In the past, it was common for central banks to exercise direct controls on bank operations by setting limits either to the quantity of deposits and credits (e.g., ceilings on the growth of bank deposits and loans), or to their prices (by setting maximum bank lending or deposit rates). As a result of the significant financial liberalization process aimed at achieving an efficient allocation of financial resources in the economy, there has been a movement away from direct monetary controls towards indirect ones.
Indirect instruments influence the behaviour of financial institutions by affecting initially the central banks‟ own balance sheet. In particular the central bank will control the price or volume of the supply of its own liabilities (reserve money) that in turn may affect interest rates more widely and the quantity of money and credit in the whole banking system.
The two most significant assets of the Central Bank are debt securities followed by loans and advances. On the liability side, debt securities are again the largest proportion, followed by deposits by central banks and deposits by banks and building societies.
The indirect instruments used by central banks in monetary operations are generally classified into the following:
Open market operations (OMOs);
i. Debt securities and open market operations
Debt securities are mainly represented by Treasury securities (i.e., government debt) that central banks use in open market operations are the most important tools by which central banks can influence the amount of money in the economy.
Although the practical features of open market operations may vary from country to country, the principles are the same: the central bank operates in the market and purchases or sells government debt to the non-bank private sector. In general, if the central bank sells government debt the money supply falls (all other things being equal) because money is taken out of bank accounts and other sources to purchase government securities. This leads to an increase in short-term interest rates. If the government purchases (buys-back) government debt this results in an injection of money into the system and short-term interest rates fall. As a result, the central bank can influence the portfolio of assets held by the private sector. This will influence the level of liquidity within the financial system and will also affect the level and structure of interest rates.
The main advantages of using open market authorities to influence short-term interest rates are as follows:
i. They are initiated by the monetary authorities who have complete control over the volume of transactions;
ii. Open market operations are flexible and precise – they can be used for major or minor changes to the amount of liquidity in the system;
iii. They can easily be reversed;
iv. Open market operations can be undertaken quickly.
Open market operations are the most commonly used indirect instruments of monetary policy in developed economies. One of the main reasons for the widespread use of market operations relates to their flexibility in terms of both the frequency of use and scale (i.e., quantity) of activity. These factors are viewed as essential if the central bank wishes to fine-tune its monetary policy. In addition, OMOs have the advantage of not imposing a tax on the banking system.
ii. Loans to banks and the discount window
The second most important monetary policy tool of central bank is the so-called „discount window‟ (in the United Kingdom this tool is often referred to as „standing facilities‟). It is an instrument that allows eligible banking institutions to borrow money from the central bank, usually to meet short-term liquidity needs. Discount loans to banks account for a relatively large proportion of a central bank‟s total assets.
By changing the discount rate, that is, the interest rate that monetary authorities are prepared to lend to the banking system, the central bank can control the supply of money in the system. If, for example the central bank is increasing the discount rate, it will be more expensive for banks to borrow from the central bank so they will borrow less thereby causing the money supply to decline. Vice versa, if the central bank is decreasing the discount rate, it will be cheaper for banks to borrow from it so they will borrow more money. Manipulation of the discount rate can therefore influence short-term rates in the market.
Direct lending to banks can also occur through the central bank‟s lender-of-last-resort (LOLR) function. By acting as a lender-of-last-resort the central bank provides liquidity support directly to individual financial institution if they cannot obtain finance from other sources. Therefore it can help to prevent financial panics.
iii. Reserve requirements
Banks need to hold a quantity of reserve assets for prudential purposes. If a bank falls to its minimum desired level of reserve assets it will have to turn away requests for loans or else seek to acquire additional reserve assets from which to expand its lending. The result in either case will generally be a rise in interest rates that will serve to reduce the demand for loans.
The purpose of any officially imposed reserve requirements is effectively to duplicate this process. If the authorities impose a reserve requirement in excess of the institutions‟ own desired level of reserves (or else reduce the availability of reserve assets) the consequence will be that the institutions involved will have to curtail their lending and/or acquire additional reserve assets. This will result in higher interest rates and a reduced demand for loans that, in turn, will curb the rate of growth of the money supply.
By changing the fraction of deposits that banks are obliged to keep as reserves, the central bank can control the money supply. This fraction is generally expressed in percentage terms and thus is called the required reserve ratio: the higher the required reserve ratio, the lower the amount of funds available to the banks. Vice versa, the lower the reserve ratio required by the monetary authorities, the higher the amount of funds available to the banks for alternative investments.
The advantage of reserve requirements as a monetary policy tool is that they affect all banks equally and can have a strong influence on the money supply. However, the latter can also be a disadvantage, as it is difficult for the authorities to make small changes in money supply using thbanks that do not have excess reserves. If the authorities regularly make decisions about changing reserve requirements it can cause problems for the liquidity management of banks. In general, an increase in reserve requirements affects banks‟ ability to make loans and reduces potential bank profits because the central bank pays no interest on reserves.
Reserve requirements are often referred to as instruments of portfolio constraint. It means that they may be imposed by the authorities on the portfolio structure of financial institutions, with the purpose of influencing credit creation and, possibly, the type of lending taking place.is tool. Another drawback is that a call for greater reserves can cause liquidity problems for banks that do not have excess reserves. If the authorities regularly make decisions about changing reserve requirements it can cause problems for the liquidity management of banks. In general, an increase in reserve requirements affects banks‟ ability to make loans and reduces potential bank profits because the central bank pays no interest on reserves.
Reserve requirements are often referred to as instruments of portfolio constraint. It means that they may be imposed by the authorities on the portfolio structure of financial institutions, with the purpose of influencing credit creation and, possibly, the type of lending taking place.