Central bank forecasts of liquidity factors: Quality, publication and the control of the overnight rate

A simple model of the interaction between central bank liquidity management and the inter-bank overnight rate is suggested which allows analysing the publication of forecasts of liquidity factors by the European Central Bank adopted in June 2000. The paper argues that the main practical advantage of the publication of these forecasts is that it makes the signal extraction problem with regard to the central bank's intentions trivial and hence allows establishing a superior behavioural equilibrium between the central bank and the money market participants. In this equilibrium, the central bank can achieve a better steering of overnight rates than under private autonomous factor forecasts, depending of course also on the quality of liquidity forecasts. It is furthermore shown that the publication of an average of autonomous factors, such as adopted by the ECB, is, at least within the model presented, superior to the separate publication of autonomous factors for each single day JEL Classification: D84, E52forecasts of liquidity factors

Equilibrium bidding in the Eurosystem's open market operations

Open market operations play a key role in allocating central bank funds to the banking system and thereby to steer short-term interest rates in line with the stance of monetary policy. This note presents some elements of a theory of bidding in central bank tenders in a framework such as the one of the Eurosystem. The ECB has so far used fixed rate tenders and a variant of the variable rate tender, which may be similar to a fixed rate tender depending on market circumstances. In doing so, it faced consecutively an 'under-' and an 'overbidding' issue. The tools developed in this note to understand the bidding behavior of banks in these operations allow revisiting these phenomena and the more general question of the optimal tender procedure and allotment policy. JEL Classification: D84, E43, E52central bank liquidity management, Open market operations, tender procedures

The operational target of monetary policy and the rise and fall of reserve position doctrine

Before 1914, there was little doubt that central bank policy meant first of all control of short term interest rates. This changed dramatically in the early 1920s with the birth of “reserve position doctrine” (RPD) in the US, according to which a central bank should, via open market operation, steer some reserve concept, which would impact via the money multiplier on monetary aggregates and ultimate goals. While the Fed returned to an unambiguous steering of short term interest rates only in the 1990s, for example the Bank of England never adopted RPD. This paper explains the astonishing rise and fall of RPD. The endurance of RPD is explained by a symbiosis of central bankers who may have partially sympathised with RPD since it masked their responsibility for short term interest rates, and academics who were too eager to simplify away some key features of money markets and central bank operations. JEL Classification: E43, E52, B22instruments’ choice problem, monetary policy implementation, monetary policy instruments, operational target of monetary policy

Over- and underbidding in central bank open market operations conducted as fixed rate tender

Open market operations play a key role in allocating central bank funds to the banking system and thereby to steer short-term interest rates in line with the stance of monetary policy. Many central banks apply so-called “fixed rate tender” auctions in their open market operations. This note presents, on the basis of a survey of central bank experience, a model of bidding in such tenders. In their conduct of fixed rate tenders, many central banks faced specifically an “under”- and an “overbidding” problem. These phenomena are revisited in the light of the proposed model and the more general question of the optimal tender procedure and allotment policy of central banks is addressed. --open market operations,tender procedures,central bank liquidity management

The Basel III framework for liquidity standards and monetary policy implementation

Basel III introduces for the first time an international framework for liquidity risk regulation, reflecting the experience of excessive liquidity risk taking of banks in the run up to the financial crisis that erupted in August 2007, and associated negative externalities. As central banks play a crucial role in the liquidity provision to banks during normal times and in a financial crisis, the treatment of central bank operations in the regulation is obviously important. To ensure internalisation of liquidity risks (i.e. pricing of liquidity risk) and to address excessive reliance ex ante on central bank liquidity support by the banks, the regulation deliberately does not establish a direct close link with the monetary policy operational framework. While this reflects the purpose of the regulation and is also natural outcome of an international rule being applied under a multitude of very different monetary policy operational frameworks, this paper shows that the interaction between the two areas can be substantial, depending on the operational and collateral framework of the central bank. This implies the need for further study and the development of policies at the central bank and regulatory/supervisory side on how to handle these potential interactions in practice.Basle III, Liquidity Risk, Banking Regulation, monetary policy implementation

