Background for the system for managing bank reserves in Norway

In October 2011, Norges Bank introduced a new system for managing bank reserves (bank deposits with the central bank). While banks previously received interest on all deposits at the key policy rate (the sight deposit rate), quotas were introduced in October 2011, restricting the level of a bank's reserves that would be remunerated at the key policy rate. The interest rate on deposits in excess of the quota is called the reserve rate, which is lower than the key policy rate.

The purpose of changing to a quota-based system was to limit bank demand for central bank reserves and to provide a stronger incentive for banks to redistribute liquidity in the interbank market.

The previous system: a floor system

From the mid-1990s until 3 October 2011, Norges Bank used a so-called floor system for the management of banks' reserves. Under a floor system, banks receive interest on all deposits with the central bank at the sight deposit rate, which is also the central bank's key policy rate. The sight deposit rate normally forms a floor for the shortest money market rates, as banks will not normally lend reserves at an interest rate that is lower than the rate they receive from the central bank. Similarly, Norges Bank's overnight lending rate (for D-loans) forms a ceiling for the shortest money market rates. Normally, banks will not borrow reserves at an interest rate that is higher than the rate they have to pay the central bank. In a floor system, the central bank must ensure that there is a surplus of reserves in the banking system, i.e. that banks hold deposits of a certain volume in the central bank. When these deposits are sufficiently large, the shortest money market rates will be driven down towards the sight deposit rate. The level of reserves required to achieve this depends on bank demand and can vary over time. Under the floor system, Norges Bank supplied reserves by providing F-loans to banks against collateral in the form of securities. These loans were offered when, in Norges Bank's judgement, there was a need for more reserves in the system to keep the market rate close to the sight deposit rate. The interest rate on F-loans normally hovered just above the sight deposit rate.

Motivation for changing the system

One of the characteristics of a floor system is that banks have ample access to central bank reserves and that the cost of borrowing reserves through the central bank's market operations is relatively low. Under this system, a bank could increase its holding of reserves with Norges Bank by borrowing reserves by means of an F-loan at an interest rate that was normally just above the sight deposit rate. Since all reserves were remunerated at the sight deposit rate, the cost of holding more reserves acquired through F-loans was normally only a few basis points. All else being equal, a lower price for holding reserves implies that banks will want to hold more of them. Norges Bank observed that demand for reserves at F-loan auctions was generally high and higher than needed by banks to settle payments in Norges Bank's settlement system. Norges Bank observed that there tended to be a need to supply steadily more reserves to keep the short-term money market rate close to the sight deposit rate. The level of reserves in the banking system generally increased over time. Particularly following the financial crisis, when the central bank temporarily supplied substantial reserves, the level tended to remain higher than previously.

As central bank reserves grew over time, Norges Bank observed that the redistribution of reserves in the interbank market functioned poorly. Since the overnight rate in the interbank market was close to the central bank deposit rate, banks' earnings from lending to other banks were low. In some situations, there were signs that the short-term money market rate had to be bid up considerably before a lender would enter the market. Demand for central bank reserves then increased, and to keep the overnight rate close to the sight deposit rate, Norges Bank had to supply reserves to the banking system. Norges Bank viewed these developments as unfavourable and sought to change the liquidity management system. Two objectives in particular were important. One was to stop growth in central bank reserves. The other was to generate more interbank activity in the overnight market as rising quantities of reserves in the banking system entailed a risk that Norges Bank would assume some of the functions of the interbank market. The role of the central bank is to steer the total amount of reserves, while banks' should redistribute the reserves overnight in the interbank market. This resulted in a change of system from a floor system to a quota-based system for reserves.

More on the choice of a quota system

In principle, the banking system can function without banks' holding overnight deposits with the central bank, i.e. the total amount of reserves in the banking system is zero. This is the case under a so-called corridor system (with no reserve requirements). The redistribution of reserves through the day via interbank payments is reversed via interbank loans at the end of the day. Banks with a negative position vis-à-vis the central bank borrow reserves from banks that have been supplied with reserves through the day and thus have a positive position vis-à-vis the central bank. Since the total amount of reserves is zero, the sum of negative positions will always be matched by the sum of positive positions. When the interbank market functions efficiently, banks do not need to use central bank standing deposit and lending facilities (which are normally more expensive for banks to use).

Thus, a corridor system requires reserves to be redistributed efficiently in the interbank market. Furthermore, it places considerable demands on central bank liquidity management, which must at all times steer towards zero reserves in the banking system. This is done by supplying reserves to banks when there is a deficit of reserves in the banking system (the sum of banks' positions vis-à-vis the central bank is negative) and by draining reserves when there is a surplus of reserves in the system. Reserves change in particular as a result of transactions between banks and the government when the government has an account at the central bank. Payments to the government drain reserves from the banking system, while payments from the government have the reverse effect. Consequently, payments to and from the government give rise to fluctuations in banks' overall reserves in the central bank.

