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5 Central bank impotence and market
liquidity By Henry C K Liu
primary credit for short-term
contingency funding should be viewed as
appropriate and unexceptional by both [bank]
management and supervisors". Still, banking being
a traditionally conservative industry, such stigma
persists about discount window borrowing. The
above-market price of the discount rate cut on
August 17 by the Fed by half from its100 basis
points cap to 50 basis points over the Fed Funds
rate target to facilitate discount borrowing had
to be qualified with a public repeat of Fed policy
that such
borrowing does not reflect
weakness in the borrowing banks. Yet the cut in
the discount rate reflects weakness in the entire
banking system, a message not missed by astute
market participants.
When a bank borrows
from the Fed's discount window, it increases the
funds it has in its reserve account held at the
Fed, which the bank can apply towards meeting its
reserve requirement. Thus, ceteris paribus
(all other things being equal), one would expect
that when required reserves are higher, discount
window borrowing would be higher.
Reserve
requirements are the amount of funds that a
depository institution must hold in reserve
against specified deposit liabilities. Within
limits specified by law, the Federal Reserve board
of governors has sole authority over changes in
reserve requirements. Depository institutions must
hold reserves in the form of vault cash or
deposits with Federal Reserve banks. The dollar
amount of a depository institution's reserve
requirement is determined by applying the reserve
ratios specified in the Federal Reserve board's
regulation D to an institution's reservable
liabilities, which consist of net transaction
accounts, non-personal time deposits and
euro-currency liabilities.
Since December
27, 1990, non-personal time deposits and
euro-currency liabilities have had a reserve ratio
of zero. The reserve ratio on net transactions
accounts depends on the amount of net transactions
accounts at the depository institution. The
Garn-St Germain Act of 1982 exempted the first $2
million of reservable liabilities from reserve
requirements. This "exemption amount" is adjusted
each year according to a formula specified by the
act. The amount of net transaction accounts
subject to a reserve requirement ratio of 3% was
set under the Monetary Control Act of 1980 at $25
million. This "low-reserve tranche" is also
adjusted each year. Net transaction accounts in
excess of the low-reserve tranche are currently
reservable at 10%.
Reserve balance
driven by interbank payments The demand
for reserve balances is increasingly being driven
by growth in interbank payment activity rather
than by minimum reserve requirements. Interbank
payments are processed over Fedwire, the
large-value payment system owned and operated by
the Fed. The value of aggregate Fedwire payments
increased from roughly $1.3 trillion a day in 1992
to roughly $3 trillion a day in early 2004. These
payments are funded from an aggregate reserve
balance that, as of the first quarter of 2004,
averaged only $11.5 billion.
To facilitate
an efficient payment system, the Fed allows banks
to maintain limited negative reserve balances
during the business day at a low cost, currently
27 basis points at an annual rate, but imposes a
stiff 400 basis point penalty on negative balances
held overnight. Before 2003, banks faced with an
unexpected negative balance late in the day might
have gone to the discount window, but they might
have remained reluctant. The new primary credit
facility reduces the perceived stigma of borrowing
from the Fed, and banks in this situation would
borrow from the central bank and pay a penalty
capped at 100 basis points over Fed Funds rate.
The Clearing House Interbank Payments
System (CHIPS) is a privately operated, real-time,
multilateral, payments system typically used for
large dollar payments, owned by financial
institutions, and any banking organization with a
regulated US presence may become an owner and
participate in the network.
The payments
transferred over CHIPS are often related to
international interbank transactions, including
the dollar payments resulting from foreign
currency transactions, such as spot and currency
swap contracts, and euro placements and returns.
Payment orders are also sent over CHIPS for the
purpose of adjusting correspondent balances and
making payments associated with commercial
transactions, bank loans and securities
transactions.
Since January 2001, CHIPS
has been a real-time final settlement system that
continuously matches, nets and settles payment
orders. In June, CHIPS processed $2.645 trillion
of payments. CHIPS typically handles about 300
payments ($90 billion in gross, $36 billion net)
in its queue at the end of the day.
Liquidity risk in the interbank payment
system Liquidity risk is the risk that the
financial institution cannot settle an obligation
for full value when it is due even if it may be
able to settle at some unspecified time in the
future. Liquidity problems can result in
opportunity costs, defaults in other obligations,
or costs associated with obtaining the funds from
some other source for some period of time.
