Norges Bank's assessment of the consultation responses

On 6 October, Norges Bank distributed a consultative document concerning changes to the system for the management of banks’ reserves. Four consultation responses have been received, from Finance Norway (FNO), DnB NOR, Sparebanken Vest and Haugesund Sparebank.

In addition, we have received a copy of a consultation response from Swedbank to FNO. DnB NOR, Sparebanken Vest and Haugesund Sparebank endorse the comments from FNO. Sparebanken Vest has some additional comments concerning how banks’ quotas should be calculated, while DnB NOR has some additional comments concerning settlement banks’ role in the new system. Swedbank is positive about the new system and believes that it will lead to greater activity in the interbank market.  (1)      

1. Large movements in structural liquidity

The Norwegian government has an account in Norges Bank. Payments to and from this account result in substantial changes in structural liquidity, i.e. banks’ combined need to borrow from or deposit reserves in Norges Bank before Norges Bank conducts any market operations.

FNO notes: 
…The need for a large liquidity buffer needs to be seen in the context of large variations and uncertainty about developments in liquidity in the money market from day to day. Having payments to and from the government continuously deposited in and withdrawn from Norges Bank brings considerable uncertainty about movements in the banking system’s aggregate liquidity, including from the perspective of the individual bank…

In neither the current system nor the new system is there any uncertainty about whether the banking system as a whole will have sufficient reserves at all times. When structural liquidity is low, Norges Bank will always offer banks loans. This reaction pattern is familiar to all banks that operate in Norway and will be retained in the new system. Banks can safely assume that Norges Bank will continue to ensure that banks collectively have sufficient reserves. However, it will be up to the banks to distribute these reserves in the interbank market. 

In the new system, the sum of banks’ quotas (the total quota) will be set closer to today’s level than to zero. Norges Bank will aim for a total level of bank reserves that is somewhat below the total quota. Norges Bank’s target level will be published each time operations to supply or drain liquidity (F-loans and F-deposits) are conducted. 

In the new system, Norges Bank will update and publish its forecasts of movements in structural liquidity more frequently than at present. However, there is still a risk of forecasting errors being made. Historical data show that forecasting errors in the region of NOK 4-5 billion are not uncommon, while forecasting errors in the order of NOK 10 billion occur rarely. Should payments to the government nevertheless be NOK 10-15 billion higher than expected, the surplus of reserves on the day of these payments will still be more than enough to cover payments into the government’s account. Thus, the uncertainty associated with activity in the government’s account is addressed by the new system too, with the aim of maintaining a substantial surplus of reserves.

Uncertainty may also lead to the total amount of reserves in the banking system exceeding the sum of banks’ quotas. In the new system, Norges Bank will, where necessary, conduct fine-tuning operations at short notice and with same-day settlement to steer banks’ combined reserves towards Norges Bank’s target level.

Provided that banks manage to redistribute reserves in the interbank market, it is not a problem that payments into the government’s account are unevenly distributed. Norges Bank will ensure that there is sufficient liquidity overall at all times and will provide F-loans as necessary in the event of large payments to the government. Provided that banks collectively bid for sufficient amounts in these auctions, there will always be adequate reserves in the banking system as a whole. Should a bank be allocated less than it needs to cover its share of the payments into the government’s account, it will be able to borrow the balance from other banks in the system. Uncertainty about forecasting errors will be reduced by Norges Bank conducting fine-tuning operations to allow for such. 

Banks that make large payments into the government’s account may feel a need to make sure in advance that they have sufficient reserves at the time of payment. They may therefore wish to build up their holdings of liquid assets before the payments to the government take place. They must then adjust their liquidity management so that their holdings of reserves are sufficient on the payment date. This can be achieved by borrowing NOK on long maturities and investing in the market so that these funds are available at the time of the payments to the government.

2. Effect on interest rates

FNO notes that the new system may make interest rate formation more complex and money market rates more volatile:    
…A new rate, the “reserve rate”, lower than the sight deposit rate, will complicate interest rate formation in the Norwegian money market. In the event of large liquidity movements, such as when taxes fall due, uncertainty about the overall liquidity situation and imbalances in the distribution of liquidity between banks could lead to confusion about whether it is the sight deposit rate or the lower reserve rate that actually constitutes the “floor” for money market rates. Larger fluctuations must therefore be expected in the shortest rates, which could affect volatility in longer money market rates…

…To avoid increased interest rate volatility, Norges Bank will therefore have to be much more active in its management of liquidity in the money market. Norges Bank may possibly also need to take different/new instruments into use for liquidity management. Accurate liquidity forecasts will be much more important…

