“Central banking, liquidity risk, and financial stability” – Tutorial

U. Bindseil -- TU Berlin, Summer 2010

Presentations: 1/3 of the final grade will be determined by presentations. The topic of the presentation is as follows. For one central bank (to be assigned on first lecture day), describe, using material you find on the website:

  • Describe the pre-crisis monetary policy implementation framework (types of instruments, liquidity management technique, operational target) of the central bank and the main positions of its balance sheet (e.g. end 2006 balance sheet);
  • What specific measures did the central bank take during the financial crisis in the area of financial market operations? What was the impact on its balance sheet?
  • What is the central bank’s strategy of exit from unconventional market operations measures, and where does the central bank stand in its exit?

Length of the presentation: [15] minutes per person. “Large” central banks (e.g. US Fed, ECB, BoE) could be presented by two persons (implying the double length of the total presentation).

The presentation can be based on a PPT or DOC (or PDF) file, that would be posted on the course website.

Each student has to summarize his / her presentation in bullet points on a short handout which will be distributed among the other students before the presentation.

Chapter 1 (Introduction)

  1. Define the main types and sub-types of monetary policy instruments.
  2. To what extent is there a “continuum” between standing facilities and open market operations?
  3. Why is the fulfillment of reserve requirements not measured more frequently than once a day? Why is it not measured less frequently, e.g. once a year?
  4. What is the relationship between the operational target of monetary policy, its ultimate target, the transmission mechanism, and the monetary policy instruments?
  5. Poole (1970: 198) defined an ‘instrument’ to be a ‘policy variable which can be controlled without error’ (which does not seem to apply to the ‘money stock’) and considered three possible approaches to its specification (1970, p. 199): “First, there are those who argue that monetary policy should set the money stock while letting the interest rate fluctuate as it will. The second major position in the debate is held by those who favor money market conditions as the monetary policy instrument. The more precise proponents of this general position would argue that the authorities should push interest rates up in times of boom and down in times of recession, while the money supply is allowed to fluctuate as it will. The third major position is taken by the fence sitters who argue that the monetary authorities should use both the money stock and the interest rate as instruments . . . the idea seems to be to maintain some sort of relationship between the two instruments.” Assess this statement.
  6. Explain today’s concept of a dichotomy between monetary macroeconomics and monetary policy implementation. How does this compare with the following announcement of the Fed from 1954 [taken from Bindseil – 2004, p. 213]:

Open market operations. In January and February 1954, the Federal Reserve madeopen market sales to absorb only in part the redundancy of bank reserves thatappears at that season. Receding credit demands in these and early spring monthsalso contributed to easier bank reserve positions . . . Beginning of September, openmarket operations were geared to the maintenance of an easy member bankreserve position during the fall phase of bank credit and monetary expansion.

Changes in discount rate. During the first half of February, 1954, the discountrate was reduced from 2 to 13/4 per cent at all Federal Reserve Banks. A secondreduction was made by the Reserve Banks during the period April 14–May 21,when this rate was changed to 11/2 per cent. In both instances, the actions weredesigned to bring the discount rate into closer alignment with short-term marketrates as well as to make it less expensive for individual member banks to maketemporary adjustments in their reserve positions by borrowing at the FederalReserve Banks.

Change in reserve requirements. On June 21, 1954 the Board announced aprogram to reduce member bank reserve requirements . . . it included a reductionof 1 percentage point on time deposits at all member banks, a reduction of2 percentage points on net demand deposits at central reserve city banks, and areduction of 1 percentage point on net demand deposits at reserve city and countrybanks. The reductions in reserve requirements, which released about 1.6 billiondollars of reserve funds, were made in anticipation of bank reserve needs overthe fall. They took into account probable expansion of financing requirements forprivate activities, including seasonal needs for marketing crops . . .

