Garreth Rule
CCBS – PFTAC Course on Monetary Transmission Channels, Liquidity Conditions, and Determinants of Inflation
Overview
• Liquidity Position.
• Excess vs. Voluntary Reserves.
– Estimating Excess vs. Voluntary Reserves.
• The Impact of Surplus Liquidity.
– Channels of Impact.
– Quantifying the Impact.
– Other Impacts.
• The liquidity position of the financial system vis-a-vis the central bank can largely be determined by the
structure and dynamics of the central bank‟s balance
sheet.
Liquidity Position
• We often state that when a central bank‟s balance sheet is liability-driven, the economy has a demand for central bank liabilities, predominantly for payment purposes, and the central bank lends money to the banking sector.
• In this case we say there is a shortage of liquidity.
Liabilities Assets Notes
Required Reserves
Free Reserves
Capital Other
OMOs Government
FX
Liquidity Position
Liabilities (£billions) 28-Jun-06 Assets (£billions) 28-Jun-06
Banknote Issue 38.0 Short term £ reverse repo 32.9
Reserve Account Balances 20.7 Long term £ reverse repo 15.4
Other Liabilities 17.5 Other Assets 12.3
CRDs, BoE Capital and Reserves
Foreign Currency Denominated 6.0 Bonds and Other Securities Acquired 8.2
Liabilities via Market Transactions
Ways & Means Advance 13.4
Total 82.2 Total 82.2
• Similarly when a central bank‟s balance sheet is
asset-driven, an exogenous or policy-driven increase in certain asset items results in a balance-sheet
expansion greater than apparently needed to
accommodate the economy‟s demand for central bank liabilities and a central bank often needs to absorb
money to offset this.
• In this case we say there is a surplus of liquidity.
Liquidity Position
Liabilities Assets
Notes
FX Required Reserves
Government Free Reserves
Other Capital
Liabilities Assets Notes
Required Reserves
OMOs
Other Capital
FX
Government
Liquidity Position
Liabilities (RM billions) 31-Dec-11 Assets (RM billions) 31-Dec-11
Currency in Circulation 61.9 Gold & Foreign Exchange 414.4
Deposits by Financial Institutions 214.9 IMF Related Assets 8.9
Deposits by Others 23.9 Malaysian Government Securities 2.0
Bank Negara Securities 108.0 Other Assets 47.6
Other Liabilities 32.4
Capital 31.9
Total 473.0 Total 473.0
• Therefore to measure surplus liquidity do we need only to measure the quantity of free reserves present in the financial system?
• As noted previously free reserves are composed of two elements – voluntary reserves and excess
reserves.
• The distinction between these two elements is crucial not only to measuring surplus liquidity, but also to
understanding its impact.
Excess vs. Voluntary Reserves
Free Reserves
Excess Reserves
Voluntary Reserves
• Voluntary reserves are additional reserves held by commercial banks for precautionary motives.
• The demand for voluntary reserves arises from a desire to self-insure and can vary dependent on the uncertainty of payment flows.
• In addition in times of market stress, reserves are a highly liquid and safe asset, often in such
circumstances counterparty demand increases.
Excess vs. Voluntary Reserves
• Excess reserves on the other hand are reserves that exceed commercial banks demand for them.
• Crucial to remember that in aggregate the quantity of reserves in the system is determined by the elements of the central bank‟s balance sheet.
• When a commercial bank makes a new loan or purchases an asset the reserves are merely
transferred to another counterparty‟s account at the
central bank.
• Determining the difference between holdings
voluntary or excess reserves is not a trivial task.
• One method is to survey banks as to their intentions,
however, this can be a slow and cumbersome task.
Estimating Excess vs. Voluntary Reserves
• An alternative method is to estimate econometrically whether the determinants of free reserve are factors related to voluntary or excess reserves.
• One model to do this was proposed first by Agénor, Aizenman and Hoffmaister (2004), when looking at the case of Thailand during the Asian crisis, and built upon by Saxegaard (2006), when looking at liquidity surpluses in Sub-Saharan Africa.
