“Managing Liquidity in the System: The Bank’s Liquidity Insurance Operations”

The Bank of England uses its balance sheet1 to support its core objectives of both monetary and financial stability. The financial crisis over the past three years has clearly placed more emphasis on the latter. So, this morning, I want to set out how the Bank has developed its ‘Sterling Monetary Framework’ in order to support financial stability: in particular what we refer to as the ‘liquidity insurance’ operations. Since the liquidity of the banking system is crucial to the functioning of financial markets, this should be of direct interest to the LMA’s members. I intend to briefly describe the main facilities as they now stand, including changes made during the past three years. I then want to address some topical issues that have arisen.

Central bank money and monetary policy
The balance sheet of a Central Bank plays a crucial role in the implementation of its policy objectives. In a Quarterly Bulletin article earlier this year, we set out an analysis of how the Bank of England’s balance sheet evolved during the financial crisis.2 Let me briefly spell out the main elements. The main entry on the liability side of the balance sheet is ‘central bank money’, comprising banknotes, which are supplied on demand, and the reserve accounts of commercial banks and building societies.3 These are effectively sterling current accounts for the commercial banks – they are among the safest assets a bank can hold and are the ultimate means of payment between banks. In normal circumstances, the main entry on the asset side of the balance sheet is the Bank’s lending to those same commercial banks.4 In setting monetary policy, our normal objective would be to lend exactly the amount of central bank money demanded, consistent with the MPC’s choice of Bank Rate. Crucially, although the targets for reserves accounts may react to the state of financial stability in the system, the Bank’s choices here are dictated by the stance of monetary policy.

In normal times, we ask the banks to choose their own targets for reserve accounts and then lend just enough cash to the system as a whole so that the banks can collectively meet the aggregate of their targets. The commercial banks will then lend to, or borrow from each other in the inter-bank market, to distribute the total amount of cash around the system so that each individual institution can meet its target. Each bank is incentivised to meet its reserves target by the application of penalty rates to those who are – on average over a monthly maintenance period – eitherexcessively short or long. If an institution cannot meet its target through the inter-bank market, it can use the Bank’s standing deposit and lending facilities. Under these facilities, reserve account holders can deposit with, or borrow from the Bank overnight for unlimited amounts at a fixed penalty to Bank Rate. So in practice, these facilities impose a narrow corridor on either side of the Bank Rate. For example, if it becomes cheaper for a commercial bank to borrow under the standing facilities than to borrow in the market, then it will do so, providing a natural ceiling to short-term market interest rates. That in turn ensures that overnight interest rates5 remain close to Bank Rate set by the MPC.

For the full speech see: http://www.bankofengland.co.uk/publications/speeches/2010/speech450.pdf