In the new system, the shortest money market rate may drop below the key rate. This may happen if one or more banks with deposits in Norges Bank exceeding their quotas wish to offer the surplus reserves in the interbank market. How far this rate might fall below the key rate, and how volatile this rate might be, will depend on how well the interbank market functions. In a well-functioning interbank market, even small movements in rates will be sufficient to trigger the redistribution of reserves between banks. In a poorly-functioning market, larger movements in rates may be needed to trigger trading. The distribution of quotas between banks has been set with a view to reducing interest rate volatility. Banks that quote money market rates have the largest quotas because they are probably in the best position to conduct arbitrage operations when reserves are offered at a rate below the key rate. Except for the somewhat higher quota assigned to settlement banks, all banks that quote money market rates have been assigned the same quota to encourage a degree of competition for these reserves. This competition will limit how far short money market rates can drop below the sight deposit rate.

There is no evidence that the floor system we have today results in lower volatility in the shortest money market rates. In the current market, there are signs that interest rates need to move a long way to spark off trading. Even with a large surplus of reserves in the banking system, there can sometimes be considerable variations in the shortest NIBOR rate (tomorrow/next). Even in the current system with a clearly defined floor, the Norwegian tomorrow/next rate varies as much as short-term rates in other countries.

In addition, interest rates do not need to have a floor to fulfill the function of prices, i.e. to convey information. Movements in interest rates are to provide information about shortages and surpluses of liquidity. In normal periods, most countries have a kind of corridor system where the short-term money market rate fluctuates around the key rate, precisely because of banks’ supply of and demand for reserves in the interbank market. In the new system, we have to assume that the shortest money market rate will tend to fluctuate around the key rate, unlike today when it fluctuates above the key rate. How much it fluctuates will depend largely on banks’ ability and willingness to redistribute reserves in the interbank market. The new system will give banks a stronger incentive to actively manage their own reserves.

If the total amount of reserves in the banking system approaches zero or exceeds the sum of all quotas, interest rate volatility could increase considerably in the new system. To avoid this, Norges Bank will, as explained above, aim to keep total reserves well above zero, but below the sum of banks’ quotas, where necessary through fine-tuning operations.

Norges Bank will publish forecasts of movements in banks’ reserves and announce in advance when it plans to conduct operations to supply or drain liquidity (F-loans and F-deposits). Norges Bank’s operations to manage banks’ reserves will be more predictable than in the current system. Depending on developments in structural liquidity, Norges Bank will, where necessary, also consider offering longer F-loans than is usual in the current system. A more predictable liquidity policy could help reduce volatility in the shortest money market rates.

Swedbank has no objections to the new system for the management of banks’ reserves and believes that it …will contribute to more efficient distribution of reserves overnight in the banking system… Swedbank also agrees with Norges Bank’s view …that the overnight rate will probably, on average, be somewhat closer to the key rate, and at times below the key rate, in the new system...

However, Swedbank sees …no good reason to expect the new system to result in a significantly lower credit premium in money market rates with longer maturities…

The effect on money market rates with longer maturities (three months) will probably depend on the effect on volatility in the shortest rates. If the new system helps reduce volatility in the shortest rates, volatility in longer money market rates will probably also decrease.

3. Basel III requirements

The new liquidity requirements mean that banks must hold sufficient liquid assets to cover their funding requirements (net outflows) for 30 days. Eligible assets will be government securities and central bank reserves. The requirements are due to be introduced from 1 January 2015 and mean that banks will need to hold a larger proportion of liquid assets. (2)

FNO notes the following: 
…The regulatory authorities are currently working on new quantitative requirements for liquidity reserves (“Basel III”), which require holdings of approved highly liquid assets... …In the present proposal for liquidity requirements, only central bank liquidity and holdings of government debt, in principle, qualify as high-quality liquid assets in Norway… …Sight deposits in the central bank could also emerge as an essential means of satisfying the liquidity requirements…

Under the proposed new liquidity requirements, a bank must hold sufficient liquid assets that it can meet its net funding requirements over a specified stress period of 30 days by drawing on these assets. In the proposals, deposits in central banks are included in a bank’s liquid assets. When assessing whether the liquidity requirement is met, a deciding factor will be how the deposit is funded. For an individual bank, a deposit in the central bank will count if it is funded beyond 30 days. If structural liquidity in the banking system is negative, such that banks’ combined deposits in the central bank are funded by F-loans or other market operations, deposits will only make a positive contribution to the liquidity requirement to the extent that these F-loans have a remaining maturity of more than 30 days. In the reverse case, total F-loans will match deposits, and the net effect on the liquidity requirement will be neutral. Hence as long as Norges Bank’s F-loans have a maturity below 30 days, banks will not be able to meet the new liquidity requirements by depositing these F-loans overnight in Norges Bank.

