Ric Battellino: Central bank market operations
Address by Mr Ric Battellino, Deputy Governor of the Reserve Bank of Australia, to the
Retail Financial Services Forum, Sydney, 28 August 2007.
* * *
Central bank market operations around the world have been in the news in recent weeks, so
I thought it might be useful to take this opportunity to run through those developments. While
this topic may seem somewhat distant from retail financial services, there is in fact a strong
relevance to today's conference, because much of what central banks do in financial markets
eventually flows through the whole financial system, including retail services.
Background
The Reserve Bank has been using market operations to implement monetary policy since the
1980s.1 Essentially, this involves dealing in markets to influence the interest rate on
overnight funds in the money market - also known as the cash rate. Central banks are able
to closely control the overnight interest rate because they have unlimited ability to inject
funds into, or withdraw funds from, the money market. This model for implementing monetary
policy is now fairly standard across the developed world.
The Reserve Bank Board sets the stance of monetary policy in terms of a target for the cash
rate because this rate ultimately influences the broad spectrum of interest rates in the money
and capital markets and the interest rates that intermediaries charge on loans, including
those in the retail market. In effect, all interest rates in the financial system are determined in
one way or another relative to the cash rate. By targeting the cash rate, central banks are
therefore able to exert broad influence over the overall cost of credit in the economy and, in
turn, economic activity and inflation.
After the Reserve Bank Board has decided the target for the cash rate each month, the
Domestic Markets Department of the Bank is responsible for keeping the actual cash rate in
the market as close as possible to the target over the ensuing inter-meeting period. A major
determinant of the cash rate is the aggregate level of balances held by commercial banks in
their exchange settlement accounts at the Reserve Bank. These are the funds that banks
rely on to meet their daily settlement obligations to each other and to the Reserve Bank. If
banks do not have enough of these funds, they risk failing in their payments, so a shortage of
funds causes banks to bid more aggressively in the money market to try to restore their
holdings. On the other hand, because these funds earn an interest rate that is below the rate
that could be earned in the market (25 points below the cash rate), banks do not want to hold
more than necessary. As such, a build-up in exchange settlement balances makes banks
more eager to lend funds, and this pushes market interest rates down.
The job of Domestic Markets Department is therefore to ensure that the aggregate supply of
exchange settlement balances is sufficient for the cash market to clear each day at the target
cash rate. As can be seen from Graph 1, the level of exchange settlement balances
necessary to achieve this is typically around $700-800 million. However, for various reasons,
there are times when banks need more, or less, cash. In these cases, the Reserve Bank
responds by adjusting the amount it provides, in order to equilibrate demand and supply. It
does this by buying securities to increase the supply of exchange settlement balances and
selling securities to reduce the supply. These transactions may be either outright purchases
or sales, or repurchase agreements which involve the sale of a security with an undertaking
to repurchase it at a future agreed date and at an agreed price. In recent years, the Reserve
Bank's operations have been predominantly by way of repurchase agreements.
Graph 1
It is worth noting that the range of securities that the Bank is prepared to deal in has been
widened over the years. Ten years ago, the Bank only dealt in Commonwealth Government
securities, but in response to the diminished supply of these securities and in recognition of
growing markets in other securities, the Bank over the years has added semi-government
securities, bonds issued by international organisations and Australian bank bills to the list of
securities in which it is prepared to deal.
International practice by central banks in this regard is quite varied: some central banks take
a narrower range of securities than the Reserve Bank; others take a broader range. There
has, however, been a general tendency over the years for central banks to widen the range
of securities in which they are prepared to deal.
Over time, the Reserve Bank has also widened the range of counterparties with which it is
prepared to deal. Currently, it deals with any holder of securities that is able to settle its
transactions electronically through the dedicated RITS settlement system. In this regard, the
Reserve Bank is at the more liberal end of the international spectrum. Many other central
banks limit their dealing to banks or selected groups of primary dealers.
The daily routine in market operations is fairly straightforward. The Bank's dealing intentions
are announced at 9.30 am each morning, dealing is completed over the subsequent half
hour, and details of dealings are published at around 10.15 am. Second rounds of dealing
may be undertaken later in the day if needed, but such circumstances have been rare.
As well as these regular operations, the Bank has put in place a standing facility to allow
market participants to access cash, at their discretion, in unforeseen circumstances. This
facility allows banks and other holders of exchange settlement accounts to borrow overnight
on a secured basis, though at a penalty of 25 basis points over the cash rate target. Banks
typically use this facility only if they experience some operational difficulty or miscalculate
their daily funds flows, which is rare.