Chapter 2 (Representing monetary policy implementation in a closed system of financial accounts)

  1. Consider the following system of financial accounts:

Government
Real assets 200 / Debt 200
Total assets200 / Total liabilities 200
Corporations
Real assets 200 / Equity 20
Debt180
Total assets 200 / Total liabilities200
Households
Real assets 600
Banknotes 100
Deposits banks100
Bank equity 100
Corporate equity20
Corporate bond5
Government bond75 / Equity1000
Total assets1000 / Total liabilities1000
Banks
Corporate bonds 75
Government bonds 75
Deposits with CB 50
CB Deposit facility0 / Deposits of HH100
Equity 100
CB OMO 0
CB borrowing facility0
Total assets200 / Total liabilities200
Central bank
Corporate bonds100
Government bonds50
OMO lending0
CB borrowing facility0 / Banknotes100
Deposits of banks (RR)50
CB Deposit facility0
Total assets 150 / Total liabilities150

How are the following events reflected in this system of financial accounts?

  1. The central bank buys new headquarters for 10;
  2. Because of technical progress in electronic payment technologies, banknote demand shrinks by 80%
  3. The CB purchases foreign reserves for 50 (introduce the accounts of the “rest of the world”);
  4. The real assets of the corporate sector loose 50% of their value due to an earthquake.
  5. Because of a financial panic, the households substitute all bank deposits with banknotes.
  6. The CB decides to substitute all securities holdings with reverse open market operations.
  7. The CB decides to abolish reserve requirements
  1. Consider the case of a monetary area such as the euro area, with a system of national central banks (NCBs) and the ECB. The following accounts represent this case, whereby the Eurosystem is split into the NCB of country Q and the rest of the Eurosystem.

Euro area households

Deposits with Q banks 900
Deposits with non-Q bans 100
Banknotes 500 / Equity 1500
1500 / 1500

Q Banking system

Loans 100
Financial assets 100
Deposits with NCB Q (RR) 100 / HH Deposits 100
Eurosys refinancing 100
Net interbank liability 100
300 / 300

Rest of euro area banking system in

Loans 500
Financial assets 500
Net interbank liability 100
Deposits with RoES (RR) 900 / HH Deposits 900
Eurosystem refinancing 1100
2000 / 2000

NCB of Q

Eurosys. refinance. 100
Financial Assets 100 / Banknotes 100
Current accounts of banks 100
Net intra –Eurosystem liabs. X
200 / 200

Rest of Eurosystem

Eurosystem refinancing 1100
Financial Assets 200
Net intra –Eurosys. claims x / Banknotes 400
Current accounts of banks (RR) 900
1300 / 1300

Assume now that doubts arise on the solvency of the banking system of Q (or people realise that the deposit insurance in Q is less good than in other countries etc.). Represent the following four shocks in the system of financial accounts:

  • a = households shift deposits from Q to non-Q banks
  • b = interbank market freezing vis-à-vis Q banks => decline on interbank lending to Q banks
  • c = households withdraw banknotes from Q banks
  • d = NCB Q injects reserves into the Q banking system through financial asset purchases

Chapter 3 (The short term interest rate as the operational target of monetary policy)

  1. How would you graphically derive the real interest rate in a Robinson Crusoe economy?
  2. Generalise the Wicksell-Richter arbitrage diagram to two real goods. Is there only one real rate of interest? What implications arise for the central bank?
  3. Why is the monetary policy decision making body of the FED called the “Federal Open Market Committee”, although it decides on short term interest rates, such that it could better be named “Federal Short Term Interest Rate Committee”?
  4. Friedman (1960: 50–1) argues that open market operations alone are a sufficient tool for monetary policy implementation, and that standing facilities (such as the US discount facility) and reserve requirements could thus be abolished:

The elimination of discounting and of variable reserve requirements would leave open market operations as the instrument of monetary policy proper. This is by all odds the most efficient instrument and has few of the defects of the others . . . The amount of purchases and sales can be at the option of the Federal Reserve System and hence the amount of high-powered money to be created thereby determined precisely. Of course, the ultimate effect of the purchases or sales on the final stock of money involves several additional links . . . But the difficulty of predicting these links would be much less . . . The suggested reforms would therefore render the connection between Federal Reserve action and the changes in the money supply more direct and more predictable and eliminate extraneous influences on reserve policy.