In the new system for the management of banks’ reserves, Norges Bank may also choose to offer F-loans with maturities beyond 30 days in certain situations. Overnight deposits in Norges Bank funded by long-term F-loans will help to satisfy the liquidity requirements under Basel III. Norges Bank would point out that part of the reason for the new liquidity requirements in the Basel III rules is to prevent banks from expanding too rapidly through an increase in short-term borrowing which is then invested in illiquid long-term assets. Such expansion will still be possible if banks are allowed to use illiquid assets as collateral for central bank reserves. The new system for the management of banks’ reserves will counter such circumvention of the rules.

A bank can issue a bond and deposit the proceeds overnight in Norges Bank. This will make a positive contribution to the liquidity requirement. Even if the interest rate on the bond is higher than the central bank’s key rate, this may seem a relatively attractive way of satisfying the liquidity requirements. Such a strategy may mean that banks’ deposits in Norges Bank will grow significantly over time. In the current system, if demand for reserves rises because central bank deposits are an attractive investment and not because banks require these reserves to settle payments, Norges Bank must gradually step up the supply of reserves in line with demand to keep short-term money market rates close to the key rate. We then have a situation where central bank reserves increasingly serve functions other than settling payments between banks, and where the amount of reserves in the banking system grows over time. In the new system, the financial incentive to use central bank reserves to meet the Basel III requirements will be smaller, as deposits over and above the quota will bear a lower rate of interest than the key rate. This will curb growth in reserves in the banking system.      

4. Role of settlement bank

In Norway, two banks, DnB NOR and Sparebank 1 Midt-Norge, act as settlement banks for a number of smaller banks (level 2 banks). These smaller banks have accounts with the settlement banks, and so the settlement banks are exposed to their transactions when payments are settled. The consultation responses argue that the new system for the management of banks’ reserves will complicate the role of settlement bank. DnB NOR in particular has views on this in its response to Norges Bank. The following is therefore based on DnB NOR’s comments. (3)

DnB NOR notes the following:
…For settlements to function, most banks hold deposits in an account in DnB NOR bearing interest at a rate linked to Norges Bank’s sight deposit rate. This means that most small banks do not have sight deposits in Norges Bank. While these deposits are held in DnB NOR, they form part of DnB NOR’s own liquidity and are supplied to banks that need NOK liquidity. DnB NOR therefore also sees correspondingly large movements in its total liquidity position due to movements in banks’ aggregate liquidity in Norway, for example due to payments to/from the government…

…With the proposed change in the interest borne by DnB NOR’s deposits in Norges Bank, the smaller banks will largely need to transfer their deposits from their account in DnB NOR to their account in Norges Bank, because DnB NOR will have the same quota [for] deposits in Norges Bank as much smaller banks with no settlement obligations…

…In addition, Norges Bank’s proposal will make daily settlements much more demanding for smaller banks than today. Each day they will need to transfer liquidity between their account in Norges Bank and their account in DnB NOR, and they will have to use Norges Bank’s NBO system… 

When DnB NOR refers to large movements in its total liquidity position, this is not due first and foremost to variations in smaller banks’ deposits in DnB NOR but to the bank’s own activities. Level 2 banks’ total deposits in DnB NOR are relatively stable, and variations are very small relative to those in DnB NOR’s sight deposits in Norges Bank.

Settlement bank operations may nevertheless have some impact on fluctuations in settlement banks’ liquidity. On balance, therefore, Norges Bank has decided to award the settlement banks a somewhat higher quota. This additional quota is determined by the size of the settlement bank relative to the size of the level 2 banks.

Settlement banks in Norway have good liquidity management, and deposits from smaller banks are relatively stable. Combined with a well-functioning interbank market and a somewhat larger quota than for other banks in the same group, this would suggest that it will not be more difficult to function as a settlement bank in the new system. If the current settlement banks no longer consider it worthwhile to play this role, or if terms deteriorate to the extent that smaller banks no longer wish to use the existing settlement banks, the smaller banks will have the option of settling their payment transactions directly in Norges Bank’s settlement system, NBO.

5. Distribution of quotas between banks

Sparebanken Vest notes that the size of the quotas and the grouping of banks …appear somewhat arbitrary… The bank argues that if all banks in the same group have the same quota, the largest banks in each group will be hit much harder than the smallest. In terms of total assets, Sparebanken Vest is the second-largest bank in group 2, but significantly larger than some of the banks in group 1.