A structural model of central bank operations and bank intermediation

The banking system is modeled in a closed system of financial accounts, whereby the equilibrium volume of bank intermediation between households and corporates reflects structural parameters such as household preferences, comparative cost structures of heterogeneous banks, loan demand of corporates, and the difference between the borrowing rate and the deposit facility rate of the central bank. The model also allows understanding the link between this difference (the width of the central bank standing facilities corridor) and the stance of monetary policy, and how this link changes during a financial crisis. It is shown how the narrowing of the standing facilities corridor can make more accommodating the stance of monetary policy in a financial crisis. JEL Classification: E43, E44, G21bank intermediation, central bank crisis measures, central bank operations, standing facilities

The optimal width of the central bank standing facilities corridor and banks' day-to-day liquidity management

Containing short-term volatility of the overnight interest rate is normally considered the main objective of central bank standing facilities. This paper develops a simple stochastic model to show how the width of the central bank standing facilities corridor affects banks’ day-to-day liquidity management and the volatility of the overnight rate. It is shown that the wider the corridor, the greater the interbank turnover, the leaner the central bank’s balance sheet (i.e. the lower the average recourse to standing facilities) and the greater short-term interest rate volatility. The obtained relationships are matched with central bank preferences to obtain an optimal corridor width. The model is tested against euro area and Hungarian daily data encompassing the financial crisis that began in 2007. JEL Classification: E4, E5liquidity management, money market, standing facilities

The supply and demand for Eurosystem deposits - The first 18 months

This paper describes the demand and supply factors affecting the amounts of deposits held by banks with the Eurosystem in the first 18 months of Stage Three of EMU and differences to the years before. The paper starts from the methodology adopted in a recent study by James Hamilton on 'The supply and demand for Federal Reserve deposits'. While the treatment of the autonomous liquidity factors is in principle similar, the modelling of open market operations and of the recourse to standing facilities diverge. These differences stem from different institutional settings, but also from somewhat different views on the accurate model. In a second part, the paper turns to prices by providing a simple econometric model capturing a large part of the variability of the difference between the EONIA rate (the price for daily funds) and the rate charged for the main refinancing operations JEL Classification: E52, E58

Credit risk mitigation in central bank operations and its effects on financial markets - the case of the Eurosystem

This paper reviews the role and effects of the collateral framework which central banks, and in particular the Eurosystem, use in conducting temporary monetary policy operations. First, the paper explains the design of such a framework from the perspective of risk mitigation, which is the purpose of collateralisation. The paper argues that, by means of appropriate risk mitigation measures, the residual risk on any potentially eligible asset can be equalised and brought down to the level consistent with the risk tolerance of the central bank. Once this result has been achieved, eligibility decisions should be based on an economic cost-benefit analysis. Second, the paper looks at the effects of the collateral framework on financial markets, and in particular on spreads between eligible and ineligible assets.

The economics of TARGET2 balances

It has recently been argued that intra-eurosystem claims and liabilities in the form of TARGET2 balances would raise fundamental issues within the European monetary union. This article provides a framework for the economic analysis of TARGET2 balances and discusses the key arguments behind this recent debate. The analysis is conducted within a system of financial accounts in which TARGET2 balances can arise either due to current account transactions or cross-border capital flows. It is argued that the recent volatility of TARGET2 balances reflects capital flow movements, while the previously prevailing current account positions did not find a strong reflection in TARGET2 balances. Some recent statements regarding TARGET2 appear to be due to a failure to distinguish between the monetary base (a central bank liability concept) and the liquidity deficit of the banking system vis-à-vis the central bank (a central bank asset concept). Furthermore, the article highlights the importance of TARGET2 for the stability of the euro area and points out that the proposal to limit the size of TARGET2 liabilities essentially contradicts the idea of a monetary union.TARGET2, central bank balance sheet, liquidity deficit, financial crisis