Friedman (1982) argues largely along the same lines and seems to suggest an ‘open market operations volume target’ (1982: 117):

Set a target path for several years ahead for a single aggregate—for example M2 or the base. . . . Estimate the change over an extended period, say three or six months, in the Fed’s holdings of securities that would be necessary to approximate the target path over that period. Divide that estimate by 13 or 26. Let the Fed purchase precisely that amount every week in addition to the amount needed to replace maturing securities. Eliminate all repurchase agreements and similar short-term transactions.

Why have these policy advices never been set into practice?

Chapter 4 (Three basic techniques of controlling short term interest rates)

  1. The basic idea to derive the “fundamental equation” of monetary policy implementation is that for risk-neutral banks, intertemporal arbitrage requires that the overnight interbank market rate is equal to the expected end of day marginal value of reserves, which itself is a weighted average of the two standing facility rates, the weights being the probabilities associated with the needs to take recourse of the two facilities, respectively. What explicit or implicit assumptions does this equation depend on?
  2. What could be the respective advantages and disadvantages of the three alternative approaches to interest rate control as described in the sections 4.1, 4.2 and 4.3, respectively?
  3. What would change in the symmetric corridor model (section 4.2) if the open market operation would take place after the daily interbank market session?
  4. Consider the following two balance sheets – what approaches to monetary policy implementation did these two central banks practice?

  1. Consider the full allotment approach to monetary policy implementation (Section 4.3). Assume that reserve requirements are 100, banknotes in circulation on average 200, and the standard deviation of banknote circulation is equal to 20. Moreover assume that the central bank only offers a borrowing facility at 6%, and no deposit facility. What will be the expected amount of bids if the fixed interest rate of the full-allotment open market operation equals 5% and 3%, respectively? What would happen to these bid amounts if the volatility of banknote demand doubles? What will happen to the interbank rate if banks realise, when the total allotment amount is announced, that they have bid collectively by 10 too much?

Chapter 5 (A disaggregate model of liquidity)

  1. Consider the full allotment approach to monetary policy implementation (Section 4.3), with two distinct banks. The financial accounts are as shown below (reserve requirements are zero and banknotes in circulation are 100). Moreover assume that the central bank only offers a borrowing facility at 6%, and a deposit facility at 1%, and that the fixed interest rate of the full-allotment open market operation equals 2%. Finally, assume that the standard deviations of η anμ are both 10 (and the two random variables are not correlated). Complete the missing positions (“X”) in the system of financial accounts below, assuming first that interbank markets function, and subsequently that they do not.

Bank 1
Securities 25
Deposits with CB 0
CB deposit facility supX
Interbank lending X / Deposits of HH50 -(η)/2 + μ
CB full allotment OMO X
CB borrowing facility X
Equity 50
Total assetsX / Total liabilities X
Bank 2
Securities275
Deposits with CB X
CB deposit facility X / Deposits of HH 50 -(η)/2 – μ
CB full allotment OMO X
CB borrowing facility X
Interbank borrowing X
Equity 50
Total assets X / Total liabilitiesX
Central bank
Full allotment OMO X
Borrowing facility X / Banknotes 100 + η
Deposits of banks 0
Deposit facility supX
Total assets X / Total liabilitiesX

Chapter 6 (A model with several autonomous factor shocks and interbank trading sessions)

  1. Consider the following two charts and interpret the empirical patterns.

First chart taken from ECB WP 67, 2001,“The daily market for funds in Europe: Has something changed with the EMU? By Gabriel Pérez Quirós and Hugo Rodríguez Mendizábal). Note: The solid line plots the spread between the overnight rate and the main refinancing operations rate. The vertical lines represent end of the reserve maintenance periods.

Second chart taken from ECB WP 439, A look at intraday frictions in the euro area overnight deposit market Vincent Brousseau and Andrés Manzanares, February 2005

Chapter 7 (Efficient frameworks for monetary policy implementation)

  1. Assess the following frameworks from the perspective of the 6 ideal properties of efficient frameworks (leanness, automation, financial returns, cost of the cash management of cash management of commercial banks, financial stability, universality) and the instrument specification of efficient frameworks.

