The Monetary Policy Committee of the Bank of England sets Bank Rate – the official policy rate. Un What does it mean and what does it mean operationally in the markets for the MPC to set Bank Rate? Is Bank Rate the UK version of the Federal Funds target rate, that is, does it set the target rate for the overnight sterling interbank market? Does the MPC play any formal, constitutional role in design (or even the implementation) of the Bank of England’s liquidity management in the overnight markets, or its wider liquidity management at longer maturities and at the discount window?
In this blog I want to discuss both the technical issue about what the Bank does when it implements the Bank Rate decision of the MPC, and the wider constitutional issue about the role of the MPC in the whole gamut of decisions the Bank of England takes in the area of liquidity management – both the provision of funding liquidity to individual troubled banks and the provision of market liquidity to illiquid and disorderly financial markets.
The Bank has four specific objectives:
Objective 1: Overnight market interest rates to be in line with the Bank’s official rate, so that there is a flat money market yield curve, consistent with the official policy rate, out to the next MPC decision date, with very limited day-to-day or intra-day volatility in market interest rates at maturities out to that horizon.
Objective 2: An efficient, safe and flexible framework for banking system liquidity management – both in competitive money markets and, where appropriate, using central bank money – in routine and stressed, or otherwise extraordinary, conditions.
Objective 3: A simple, straightforward and transparent operational framework.
Objective 4: Competitive and fair sterling money markets.
The framework has three main elements:
Reserve-averaging scheme. Eligible UK banks and building societies undertake to hold target balances (reserves) at the Bank on average over maintenance periods running from one MPC decision date until the next. If an average balance is within a range around the target, the balance is remunerated at the Bank’s official rate.
Standing facilities. Standing deposit and (collateralised) lending facilities are available to eligible UK banks and building societies. They may be used on demand. In normal circumstances, they carry a penalty, relative to the Bank’s official rate, of +/- 25 basis points on the final day of the monthly reserves maintenance period and of +/- 100 basis points on all other days.
OMOs. Open market operations (OMOs) are used to provide to the banking system the amount of central bank money needed to enable reserve-scheme members, in aggregate, to achieve their reserve targets. OMOs comprise short-term repos at the Bank’s official rate, long-term repos at market rates determined in variable-rate tenders and outright purchases of high-quality bonds.”
Note that both regular reserves (balances with the Bank of England within the tolerated range around the target) and borrowing at the standing lending facility is collateralised.
What this means is that the eligible banks (and building societies – ‘banks’ for short in what follows) have to make a guess at their reserve requirements for the next ‘reserve maintenance period’ (the period between scheduled MPC meetings –roughly one month) a few days before the beginning of that maintenance period. Call these the banks’ target balances. These target balances are remunerated at Bank Rate. If, at the end of the maintenance period, the banks turn out to have been within certain specified margins from the target balances, all is forgiven. If they exceed the target balances by more than the permitted margin, the banks only receive the standing deposit facility rate (100 basis points below Bank Rate) on the excess except on the last day of the maintenance period, when it is 25 basis points). If they fall short of the target balances by more than the permitted margin, they have to pay the collateralised standing lending facility rate on the excess- 100 basis points except for the last day of the maintenance period, when it is 25 basis points.
Some in the Bank of England are very fond of this clumsy, klutzy, over-engineered and pretty ineffective arrangement for money market operations in the overnight sterling market. They remember the bad old days, before the introduction of the current regime on 18 May 2006. That regime was completely incomprehensible. As an MPC member for three years between June 1997 and May 2000, I never had the foggiest idea as to what the market operations chaps and chappettes were up to by way of implementing the rate decision I had just taken part in making. I was told repeatedly that the rate the MPC set at the time was the 2-week Repo rate. What that actually meant in practice, I never discovered.
I am happy to agree that the current arrangement for money market operations in the overnight market in the UK is better than it was before May 2006. It may even be better than the similarly opaque and bizarre procedures of the Fed and the ECB. But it still is a bad arrangement. Fortunately, there is an easy fix.
What does it mean to set an interest rate?
Fixing a rate of interest is pegging or setting a price. The one-year (default-) risk-free nominal sterling interest rate determines the price today of 1£ a year from now. If i is this interest rate, the price of 1 £ one year from now is (1+i)-1. When you set, fix or peg a price or interest rate, it means you are willing to buy or sell any amount the rest of the economy wants from you or throws at you, at that price. For instance, when the UK monetary authority, in a fixed exchange rate regime of days gone by, fixed the nominal spot exchange rate between its currency (sterling) and some benchmark currency (the US dollar, say), it meant that the monetary authority was willing to buy or sell any amount of US dollars at that exchange rate. At most there is a tiny bid-ask spread between the exchange rate at which it buys foreign exchange and the exchange rate at which it sells foreign exchange, to defray the cost of operating in the foreign exchange market.