In addition, operational failures may also
negatively affect liquidity if payments do not
settle within an expected time period. Until
settlement is completed for the day, a financial
institution may not be certain what funds it will
receive and thus it may not know if its liquidity
position is adequate. If an institution
overestimates the funds it will receive, even in a
system with real-time finality, then it may face a
liquidity shortfall. If a shortfall occurs close
to the end of the day, an institution could have
significant difficulty in raising the liquidity it
needs from an alternative source.
Systems
that postpone a significant portion of their
settlement activity in dollars toward the end of
the day, such as CHIPS, may be particularly
exposed to liquidity risk. These risks can also
exist in Real Time Gross Settlement (RTGS) systems
such as Fedwire. Systems or markets that pose
various forms of settlement risk also pose forms
of liquidity risk.
With the average daily
turnover in global foreign exchange
(FX)transactions at over $2 trillion, the FX
market needs an effective cross-currency
settlement process. Continuous Linked Settlement
(CLS) is a means of settling foreign-exchange
transactions finally and irrevocably. CLS
eliminates settlement risk, improves liquidity
management, reduces operational banking costs and
improves operational efficiency and effectiveness.
CLS Bank based in New York is an Edge
Corporation bank supervised by the Federal
Reserve. CLS Bank is a multi-currency bank,
holding an account for each settlement member and
an account at each eligible currency's central
bank, through which funds are received and paid.
Technical and operational support is provided by
CLS Services, an affiliate of CLS Bank.
CLS Bank, while eliminating the bulk of
principle risk through its payment-versus-payment
design, retains significant liquidity risk, as
funding is made on a net basis, and pay-in
obligations may need to be adjusted in the event
that a counterparty is unable to fund its
obligations. Other systems, including securities
settlement systems, may also be subject to
liquidity risks.
To manage and control
liquidity risk, it is important for financial
institutions to understand the intraday flows
associated with their customers' activity to gain
an understanding of peak funding needs and typical
variations. To smooth a customer's peak credit
demands, a depository institution might consider
imposing overdraft limits on all or some of its
customers. Moreover, institutions must have a
clear understanding of all of their proprietary
payment and settlement activity in each of the
payment and securities settlement systems in which
they participate.
Clearing balance
requirements represent obligations to hold
reserves that are set at the discretion of a bank
before each reserve maintenance period. Only
balances held at the Federal Reserve during the
two-week reserve maintenance period are eligible
to satisfy clearing balance requirements. A bank
is penalized for ending any day overdrawn on its
account at the Fed, as well as for failing to meet
its requirements by the end of the maintenance
period.
To obtain the necessary reserves
to avoid these fees if unable to borrow the
necessary amount of reserves from another bank, a
qualifying bank may borrow reserves directly from
the Federal Reserve at its discount window
facility under the primary credit program, at a
rate typically set not more than 100 basis points
above the target Fed Funds rate. This spread
between the primary credit rate and the Fed Funds
rate target is generally viewed as representing a
de facto penalty associated with being deficient.
This penalty was cut in half on August 18. The
Federal Reserve does not pay interest on reserves
held in excess of requirements. Thus, the
opportunity cost of holding excess reserves is a
bank's marginal funding cost, which is represented
by the Fed Funds rate.
To provide banks
with some flexibility in meeting their
requirements for avoiding these penalties and
costs, the Fed allows banks to apply excess
reserve balances held in one maintenance period to
meet reserve requirements in the following period,
in an amount up to 4% of reserve requirements in
the second period. Similarly, a bank may end a
period up to 4% short of its reserve requirements
and pay no penalty, as long as it holds sufficient
excess reserves in the following period to offset
this deficiency.
Fed actions aim at
mutually contradicting objectives The
Federal Reserve action on the discount rate tries
to meet its short-term responsibility to keep
financial markets functioning by injecting funds
into the banking system. At the same time, the Fed
tries also to macro manage the economy in
containing inflation by tightening the money
supply through interest rates increases.
For almost a century since its
establishment in 1913, the Fed has been engaged in
a continuous battle between inflation and economic
growth by standing on both sides of the conflict
to keep a balance. This conflict is a structural
malady of market capitalism. Recurring economic
recessions or depressions lead to
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