• Saxegaard‟s extensions mean that the model is also
capable of decomposing the evolution of free reserves
into voluntary and excess reserve factors.
Estimating Excess vs. Voluntary Reserves
• In Saxegaard‟s model holdings of free reserves are
regressed upon a range of variables thought important in determining holding of voluntary and excess
reserves:
• In this specification EL
tis the ratio of statutory excess reserves to total deposits, X
1and X
2are vectors of
variables, v is a well behaved error term and α (L) are
Estimating Excess vs. Voluntary Reserves
• The variables included in the vectors are set to reflect the factors thought to influence holdings of voluntary and excess reserves.
• For sub-Saharan Africa, Saxegaard included the following variables.
Monetary Transmission Channels, Liquidity Conditions, and Determinants of Inflation
• Where:
– RR is the ratio of required reserves to total private sector deposits.
– VOLY and VOLCD are 5-year moving averages of the standard deviations of the output gap and cash to deposit ratio.
– VOLPS and VOLGOV are 5-year moving averages of the standard deviations of private and government deposits divided by the 5-year moving average of these series.
– PORT is the ratio of demand to savings deposits.
– Y is the output gap
Estimating Excess vs. Voluntary Reserves
• Where:
– DEPPS and DEPG are, respectively, private sector and government deposits as a fraction of GDP.
– CREDPS and CREDG are the ratios of private sector credit and credit extended to government to GDP.
– BOND is the ratio of securitised domestic debt to GDP.
– AID and OIL are the ratios of aid inflows and oil exports to GDP.
– POIL is the quarterly percentage change in the oil price.
– rL is the commercial bank lending rate.
• Because of the presence of several explanatory variables that are likely to be endogenous, OLS
estimation would be inconsistent, instead the model is estimated using the instrumental variables estimator (IV).
• Estimation will only be valid if the variables are stationary.
• Results of the estimation should reveal which factors
are the main drivers of holdings of voluntary and
Estimating Excess vs. Voluntary Reserves
• Saxegaard establishes a dynamic forecast for
voluntary and excess reserves using the following formulae:
• Where ĉ, ά
1ά
2ά
3are parameter estimates. EL
Pare precautionary reserves as a ratio of total deposits and EL
Iare involuntary reserves.
Monetary Transmission Channels, Liquidity Conditions, and Determinants of Inflation
• There are a couple of drawbacks with this methodology.
• The estimation is clearly sensitive to the variables included in the vectors X
1and X
2.
• Second only the sum of the two constants is identified.
Note that any given value of a is consistent with the
requirement that the sum of EL
Pand EL
Iequals total
excess liquidity. The implication is that the level of
voluntary and involuntary reserves is not identified,
The Impact of Surplus Liquidity
• Under a liquidity shortage central bank operations have the following characteristics:
– Commercial banks are forced to transact with the central bank (potentially in standing facilities).
– Central bank can dictate the terms on which they interact with the market; including which assets back respective liabilities.
– Operations should earn a central bank money.
Liabilities Assets Notes
Required Reserves
Free Reserves
Capital Other
OMOs Government
FX
The Impact of Surplus Liquidity
• When there is a surplus of liquidity its impact on the
operations of the central bank will be determined by
the extent to which free reserves are being held for
voluntary or excess reasons.
• Central bank attempts to absorb voluntary reserves may be ineffective unless the instrument used in draining operations is similarly desirable to the counterparty.
• However, holdings of voluntary reserves if stable are unlikely to impact on the central bank‟s ability to
implement monetary policy or significantly impact on the transmission of monetary policy.
• Ultimately they can be modelled as an additional
The Impact of Surplus Liquidity
• Commercial banks holding excess reserves may be more willing to make use of draining operations if they offer a positive return.
• However, the presence of excess reserves in the financial system creates a deadweight loss for the commercial bank if they are left holding them.
• This will impact on the interbank market, lending by
commercial banks and the deposit rates they offer.
