POLICY INSTRUMENTS:Open Market Operations, Capital Requirements

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Management of Financial Institutions - MGT 604

Lecture # 4

POLICY INSTRUMENTS

The main monetary policy instruments available to central banks are open market operation,

bank reserve requirement, interest-rate policy, re-lending and re-discount (including using

the term repurchase market), and credit policy (often coordinated with trade policy). While

capital adequacy is important, it is defined and regulated by the Bank for International

Settlements, and central banks in practice generally do not apply stricter rules.

To enable open market operations, a central bank must hold foreign exchange reserves

(usually in the form of government bonds) and official gold reserves. It will often have

some influence over any official or mandated exchange rates: Some exchange rates are

managed, some are market based (free float) and many are somewhere in between

("managed float" or "dirty float").

Interest Rates

By far the most visible and obvious power of many modern central banks is to influence

market interest rates; contrary to popular belief, they rarely "set" rates to a fixed number.

Although the mechanism differs from country to country, most use a similar mechanism

based on a central bank's ability to create as much fiat money as required.

The mechanism to move the market towards a 'target rate' (whichever specific rate is used)

is generally to lend money or borrow money in theoretically unlimited quantities, until the

targeted market rate is sufficiently close to the target. Central banks may do so by lending

money to and borrowing money from (taking deposits from) a limited number of qualified

banks, or by purchasing and selling bonds. As an example of how this functions, the Bank

of Canada sets a target overnight rate, and a band of plus or minus 0.25%. Qualified banks

borrow from each other within this band, but never above or below, because the central

bank will always lend to them at the top of the band, and take deposits at the bottom of the

band; in principle, the capacity to borrow and lend at the extremes of the band are

unlimited. Other central banks use similar mechanisms.

It is also notable that the target rates are generally short-term rates. The actual rate that

borrowers and lenders receive on the market will depend on (perceived) credit risk, maturity

and other factors. For example, a central bank might set a target rate for overnight lending

of 4.5%, but rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of

inverted yield curves, even below the short-term rate. Many central banks have one primary

"headline" rate that is quoted as the "Central bank rate." In practice, they will have other

tools and rates that are used, but only one that is rigorously targeted and enforced.

"The rate at which the central bank lends money can indeed be chosen at will by the central

bank; this is the rate that makes the financial headlines." - Henry C.K. Liu, in an Asia Times

article explaining modern central bank function in detail He explains further that "the US

central-bank lending rate is known as the Fed funds rate. The Fed sets a target for the Fed

funds rate, which its Open Market Committee tries to match by lending or borrowing in the

money market.... a fiat money system set by command of the central bank. The Fed is the

head of the central-bank snake because the US dollar is the key reserve currency for

international trade. The global money market is a US dollar market. All other currencies

markets revolve around the US dollar market." Accordingly the US situation isn't typical of

central banks in general.

Management of Financial Institutions - MGT 604

A typical central bank has several interest rates or monetary policy tools it can set to

influence markets.

Marginal Lending Rate (currently 5.00% in the Eurozone) a fixed rate for

institutions to borrow money from the CB. (In the US this is called the Discount rate).

Main Refinancing Rate (4.00% in the Eurozone) this is the publicly visible interest

rate the central bank announces. It is also known as Minimum Bid Rate and serves as a

bidding floor for refinancing loans. (In the US this is called the Federal funds rate).

Deposit Rate (3.00% in the Eurozone) the rate parties receive for deposits at the

CB.

These rates directly affect the rates in the money market, the market for short term loans.

Open Market Operations

Through open market operations, a central bank influences the money supply in an

economy directly. Each time it buys securities, exchanging money for the security, it raises

the money supply. Conversely, selling of securities lowers the money supply. Buying of

securities thus amounts to printing new money while lowering supply of the specific

security.