So when the MPC sets Bank Rate at, say, 5.25%, and if (the inverse of 1 plus) Bank Rate is defined as the price of reserves at the Bank of England, it ought to mean the following:
1. the Bank of England is willing to borrow overnight any amount from eligible banks and building societies at that rate, and
2. the Bank of England is willing, against eligible collateral, to lend overnight any amount to eligible banks and building societies at that rate.
We again can allow for a small bid-ask spread between the Bank of England’s lending rate and borrowing rate to cover transactions costs in the overnight market. Note also that while lending by the Bank of England is collateralised, because banks and building societies are subject to default risk and the MPC sets a default-risk free rate, borrowing by the Bank of England is not collateralised, because as long as the borrowing is sterling-denominated, there is no default risk.
This, however, is not what the Bank of England does. Instead of setting a price (an interest rate) and accommodating whatever the demand for or supply of reserves is at that rate, the Bank of England falls victim to the ultimate vanity in market economics: the desire to set both price and quantity and the belief that it has found a way to do this reliably. If you want to be pedantic, you could point out that it is the Bank of England that fixes the price (Bank Rate) and the banks and building societies that fix the quantity (the target reserves to be held, on average, over the maintenance period, plus or minus some tolerance thresholds). But the effect is the same.
The Bank of England’s overnight money market management policy (which is similar to what the Fed and the ECB do) is an economic nonsense: you can fix the price and let the rest of the market determine the quantity endogenously, or you can fix the quantity of reserves you are injecting into or withdrawing from the markets, or you can announce some functional relationship between price and quantity which you will adhere to, leaving it to the market to pick a point on that schedule. Setting both price and quantity before the reserve maintenance period is asking for trouble when the economic environment is unpredictable. And so it proved.
Chart 1 shows the difference between the effective overnight rate in the London interbank market and the official policy rate since 1998. I lived through the first 2½ years, so my constant bewilderment at what the rate I had just voted for was doing in practice will not be surprising.
It is clear that the new arrangement in place since May 2006 was a major improvement over the old mess. But not as much an improvement as could have been achieved had the Bank just decided to peg the overnight rate in the sense I will describe in a minute. Note the spikes in July, August and September 2007.
Chart 2 shows the most recent period in greater detail. The overnight spread should be just the probability that both the borrowing bank and the issuer of the collateral default overnight. This should be close to zero – certainly no more than five basis points. Yet we see that even in 2008 the average daily spread can still exceed 20 basis points.
I propose the following alternative operating procedure, which is really no more than a fixed-rate tender. It has the following features.
1. The Bank of England decides the collateral it will accept for repos at Bank Rate. I would propose this would be a wide class of securities, including private securities rated A category or higher.
2. The Bank stands ready to lend any amount to eligible counterparties at Bank Rate against eligible collateral. The Bank is always present (during normal working hours) in the overnight market.
3. The Bank stands ready to borrow any amount (absorb reserves) from eligible counterparties at Bank Rate.
One consequence of this arrangement might be that banks and building societies would no longer deal with each other in the overnight interbank market, but instead transact only with (and indirectly with each other through) the central bank. This would not bother me, since the banks and building societies would continue to be in constant contact and communication lending and borrowing at all maturities longer than overnight. If triangular lending and borrowing among private banks in the overnight interbank market through the intermediary of the central bank is at least as cost-effective as direct lending and borrowing between private parties, there is no reasonable argument against the central bank playing that part.
If this were nevertheless considered an obstacle, the central bank could instead be ready to repo, in the overnight market, any amount against eligible collateral at Bank Rate plus ε>0, and to borrow any amount at Bank Rate minus ε>0, where 2ε is just a bit above a reasonable estimate of the normal bid-ask spread in orderly, competitive markets.
The standing facilities would be redefined as follows. Eligible counterparties would be able to borrow from the standing (collateralised) lending facility, on demand, at Bank Rate + 100 basis points (25 basis points at the end of the maintenance period), against a wider range of eligible collateral that is accepted for borrowing at Bank Rate. I would recommend that all investment grade private securities should be acceptable as collateral at the standing lending facility. The standing deposit facility would become redundant, as the Bank of England would be ready to absorb any amount of reserves from the eligible banks and building societies at Bank Rate.
So no more guessing by the banks and building societies at what their need for reserves is likely to be. As long as you have the right collateral, you can get any amount of liquidity at Bank Rate from the Bank of England. No last-minute scrambles to get rid of excess reserves.