• Therefore the presence of excess reserves can
influence the transmission mechanism of monetary policy.
• Despite surplus liquidity being a common feature of many economies around the world there has been surprisingly little work formalising either the channels through which excess liquidity impacts on the
transmission mechanism, nor the scale of the impact.
Channels of Impact
• Agénor and El Aynaoui (2009) present one attempt to map the channels through which excess reserves can impact on the transmission channel.
• Using a simplified model of the economy they
establish two elements of commercial bank behaviour that are distorted by the presence of excess reserves:
– Deposit Rates
– Lending Rates
• In the model, the presence of excess reserves leads commercial banks to respond asymmetrically when adjusting deposit rates following a change in
monetary policy.
• Following a tightening of policy commercial banks will
internalise the possibility that tighter monetary policy
will lead to greater demands for deposits. This will
compound the problems of excess reserves, and so
banks will likely not raise deposit rates in step.
Channels of Impact
• Excess liquidity can also induce asymmetric pricing of loans by commercial banks.
• The overall presence of excess reserves may lead to commercial banks to weaken lending criteria in an attempt to increase returns. The extent to which
commercial banks would do this is determined by the overall scale of surplus liquidity.
• If an increase in interest rates leads to an increase in excess reserves, then a commercial bank may loosen credit standards, making the impact of policy
ambiguous.
• The results of Agénor and El Aynaoui formalise the channels through which surplus liquidity can impact on the transmission of monetary policy.
• In particular central banks facing the presence
significant holdings of excess reserves may find their
ability to tighten monetary policy compromised.
Quantifying the Impact
• Despite the establishment of these potential channels little work has been done on quantifying their effects.
• Partly as surplus liquidity is often found in economies where the transmission of monetary policy through the interest rate channel is limited by underdeveloped
banking systems.
• One attempt to quantify the impact was produced by Saxegaard (2006). Looking once again at the Sub- Saharan Africa region. By comparing the impulse
response in a Threshold VAR (TVAR) model that has
two states, depicting the presence and absence of
significant holdings of excess reserves.
Quantifying the Impact
• The TVAR model is specified as follows:
• Where v
itYand v
itMare regime dependant vectors of non-policy and policy shocks. C
i(L) is a regime
dependant lag polynomial of autoregressive
parameters. Finally EL
Itis the threshold variable
whose value relative to a threshold that determines
Monetary Transmission Channels, Liquidity Conditions, and Determinants of Inflation
• The variables are split into a policy (Y
t) and non-policy
blocks (M
t). In Saxegaard‟s analysis variables in the
non-policy block are real GDP and inflation, whereas
in the policy block are the nominal exchange rate and
M0. For Nigeria the oil price is also included.
Quantifying the Impact
• Saxegaard finds that the in the cases of Nigeria and Uganda “an unexpected contraction in reserve money lowers inflation more when involuntary excess liquidity is low than when excess liquidity is high”. Though for the CEMAC region the results are not conclusive.
• The results of Saxegaard provide some evidence that
the ability of a central bank to tighten monetary policy
may be weakened by the presence of surplus liquidity.
• There are other potential channels through which surplus liquidity can influence a central bank‟s
interaction with financial markets.
• One such effect is that commercial banks have a greater influence the central bank‟s choice of policy instruments.
• Under such conditions the central bank faces
temptation to introduce to use non-market tools. While
these can have short-term benefits they can impede
Other Impacts
• The presence of a excess reserves has influence of financial stability objectives as well as monetary policy ones.
• Under such a surplus of liquidity commercial banks have less incentive to manage their own liquidity well.
• However, under a surplus of liquidity failure of central
bank operations to ensure that the optimal amount of
liquidity available to the banking system will not lead
to payments systems problems.
• Operations under a surplus of liquidity can lead to the central bank incurring losses.
• Crucial to note that losses occur as a result of the
mismatch between costs due on liabilities compared
to income from assets.
Other Impacts
Liabilities Assets
Notes
Required Reserves
OMOs
Other Capital
FX
Government
