Chris Salmon: Remarks on the Sterling Monetary Framework (SMF)
Annual Report
Remarks by Mr Chris Salmon, Executive Director for Markets of the Bank of England, at the
Money Markets Liaison Committee meeting, London, 13 July 2015.
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I would like to thank Eleanor Broughton, Ronnie Driver, Sarah John, Ben Martin and Ben Morley for their
comments and contributions.
The Bank will hold an Open Forum this autumn. The Forum will facilitate an open debate
about the role of markets in society, and provide an opportunity to review how key financial
markets are functioning. The Bank's own mechanism for interacting with markets, when
implementing monetary policy and providing liquidity insurance, is set out in the Sterling
Monetary Framework (SMF). Markets work more effectively when participants are open and
transparent about their activities, and the Bank aspires to meet that standard in relation to its
own market operations, including through publishing an annual report on the effectiveness of
the SMF.
This Committee brings together key participants in sterling money markets and is a natural
venue to discuss the operation of SMF. As such, today I want to summarise the key themes
that were covered in our most recent annual reports and to sketch out some of the issues
that the Bank is likely to confront in coming years. These are areas where your future
feedback will be essential as we work to maintain the effectiveness of the SMF.
Liquidity insurance
We have made a number of significant changes to the way the Bank offers liquidity provision
through the SMF. As the Governor has remarked, these changes have been aimed at
providing more liquidity, at longer terms, at cheaper rates, and to a wider range of
counterparties with the objective of ensuring that the Bank of England is "open for business".
As discussed in the SMF annual report, the main highlights over the past couple of years
have included the extension of SMF membership to broker-dealers and central
counterparties (CCPs), and the expansion of the monthly indexed long term repo (ILTR)
operations.
The extension of the SMF to broker-dealers and CCPs gives non-banks access to the Bank
of England's balance sheet for the first time. Non-banks are becoming increasingly important
to the financial system. The Bank considered three key themes before widening SMF
membership: whether the non-bank institutions were systemically important, whether they
were exposed to sterling liquidity risk, and whether they were appropriately prudentially
regulated so that usage of the facilities remained appropriate. In light of this, the Bank
announced in November 2014 that broker-dealers and CCPs would be eligible to apply for
access to the SMF. And some of these institutions have indeed formally signed up in recent
months.
Another recent, major change to the SMF was the reform to the Bank's ILTR operations in
February 2014. These auctions offer reserves at lower prices and for a longer maturity
against a wider range of collateral than had been the case previously. And the auctions are
responsive to market conditions, with the amount of liquidity available rising automatically if
there is greater demand. Reflecting the improved financial positions of banks and building
societies, and the liquidity provided to the market through QE, the Bank's liquidity insurance
facilities saw relatively modest usage over the year covered by the most recent annual
report. More recently, however, usage has increased, as banks sought to make use of the
liquidity insurance provision on offer by pre-emptively securing term funding ahead of a
period of potential uncertainty around key events, such as the UK general election, and
Greece. This pattern of usage is encouraging and welcome, as it demonstrates that banks
are prudently managing their liquidity position ahead of potential risks, and that the ILTR is
an active part of their liquidity management. Despite the increase, however, demand has
remained relatively low, with just over £4 billion allocated in the May operation: a high water
mark for the expanded ILTR operation.
Looking back to 2007, before the crisis, the cumulative changes we have made to the SMF
have been transformative. The SMF now has 164 members, more than double the number
signed up in 2007, with banks and building society SMF members accounting for 98% of total
sterling deposits. The drawable value of collateral delivered to the Bank for actual or potential
use in the Bank's facilities has increased dramatically, and stood at £327.4 billion at
endJune 2015. And the Bank now has a comprehensive set of market wide and bilateral
facilities. These developments give the Bank tremendous flexibility to support financial
institutions during periods of stress. As you will see from the FPC's published record, it was
in that context that the Bank decided to announce two additional ILTR operations in the event
of a "yes" vote in the referendum on Scottish Independence, as a precautionary measure to
backstop sterling market liquidity. As part of its contingency planning, the Bank assessed its
ability to provide liquidity support to the banking system should it become necessary and
concluded that the range of tools within the existing framework offered sufficient flexibility to
respond.
But the Bank is not standing still; we are continuing to develop our liquidity insurance
framework to ensure that it can react to a wide range of liquidity challenges.
First, as part of the strategy to broaden liquidity provision, the Bank has committed to
consider the feasibility of offering Shari'ah compliant facilities. All banks must hold an
adequate stock of liquid assets to meet prudential regulations and, as the most liquid assets
in the economy are the reserves held by banks and building societies on account at the
Bank, it would be beneficial to Shari'ah compliant banks to have access to our balance
sheet. There are significant challenges to this work: for example, in designing a Shar'iah
compliant deposit account which has similar economic properties to interest-paying reserve
accounts and in identifying sufficient Shari'ah compliant collateral to support lending facilities.
But the Bank is now actively working on these issues and I am hopeful that we will be able to
release further details as early as the turn of the year.