Improved transparency for the MPC
My proposal would make the division of labour between the MPC and the executive, professional staff at the Bank of England highly transparent. The MPC sets Bank Rate. The operational departments of the Bank then stand ready to lend (against eligible collateral and to eligible counterparties) any amount at Bank Rate, or to borrow any amount at Bank Rate. The overnight interbank market rate, which is for unsecured lending, can still differ from Bank rate because of transactions costs and overnight default risk of the banks operating in the interbank market. I would be very surprised if, unless one or more major clearers are tottering on the edge of the insolvency abyss, the effective overnight interbank rate were to deviate from Bank Rate by more than 5 basis points under this regime.
A key constitutional issue is whether the MPC should have a say in:
1. the determination of the eligible collateral for market operations at Bank Rate, and of the less restrictive set of eligible collateral for borrowing at 100 (or 25) basis points above Bank Rate from the standing lending facility.
2. The determination of the eligible counterparties for market operations at Bank Rate and for borrowing at the standing lending facility.
3. The determination of the maturity of the loans at the standing lending facility (currently only overnight, against 90 days at the Fed’s primary discount window).
Liquidity management at longer maturities
When interbank rates at longer maturities (say 1 month, 3 months and 12 months) are far above the market’s expectation of Bank Rate over those horizons, either bank default risk or illiquidity risk (or both) are rearing their ugly heads. Chart 3 shows that there is no clear evidence that the longer maturity Libor-OIS spreads are settling down. Even the one-month spread was well over 50 basis points in March 2008. The one-year spread was well over 100 basis points earlier in March this year. The Bank of England has attempted to decompose this spread into a component reflecting the market’s perception of bank default risk and the market’s perception of liquidity risk. Unfortunately, the credit default swaps (CDS) data used to gauge default risk is itself contaminated by the risk of illiquidity, not just in the interbank market but economy-wide. If you are illiquid for long enough, insolvency will follow.
My modest proposal for changing the Bank of England’s operating procedures in the overnight money markets won’t do much to address the longer-term liquidity and solvency issues of the UK financial sector. But it won’t hurt and it may help a little.
There is a further constitutional issue as to the role of the MPC in deciding liquidity management of the Bank of England at longer maturities than overnight. When financial markets are illiquid and disorderly, there is a term structure of liquidity risk premia that can be influenced through the injection by the central bank of liquidity at those maturities where (a)the liquidity risk premia are most prominent and (b) the wider economic significance is greatest. The 3-month interbank market (3-month Libor) comes to mind, because so many lending rates for households and private corporations are priced off it.
No matter how difficult the decomposition of the Libor-OIS spread into credit risk and liquidity risk components, it cannot be avoided. The policy conclusions drawn from this analysis and the resulting liquidity management decisions are clearly relevant to the conduct of monetary policy. This does not mean that the MPC should have a say in liquidity management decisions, but it does mean that the Bank Rate decisions of the MPC will depend on the liquidity management policies that are implemented.
As I understand it, the MPC has effectively had no say whatsoever in anything other than the setting of Bank Rate. The overnight money market management decisions that implement Bank Rate apparently are not part of its brief, and neither are the decisions about the provision of liquidity at longer maturities. The following issues should be clarified as a matter of urgency:
1. What is the role of the MPC in determining the range of eligible collateral for open market operations or loan/credit facilities/auctions at longer maturities than overnight?
2. What is the role of the MPC in determining the range of eligible counterparties in longer-maturity open market operations?
3. What is the role of the MPC in determining the maturities at which the Bank of England provides liquidity, and the amount of liquidity that is provided at each maturity?
4. Should the MPC be consulted when the Bank of England engages in lender of last resort actions or market maker of last resort actions? Such operations increase the default risk the central bank carries in its balance sheet. Should this risk materialise on a sufficiently large scale, the Bank might not have the financial resources (without a capital injection from the Treasury) to pursue its inflation mandate and remain solvent.
5. Shoud the MPC be consulted if and when the Bank of England engages in significant outright purchases of mortgage-backed securities and other risky and illiquid private securities to easy the liquidity squeeze?
Those who helped introduce the new arrangement for sterling reserve management on May 18 2006 tend to get very defensive when the manifest and easily remedied flaws in these arrangements are pointed out. It’s like telling a new father than his baby is ugly. The uglier the baby truly is, the more vehement the father will be in defence of his progeny. It is time to change the overnight operations of the Bank of England to a continuous, on-demand fixed rate tender, against appropriate collateral.
The role of the MPC in the myriad of liquidity management policy decisions made and implemented by the Bank of England appears to be zilch. It is not obvious that this is the right interpretation of the constitutional responsibilities of the MPC. Even if it is, it would be useful to have the division of labour between the MPC and the executive staff of the Bank of England clarified.
 The full gore can be found in The Framework for the Bank of England’s Operations in the Sterling Money Markets (the ‘Red Book’) of January 2008.