks against funds to remove surplus
liquidity from the system.

- SBP conducts four types of open market operations (OMOs) to manage system’s liquidity:
• Injection – Reverse Repo (Govt buys)
• Mop-up – Repo (Govt Sells)
• Outright Sale or Purchase (long-term liquidity mgt.)
• Bai-Muajjal (Islamic mode - Deferred Payment)
• - Eligible Collateral: For OMO (Injections) marketable government securities (i.e. MTBs and PIBs) are eligible
securities. For OMO (Mop-up), SBP sells MTBs (on repo or outright basis) to banks for removing excess liquidity
from the system. In case of Bai-Muajjal, a Shariah compliant tool for managing liquidity in the Islamic banking
system, GOP Ijara Sukuk are eligible securities.
• - Eligible counterparties: Banks and PDs are eligible counterparties to OMO transactions. For Bai Muajjal
transactions, Islamic banks and specialized Islamic windows of conventional banks are eligible counterparties.

- Tenors: There is no restriction on SBP in terms of tenor of conventional OMOs. However, usually SBP conducts
OMOs of shorter tenors (e.g. 7 to 14 days)
2- Islamic OMOs - Bai Muajjal
• Background:
• - SBP introduced OMOs for IBIs in October 2014. Under these OMOs,
SBP can purchase GOP Ijara Sukuk (GIS) on deferred payment basis
(Bai-Muajjal) for a tenor of up to 1 year and sell GIS on ready payment
basis; using competitive bidding auction process. These OMOs
provide SBP a tool to manage excess liquidity available with IBIs and
improve effectiveness of monetary policy transmission in the absence
of regular Sukuk issuances by the GOP.
• Mechanics of Bai-Muajjal Transactions:
• Under the Bai Muajjal transaction, SBP invites quotes from IBIs to sell their
holding of GOP Ijara Sukuk on deferred payment basis to SBP.

• SBP evaluates and accepts the quotes of participants based on a cut-off price.

• Successful bidders transfer their GIS holding to SBP on the deal date (which is
usually same as auction date). It is important to note that SBP does not pay any
cash to the successful bidder at this stage. Rather, SBP only pays the deferred
price to IBIs on settlement date (i.e. after one year)
3- Interest Rate Corridor
• - SBP Target Policy rate: SBP Target policy rate is a single policy rate
that unambiguously signals SBP’s stance of monetary policy to
achieve macro‐economic objectives with price stability. The SBP Policy
Rate is set between the SBP standing facilities - Floor and Ceiling of
the interest rate corridor. SBP aims at keeping the money market
weighted average overnight repo rate close to the SBP Target rate
using liquidity management tools, mainly OMOs and outright
sale/purchase of government securities.
• Standing facilities aim to provide and absorb overnight liquidity,
signal the general monetary policy stance and bound overnight
market interest rates within the acceptable levels. Two standing
facilities are available to eligible counterparties on their own
initiative. These include SBP Reverse repo (Ceiling) facility and SBP
Repo (Floor) facility. At present, the width of the Interest rate corridor,
that is, the difference between the ceiling and the floor rate is 200bps
• SBP Reverse repo (Ceiling) rate: At times of liquidity shortage,
scheduled banks, PDs and DFIs can access SBP Reverse repo facility to
borrow funds (against eligible collateral) from SBP on overnight basis
to meet their liquidity requirement. At present, the Ceiling rate is
50bps above the SBP Target policy rate i.e. the key monetary policy
rate
• SBP Repo (Floor) rate: At times of excess liquidity, scheduled banks and
PDs a can access SBP repo facility to place their surplus funds (against
eligible collateral) with SBP on overnight basis. At present, the floor rate
is 150bps below the SBP Target policy rate i.e. the key monetary policy
rate.

• SBP established an “Interest Rate Corridor” (IRC) in August 2009 with

SBP reverse repo rate, the policy rate, as ceiling and SBP repo rate as
floor.
Historical Developments in Interest rate
corridor
• - SBP introduced an interest rate corridor in August 2009 with the objective of introducing the corridor
was to minimize volatility in the short term interest rates to achieve the ultimate goal of maintaining
price stability.
• - Since the adoption of “Interest Rate Corridor” (IRC), volatility in the overnight money market repo rate
has reduced.
• - The structure of SBP’s Interest Rate Corridor (IRC) was revised in May 2015 to:
Strengthen Transmission of Monetary Policy
Align SBP’s monetary policy operational framework with International best practices
A new policy rate as “SBP Target Rate” for the money market overnight repo rate was introduced in
addition to SBP Reverse Repo Rate (ceiling rate) and the SBP Repo Rate (floor rate) of the corridor. This
O/N repo rate target is a single policy rate to unambiguously signal SBP’s stance of monetary policy.
• - The adoption of SBP Target policy rate has aligned the operational target of overnight money market
repo rate with the proposed Policy Rate (i.e., the SBP Target Rate). SBP aims at keeping the money
market weighted average overnight repo rate close to the SBP Target rate to unambiguously target SBP’s
monetary policy stance
IV. Reserve Requirements
• Cash Reserve Requirement is a percentage of banks total liabilities or some subset thereof which banks are
required to hold as reserves at the Central Bank.
• - Under current regulations (Section 36 of SBP Act, 1956), all scheduled commercial banks, microfinance
banks, Islamic banks and Islamic banking subsidiaries of the commercial banks are required to maintain a
certain proportion of their liabilities in the form of cash with SBP.
• - All banks (including Islamic Banks/Branches) have to maintain CRR at an average of 5.0% of total demand
liabilities (including time deposits with tenor of less than 1 year) during the reserve maintenance period,
however daily minimum requirement is 3.0%. Time liabilities (including time deposits with tenor of 1 year
and above) are exempt from cash reserves.
• - Bi-weekly average CRR for DFIs on their total DTL is 1%.
• - Similarly, banks are required to maintain 5 percent as cash reserve and 15 percent as special cash reserves
against foreign currency deposits.
• - For the purpose of applicable DTL for CRR, Time and Demand Liabilities (TDL) as of close of business on
Friday (first day of reserve maintenance period) is taken into account for determination of required CRR. If
Friday is a holiday then TDL as of close of business on preceding working day is taken into account.
• - It is also pertinent to mention that SBP does not remunerate required or excess reserves.