Ebook Liquidity and Money Market Operations: A Proposal
The relative liquidity of financial assets is significantly influenced by the Central Bank’s willingness to buy such assets, or to accept them as collateral, in the course of providing additional cash to banks. Those assets which the Central Bank will deal in for such purposes become more liquid, and more marketable, than those that the Central Bank will not.
When the banking system as a whole is short of cash, it has no other recourse than to go to the Central Bank for assistance. The Central Bank has to provide this, since other wise interest rates will rise very sharply, given the banks’ inelastic demand for cash reserves. A Central Bank’s choice, in practice, is the price (interest rate) at which it will supply the requisite cash, not the volume of high-powered cash reserves to supply. Normally a Central Bank will supply just enough cash to hold very short-term (e.g. overnight) rates close to the policy rate, chosen generally on broad macro-economic grounds, e.g. to maintain medium-term price stability.
Commercial banks, however, differ from each other in many dimensions, e.g. clientele, business strategies, risk preferences, expertise, etc., etc. So treating all banks as similar, e.g. the representative bank assumption, is an unhelpful concept for most analytical purposes. Thus, even when the aggregate demand and supply of cash reserves are in balance (at an overnight rate close to the policy rate), some banks will still be short of cash and other banks will have excess cash balances. Normally the individual diversity of cash positions between banks, which occurs continuously, is resolved through the inter-bank loan market, whereby surplus banks lend on to deficit banks. Allen and Gale (e.g. 2004, 2007) have written extensively on the workings of this market, whose details also depend on the money-market techniques of each Central Bank at the time, see Schnadt (1994).
Particularly when such inter-bank lending is unsecured by collateral, surplus banks will be chary of lending to deficit banks beyond some limit, or cap, in case the deficit bank cannot repay. When some event(s) occur that raise concern about the potential of the deficit bank to repay, the size of the limits on lending may be cut sharply, sometimes to zero. So the deficit bank may not be able to satisfy (all) its demand for cash liquidity in the inter-bank market at the going rate; moreover it is usually unwilling to advertise its comparative weakness by bidding for funds, in the inter-bank market or elsewhere, at a premium above the market rate. Similarly the surplus bank(s) may be left with excess cash balances, whose investment in short-term safe assets will tend to drive down their rates relative to the policy rate, e.g. Treasury Bill rates may decline relative to the policy rate.
Central Banks have responded to the likelihood of markets being unable to balance the cash needs of deficit and cash-surplus banks, (especially likely during periods of increasing risk aversion), by introducing a corridor-system. Whereas standard market mechanisms are used to keep very short-term rates in line with the policy rates, banks which found themselves still in deficit, towards the end of the market day, could borrow at the rate at which the upper corridor band, (otherwise known as a standing facility or discount window), is set. This has, typically, been set 1% above the policy rate, though the FOMC cut the margin to 0.5% (fifty basis points) on [check date] to encourage use of such facilities. Similarly, a lower level is placed on the decline of short-term interest rates on safe assets by having a lower corridor band, usually at an interest rate 1% below the policy rate, at which rate surplus banks can place deposits at the Central Bank. Most Central Banks, except the Fed, now have such a lower band; the Fed will also become able to offer interest rates on deposits with itself after October 1, 2011.
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