Second, the Bank has also started work to ensure there are no technical obstacles to our
ability to accept equities as collateral should the need arise. At present, the Bank accepts a
very broad range of collateral, including government bonds, asset backed securities and
pools of "raw" loans. But the Bank can further bolster its flexibility by removing any technical
obstacles to accepting equities as collateral, should the need arise. Given the complexities
involved, the project will take some time to deliver, and we currently anticipate that work to
remove technical obstacles will continue throughout 2015 and 2016.
Finally, as noted in the Open Forum paper1 published in June, the Bank stands ready in
principle to support core markets directly through "Market Maker of Last Resort" (MMLR)
actions. Such action would probably only be contemplated if the illiquidity in particular
markets was judged to pose a threat to financial stability, or was judged to be important to
the transmission mechanism of monetary policy. However, MMLR remains a relatively
untested tool, and the Bank's ability and willingness to act as a MMLR could be a fruitful topic
to discuss at the forthcoming Open Forum.
Monetary policy
The task of evolving our liquidity insurance framework will not end, but given the substantial
reforms made to it over recent years, it is likely that the focus will shift to monetary policy
implementation, as and when the MPC decides to move policy away from its current settings.
As the head of the Markets Directorate it is not my role to speculate when the policy setting
might change, but it is my job to ensure that decisions of the MPC are implemented
effectively. That involves, in particular, ensuring that we have the tools needed for effective
monetary control; that is, keeping overnight market interest rates in line with Bank Rate.
The Bank's current approach is to pay Bank Rate on the full balances held in reserves
accounts. This is known as the "floor" system. As set out in the SMF Annual Report, this
approach remained successful at keeping sterling overnight market rates close to Bank Rate
during 2014-15, with the "wedge" between policy rates and market rates relatively small over
the past year. But over the year, activity in the sterling money markets remained low as the
floor system, alongside a large-scale injection of reserves through QE, reduced the need for
banks to transact in money markets.
In the near-term, I expect that this system will remain effective at moving market rates in line
with any change made to policy rates by the MPC. Nevertheless, in the spirit of being
prepared, and drawing on feedback from previous meetings of this committee2, staff have
developed plans should market rates persistently settle below Bank Rate, to such an extent
that the Bank decided it was necessary to intervene in support of monetary control. In such a
scenario, the presumption is that the Bank would issue one-week Bank of England bills,
draining reserves from the system. That would tend to put upward pressure on market rates,
reducing the wedge that had opened up and tightening the link between policy and markets
rates. The Bank has a history of issuing these instruments successfully: Bank of England
bills were first issued in 2008, to drain excess reserves following the increased size of
longterm repo operations. And Bank of England bills also have the advantages of being widely
tradable, offering a close substitute to deposits for most participants in the money markets,
and of providing additional supply of high quality collateral.
I have no particular expectation that the Bank will need to issue Bills in the foreseeable
future, but the tool is ready if required.
The move to the current floor regime was prompted by the MPC's policy decisions to cut
Bank Rate to the effective lower bound and its subsequent decision to loosen monetary
conditions via asset purchases. It is unlikely that the regime would have been adopted
without these developments and so as and when the MPC starts to "normalise" the level of
Bank Rate, the Bank is likely to review whether to retain the current "floor" system indefinitely
or whether it should move to a different medium-term operating framework.
One obvious option would be to return to the framework used before the introduction of QE -
which was known as "reserves averaging". That operating regime was introduced after a
careful review of alternative regimes open to the Bank in the mid-2000s. But the world has
changed markedly since that review was undertaken. Banks have structurally higher demand
for central bank reserves than they did before the crisis, reflecting in part liquidity regulations,
and as I noted earlier, a far wider range of institutions can directly access our balance sheet
than was the case a decade ago. Moreover, the structure of money markets has evolved
considerably over this period as banks have responded to lessons learned during the crisis
and the impact of post-crisis regulation.
These changes have been sufficiently profound that the Bank no longer maintains a
presumption that it will return to a version of reserves averaging that existed prior to 2009.
While such a decision remains possible, the choice of medium-term operating framework is
now a genuinely open question and is likely to be become a key issue for the Bank as it
considers the future design of the SMF.
Whatever decision the Bank makes about its medium-term monetary policy framework it is
likely that the floor system will be retained for some time after Bank Rate is increased from its
current level.
Conclusion
The SMF defines how the Bank interacts with markets, when implementing monetary policy
and providing liquidity insurance. It is important that we are open and accountable for the
operation of the SMF. The MMLC itself and the new SMF annual review process help us
achieve that aim. In recent years we have transformed the SMF, and we believe for the
better. But reform of the SMF is an on-going process. As my remarks today have made clear,
that process is incomplete: further changes to support liquidity insurance are in the pipeline
and the Bank needs to keep under review its tools for implementing monetary policy. The
Bank is both open for business and open to outside views, and we always welcome feedback
from MMLC members or other interested parties on any aspect of the SMF, including at the
forthcoming Open Forum.