(a) Reichsbank pre-1914: until 1914 the Reichsbank’s system consisted basically of pure rediscounting, with the banking system permanently using the borrowing facility. Short-term market rates therefore followed the discount rate, which was changed by the Reichsbank whenever the stance of monetary policy needed to be changed.

(b) BBK 1950-1970 (Bindseil 2004, 230)“During the 1950s, discount quotas were established and the main pillar of money market management until the early 1990s was set up: this was to guide the market in a kind of corridor set by the discount rate and the lombard rate, the width of which was 100 basis points between 1948 and 1967.11 As Deutsche Bundesbank (1982b: 48) explains, the ‘linchpin’ of the Bundesbank’s interest rate policy consisted in the fact that, with structural use of the discount facility, market interest rates should not fall below the discount facility’s rate and, when discount quotas were exhausted, which they normally were, inter-bank rates should move upwards to the lombard rate but not above it, as long as sufficient collateral was available and the Bundesbank did not introduce further restrictions on its use. The Bundesbank thus achieved an interest rate corridor through two different borrowing facilities, of which the cheaper was, however, quantitatively limited.”

(c) BBK 1980s-1998 Deutsche Bundesbank (1994: 60) summarizes its monetary policy implementation approach, which would remain unchanged until 1998, as follows: “Since the mid eighties, a basically unchanged and proven method of money market management has been available to the Bundesbank. In engages in active liquidity management, with securities repurchase agreements being the principal instrument for providing central bank money, and minimum reserves constituting the main structural element of the demand for such money. On the one hand, the Bundesbank bears in mind the banks’ interest in the steady provision of liquidity for complying with the minimum reserve requirements; this facilitates a virtually stable trend in the day to day money market. On the other hand, the money market acts as a lever for the monetary transmission mechanism, from which monetary stimuli work through to the supply and demand conditions in the credit, deposits and capital markets and then are also reflected in the intermediate monetary target M3. By accelerating or delaying the provision of liquidity within a month, the Bundesbank can prepare the ground for interest rate changes without any, or any prior, unequivocal signals being given by varying ‘official’ rates. In the context of this indirect money market management, the day-to-day money market rate is for the Bundesbank the key variable, which it influences direct by means of interest rate policy measures. As the sole supplier of central bank money, the Bundesbank controls pricing at the short end of the money market.

(d) Fed 1954 - See quotation in question 6.

(e) Fed 1980. The domestic policy directive formulated by the FOMC and effective on 1 January 1980 specified: “. . . the FOMC seeks to foster monetary and financial conditions that will resist inflationary pressures while encouraging moderate economic expansion . . . The Committee agreed that these objectives would be furthered by growth of M1, M2, and M3 within ranges of 11⁄2 to 41⁄2%, 5–8%, and 6–9%, respectively . . . In the short run, the Committee seeks to restrain expansion of reserve aggregates to apace consistent with decelerating in growth of M1, M2 and M3 to rates that wouldhold growth of these monetary aggregates . . . within the Committee’s longer runranges, provided that in the period before the next regular meeting the weeklyaverage federal funds rate remains within a range of 11⁄2 to 151⁄2%.”

In the following, three contemporary cases are presented ((f) Sweden, (g) Denmark, (h) New Zealand), which all, in contrast to the previous, do not apply reserve requirements. The use of their instruments is summarised in the following

Use of reverse open market operations by SE, DK, NZ

Longer term OMOs / Overnight OMOs
Sweden / Weekly frequency, one-week maturity, Fixed rate tender at target rate / Almost Daily fine-tuning FRT operations conducted at +/-- 10 basis points relative to target rate
Denmark / Two weekly operations in parallel: one liquidity absorbing, one providing; two weeks maturity; FRT with full allotment (at lending = target rate) / Rarely fine-tuning operations
New Zealand (1999-2006) / Daily operations; Average maturity: 4 days; Variable rate tender with minimum bid rate and pre-announced volume

Use of standing facilities by by SE, DK, NZ