DnB NOR also notes:
…A large bank will find the system proposed by Norges Bank much more demanding than a smaller bank, and the risk of a bank being left with surplus liquidity in the central bank is clearly related to the size of the bank… …Norges Bank’s proposal could reward banks that manage their own liquidity poorly, as they will have the same quota for deposits as other, larger banks that manage their own liquidity well…

The distribution of quotas and grouping of banks need to be seen in the context of a number of factors. In a well-functioning interbank market combined with unlimited access to interest-free loans from the central bank during the day, banks do not need to have reserves in the central bank at all for settling payments. This is the case in a pure corridor system with no reserve requirements: at the end of the day, banks with surpluses can lend to banks with deficits. (4) In Norway, neither banks nor the central bank are accustomed to such a system where total reserves amount to zero. We are coming from a system with relatively little activity in the interbank market, where banks are accustomed to sitting on relatively large deposits in the central bank. Switching to a pure corridor system with total reserves equal to zero could therefore be risky, as the need for a well-functioning interbank market would increase very suddenly. We have therefore chosen a solution where there are still substantial reserves in the system.

As banks do not need deposits in the central bank for the settlement of payments to function, there is no clear relationship between the size of a bank and its deposits in Norges Bank. Nor is there a clear relationship between a bank’s transactions in Norges Bank’s settlement system and its deposits in Norges Bank. The criteria for setting quotas therefore attach considerable importance to another principle: they have been designed to stimulate activity in the money market on the basis of banks’ capacity to redistribute reserves in the interbank market. We believe that banks that quote money market rates, which are the most active in the money market, are in the best position to trade reserves overnight. These banks have therefore been assigned the largest quota (see discussion in section 2).

Based on this principle, banks have been divided into three groups based on their classification in Norges Bank’s settlement system. (5)  Distributing quotas on the basis of a bank’s size would have led to a very uneven distribution of quotas between banks and very different levels of bargaining power when redistributing reserves.

It will probably be banks with poor liquidity management, not banks with good liquidity management, that come out worst under the new system for the management of banks’ reserves. Banks with good liquidity management will be able to avoid having deposits in the central bank above their quota. Banks with poor liquidity management are more likely to end up in such a situation. The new system gives banks a financial incentive to improve their liquidity management and avoid having large central bank deposits. In time, this may pave the way for a better-functioning money market in Norway. 

6. The government’s account in Norges Bank

FNO argues that the government should transfer its account from Norges Bank to private banks. This would reduce fluctuations in structural liquidity and so reduce uncertainty about future liquidity needs. FNO is aware that this matter needs to be taken up with the Ministry of Finance and ...will do so right away… (6)

The new system for the management of banks’ reserves does not prevent the government’s account from being transferred out of Norges Bank. If the government does transfer its deposits (or parts of them) away from Norges Bank to private banks, structural liquidity in the banking system will increase. In the new system, Norges Bank will then have to drain these reserves so that the sum of reserves in the banking system does not exceed banks’ quotas. This can be done, for example, using F-deposits. Such an operation would have the characteristics of a “one-off effect”.

With the government’s account out of Norges Bank, transactions between banks and the government will no longer impact on structural liquidity, and there will be a reduced need for fine-tuning operations for liquidity management. It is because the government has an account at Norges Bank that the new system for the management of banks’ reserves has been designed the way that it has, with a substantial surplus of reserves in the banking system, quotas and fine-tuning of the supply of reserves. Had the government’s account been transferred out of Norges Bank, the total amount of reserves in the banking system and banks’ quotas could have been considerably smaller. Matters concerning the government’s account with Norges Bank are decided by the Ministry of Finance.

Footnotes

1) The consultation responses are available in Norwegian only on Norges Bank’s website.

2) It has been widely noted that banks in countries with small markets for government securities may find it difficult to meet the new liquidity requirements. The final rules are expected in the first quarter of 2011 and will include special rules for countries with small government securities markets. For a more detailed discussion of the Basel III criteria, see Financial Stability 1/2010 and Kristin Gulbrandsen’s speech on 15 September 2010 “New liquidity and capital requirements for the banking industry”, both available on www.norges-bank.no.

3) The other bank that also serves as a settlement bank, Sparebank 1 Midt-Norge, has not submitted any comments beyond those presented in Finance Norway’s response.

4) Both Sweden and Canada have corridor systems without reserve requirements. In other words, both countries aim for a total level of reserves in the banking system of zero (or marginally above zero). In both countries, the central bank conducts fine-tuning operations, daily where necessary. In Sweden, the government does not have an account in the central bank, which makes liquidity management easier. In Canada, however, the government does have an account in the central bank, and the central bank needs to conduct fine-tuning operations daily in response to activity in the government’s account in order to balance banks’ reserves.  

5) With the exception that banks that quote money market rates are included in group 1 even if they are in group A2 in NBO.

6) FNO sent a letter to the Ministry of Finance on 30 November 2010 (copied to Norges Bank) asking the ministry to consider transferring all or parts of the government’s account out of Norges Bank. 
  

Published 15 December 2010 13:30