With banks able to borrow from the Reserve Bank at their discretion at 25 points above the
cash rate, and the Reserve Bank paying interest on exchange settlement balances at 25
points under the cash rate, the rate at which cash can trade in the market is confined to a 50
point corridor around the target. In practice, the degree of fluctuation is much less than this.
As shown in Graph 2, so far this year there have only been three days when the cash rate
has deviated from the target, on each occasion by only one or two basis points.
Graph 2
Even though each central bank around the world has its own idiosyncratic arrangements in
relation to market operations, the essence of the arrangements is the same. It involves the
central bank buying and selling securities in the market to supply enough funds to banks to
keep the actual short-term interest rate as close as possible to the target. These operations
essentially work through the banking system and rely on banks passing on funds not only to
each other but also to market participants more generally. Most of the time this works
seamlessly, but there are times, such as the present, when it doesn't. Let me move therefore
to these recent events.
What changed in the past couple of weeks?
The problems experienced in money markets in recent weeks had their origins in the credit
and market-related losses incurred by investors who had bought securities collaterised by
US sub-prime mortgages. Various investment funds worldwide, including in Australia, have
been reporting losses on these securities for some months now. Most of these have been
hedge funds, and while the losses incurred in some cases have been severe, these
problems for quite some time did not seem to have any significant ramifications more
generally through the financial system.
That changed on 9 August, after a large European bank announced that it was freezing
withdrawals from three of its investment funds due to losses incurred by those funds and the
difficulty in valuing their security holdings. This seemed to trigger a shift to a much more
risk-averse approach by money market participants in dealing with each other.
What seemed to be worrying people was that, while the US Fed had calculated the losses in
the sub-prime market as being potentially as high as US$100 billion, only a few billion of
losses had been announced by investment funds. This naturally led market participants to
question who was sitting on the prospective losses, and what this meant for the
creditworthiness of market counterparties. Investors became much more risk-averse and
banks severely curtailed their lending to each other, causing gridlock in the money market.
The process spread quickly because once banks started to worry that others may stop
lending to them, they in turn stopped lending to others.
While there has been a widespread tightening in the availability of credit in all markets, those
most affected have been the vehicles used by banks to invest in, or warehouse, mortgages.
These vehicles, known variously as conduits, credit arbitrage funds or warehouses, had been
set up by many banks around the world to finance mortgages off their balance sheets. The
funding came from the issue of short-term securities backed by mortgages - so-called
asset-backed commercial paper.
Until recently, these vehicles had found it very easy and cheap to raise money. Despite the
fact that hardly a day went by without some respected commentator around the globe
warning that credit risk was being under-priced, investors remained enthusiastic and credit
spreads if anything continued to decline. For example, the yield on US 90-day asset-backed
commercial paper for much of the past year had been similar to the overnight rate on fed
funds. The amount of such paper issued almost doubled over the past couple of years, to
US$1 200 billion.
The market for asset-backed commercial paper extended well beyond the US, as banks in
most countries had set up these conduit vehicles. Many of the securities issued by these
vehicles were in international markets with the funds swapped back into the relevant
domestic currency. Cross-border flows were large, creating strong links between national
markets.
Cross-border links were also generated by the credit lines that these vehicles had
established with banks in the event that the commercial paper market failed. These lines
were spread across banks in a range of countries, so problems experienced by a conduit
vehicle in one country affected banks in many countries.
When investor attitudes to credit risk changed abruptly in early August, these links quickly
spread the problems worldwide. Asset-backed commercial paper markets came to a virtual
standstill, forcing the bulk of these conduit vehicles to turn to the lines of credit they had
negotiated with banks. This in turn meant that banks in a wide range of countries found
themselves under increased funding pressure in order to meet commitments on credit lines.
The effects on markets across countries were very similar:
Overnight money market rates rose above the level targeted by central banks. For example,
while the US Fed is currently targeting 5.25 per cent, the actual rate in the market rose to 6
per cent on 9 August (Graph 3).
Graph 3
In LIBOR and swap markets, which are further away from the direct influence of central
banks because they are more internationally focussed and have a greater diversity of
participants, margins widened relative to cash rates (Graph 4).