The main open market operations are:

Temporary lending of money for collateral securities ("Reverse Operations" or

"repurchase operations", otherwise known as the "repo" market). These operations are

carried out on a regular basis, where fixed maturity loans (of 1 week and 1 month for the

ECB) are auctioned off.

Buying or selling securities ("Direct Operations") on ad-hoc basis.

Foreign exchange operations such as forex swaps.

All of these interventions can also influence the foreign exchange market and thus the

exchange rate. For example the People's Bank of China and the Bank of Japan have on

occasion bought several hundred billions of U.S. Treasuries, presumably in order to stop the

decline of the U.S. dollar versus the Renminbi and the Yen.

Capital Requirements

All banks are required to hold a certain percentage of their assets as capital, a rate which

may be established by the central bank or the banking supervisor. For international banks,

including the 55 member central banks of the Bank for International Settlements, the

threshold is 8% (see the Basel Capital Accords) of risk-adjusted assets, whereby certain

assets (such as government bonds) are considered to have lower risk and are either partially

or fully excluded from total assets for the purposes of calculating capital adequacy. Partly

due to concerns about asset inflation and term repurchase agreements, capital requirements

may be considered more effective than deposit/reserve requirements in preventing indefinite

lending: when at the threshold, a bank cannot extend another loan without acquiring further

capital on its balance sheet.

Reserve requirements

Another significant power that central banks hold is the ability to establish reserve

requirements for other banks. By requiring that a percentage of liabilities be held as cash or

deposited with the central bank (or other agency), limits are set on the money supply.

Management of Financial Institutions - MGT 604

In practice, many banks are required to hold a percentage of their deposits as reserves. Such

legal reserve requirements were introduced in the nineteenth century to reduce the risk of

banks overextending themselves and suffering from bank runs, as this could lead to knock-

on effects on other banks. See also money multiplier, Ponzi scheme. As the early 20th

century gold standard and late 20th century dollar hegemony evolved, and as banks

proliferated and engaged in more complex transactions and were able to profit from

dealings globally on a moment's notice, these practices became mandatory, if only to ensure

that there was some limit on the ballooning of money supply. Such limits have become

harder to enforce. The People's Bank of China retains (and uses) more powers over reserves

because the Yuan that it manages is a non-convertible currency.

Even if reserves were not a legal requirement, prudence would ensure that banks would hold

a certain percentage of their assets in the form of cash reserves. It is common to think of

commercial banks as passive receivers of deposits from their customers and, for many

purposes, this is still an accurate view.

This passive view of bank activity is misleading when it comes to considering what

determines the nation's money supply and credit. Loan activity by banks plays a

fundamental role in determining the money supply. The money deposited by commercial

banks at the central bank is the real money in the banking system; other versions of what is

commonly thought of as money are merely promises to pay real money. These promises to

pay are circulatory multiples of real money. For general purposes, people perceive money as

the amount shown in financial transactions or amount shown in their bank accounts. But

bank accounts record both credit and debits that cancel each other. Only the remaining

central-bank money after aggregate settlement.

Final Money - can take only one of two forms:

physical cash, which is rarely used in wholesale financial markets,

Central-bank money.

The currency component of the money supply is far smaller than the deposit component.

Currency and bank reserves together make up the monetary base, called M1 and M2.

Exchange Requirements

To influence the money supply, some central banks may require that some or all foreign

exchange receipts (generally from exports) be exchanged for the local currency. The rate

that is used to purchase local currency may be market-based or arbitrarily set by the bank.

This tool is generally used in countries with non-convertible currencies or partially-

convertible currencies. The recipient of the local currency may be allowed to freely dispose

of the funds, required to hold the funds with the central bank for some period of time, or

allowed to use the funds subject to certain restrictions. In other cases, the ability to hold or

use the foreign exchange may be otherwise limited.

In this method, money supply is increased by the central bank when the central bank

purchases the foreign currency by issuing (selling) the local currency. The central bank may

subsequently reduce the money supply by various means, including selling bonds or foreign

exchange interventions.

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