Graph 4
Yields on securities issued by banks, such as short-term bankers acceptances, rose
noticeably. In the US they were up by 0.25 percentage points for terms of 90 days (Graph 5).
Graph 5
Yields on asset-backed commercial paper, which as noted had been at the same level as the
fed funds rate for much of the past year, rose even more sharply, by about 60 basis points
(Graph 6). More importantly, activity in this market dried up sharply, the effect being that for a
time funding was not available at any price.
Graph 6
Yields on US treasury bills fell by almost 2 percentage points, to 3.25 per cent, as investors
scrambled into secure and liquid investments (Graph 7).
Graph 7
There were also spillovers to other markets, including sharp falls in share prices, particularly
for financial stocks, and some significant re-adjustment of exchange rates (Graph 8).
Graph 8
These were all symptoms of rising risk aversion.
Central banks responded to this by sharply increasing the amount of funds supplied to their
banks in the money market. Among the developed economies, the European Central Bank,
the US Fed, the Bank of Japan, the Bank of Canada, the Swiss National Bank, the Norges
Bank, the Reserve Bank of New Zealand, as well as ourselves here in Australia, all did so to
varying degrees. Some also took other measures. The Fed, for example, cut the penalty rate
on its discount window from 100 points to 50 points in order to lessen the cost of emergency
funding to banks. Some central banks also widened the range of securities in which they
were prepared to deal.
None of these measures was intended as a change in monetary policy settings and no
central bank has reduced its interest rate target. Neither should these measures be seen as
an attempt to "bail out" banks or markets. Rather, the measures have been technical
operations aimed at breaking up the log jams in money markets and encouraging funds to
flow again, in order to prevent monetary conditions becoming tighter than the settings that
had been determined by the central bank monetary policy committees and boards in the
various countries.
The operations have restored some degree of calm to markets but conditions have not yet
returned to normal. Notably, yields on asset-backed commercial paper as yet have not fallen,
indicating a continuing high degree of nervousness among investors.
Yields on US treasury bills have reversed some of their earlier fall, but still remain unusually
low, again indicating a continuing strong risk aversion among investors. On the other hand,
share markets in many countries have recovered strongly and some of the earlier exchange
rate moves have also been largely reversed.
The Australian situation
Despite the fact that Australian banks are in very sound condition and have been
experiencing minimal credit losses, they were nonetheless affected by the spread of the
global money market turmoil. On the morning of 10 August, banks started telling us that they
were noticing a reduced flow of funds through the market. The cost of raising funds in global
markets through swaps had risen noticeably, putting more pressure on domestic funding
sources. Yields on banks bills had jumped sharply overnight, and LIBOR rates by even more
(Graph 9).
The Reserve Bank decided to supply more than the usual $700-800 million of exchange
settlement funds, so that the overnight interest rate would not rise above the target set by the
Board in early August. Those operations were successful in maintaining the cash rate at the
6.5 per cent target, though other short-term market interest rates remained unusually
elevated.
Since then, the Bank has continued to supply whatever amounts of exchange settlement
balances were necessary to keep the cash rate at the target. In the process, balances rose
to a peak of $5.5 billion in the middle of last week, the highest level for some years, though
some of this has been reversed recently. The Bank also skewed its market operations more
towards bank bills, rather than government securities, to enhance confidence in the liquidity
of highly-rated instruments in the bill market.
Graph 9
The proportion of the Bank's operations undertaken in bank bills has risen to around 80 per
cent, well above the usual 30 per cent share. This has lifted the Bank's domestic bill repo
book from a little over $18 billion at the start of August to around $40 billion today (Graph
10). The term of repos has also been lengthened appreciably, from the usual average of
around 20 days to over 100 days, to provide greater certainty of funding (Graph 11).
Graph 10
These operations have held the cash rate at the target, and helped to stabilise market
conditions more generally. Nonetheless, some pressures remain. Yields in the bill market
remain somewhat higher than usual relative to the cash rate, and yields on asset-backed
commercial paper even more so. The volume of securities issued has fallen, and the
maturities have shortened. Banks have switched some of the funding of their conduits from
the asset-backed commercial paper to on-balance-sheet, where it is supported by the banks'
capital. This seems appropriate.
In recent days, there have been some encouraging signs of improvement in markets, both
here in Australia and overseas. The Bank will continue to monitor the situation carefully. If
market developments warrant, the Bank has scope to further expand the provision of
liquidity. These matters are being kept under review.