In Norway, the government has an account with Norges Bank, and changes in reserves as a result of transactions with the government are counteracted by market operations (F-loans and F-deposits). To accomplish this, the central bank develops forecasts for changes in the reserves as a result of expected transactions between banks and the government. These forecasts are subject to a margin of error. The effect of such forecasting errors on the overnight rate is less pronounced under a floor system than under systems without surplus reserves. This is because the level of reserves in the banking system is in any case so high under a floor system that even if the supply of reserves should fall as a result of unexpected payments to the government, the quantity of reserves will still be sufficient to keep the overnight rate close to the key policy rate. The effect of government transactions on banking system reserves, making liquidity management more complicated, was a factor Norges Bank had to take into account when the liquidity management system was changed in October 2011. The new system introduced on 3 October 2011 is a compromise between a floor system and a corridor system. Under the new system, only a certain amount of each bank's deposits with the central bank – a quota – is remunerated at the key policy rate. Deposits in excess of the quota are remunerated at a lower rate, the reserve rate. The system is intended to give banks a financial incentive to reduce their demand for reserves and motivate them to redistribute reserves in the interbank market. Previously, a bank could retain large deposits in its sight deposit account at low cost. This cost has increased under the new system. A bank with deposits in excess of the quota has an incentive to offer the surplus in the interbank market. It has become easier for banks needing to borrow reserves overnight to find a lender. It is also profitable for banks with deposits lower than the quota to borrow reserves at an interest rate below the key policy rate and deposit these reserves with Norges Bank at the key policy rate.

Like the floor system, the quota-based system is a system with surplus reserves (the central bank aims to keep banking system reserves above zero). Any forecasting errors will therefore affect market rates to a lesser extent than under a corridor system. In addition, banks still have an intraday facility at Norges Bank and can borrow reserves interest-free through the day against collateral. Norges Bank ensures that banks have an adequate supply of reserves so that the overnight rate remains close to the key policy rate. In contrast to the floor system, however, the overnight rate in the quota-based system may be below the key policy rate, not only above it. This is because the floor is no longer the sight deposit rate, but the reserve rate. Under the new system, banks with surplus reserves are willing to lend reserves in the interbank market at a rate below the sight deposit rate precisely to avoid having to make deposits at the reserve rate.

More information on the transition to a new system for managing bank reserves:

More about the background for the assignment of quotas

Alternative ways of assigning quotas could be considered. One possible starting point would be to make each bank's individual quota proportional to its total assets or the size of its payments in the settlement system. (The data for individual banks are confidential. We refer here only to general conclusions.)

Deposits in Norges Bank vary considerably over time, particularly for large banks. At times, deposits are close to zero, even for the largest banks. This raises the issue of what is the true driver behind the need to hold deposits in the central bank.

With the largest banks, there is not necessarily a clear relationship between the size of a bank (as measured by total assets) and its deposits in Norges Bank. Although banks in group 1, which are by far the largest banks in terms of assets, have substantially larger deposits in Norges Bank than the smaller banks in groups 2 and 3, there is no clear relationship between the size of a bank and its deposits in Norges Bank within group 1. Thus, a bank's size is not an indication of its need to hold deposits in Norges Bank. Assigning quotas in proportion to the size of each individual bank is therefore not a suitable solution.

Alternatively, the possibility of a relationship between the size of the transactions banks execute in the settlement system and their need for deposits in Norges Bank might be considered. If transactions were large, a bank might be exposed to large outgoing payments during the course of the day. If, at the same time, receipts were limited, and the bank did not obtain cover in the market at the end of the day, it would need to have large deposits in the central bank to be able to cover payments to other banks (or borrow overnight from the central bank). However, data show that there is again no clear relationship between the size of a bank's transactions and its deposits in Norges Bank.

Banks have unlimited access to interest-free loans against collateral from Norges Bank during the day. These intraday loans ensure that payment settlement functions satisfactorily, which is the primary role of the management system for bank reserves. This access to interest-free intraday loans reduces banks' need for deposits in the central bank. Without intraday loans, banks would need to have larger deposits in the central bank to cover transactions in the banking system during the course of the day. With intraday loans, banks need only settle their net transactions with one another at the end of the day. The greater the symmetry between a bank's receipts and payments during the day, the smaller the need for deposits at the central bank. This means that the more predictable banks' receipts and payments are, and the better their short-term liquidity management, the less they will need deposits in the central bank.

The aim of the changes in the management system is to enhance the functioning of the money market. The criteria for assigning quotas have therefore been designed primarily to stimulate money market activity on the basis of banks' capacity to redistribute reserves in the interbank market.

More about the floor and corridor systems

In a floor system, the central bank ensures that there are ample reserves in the banking system. The system in Norway works as follows:

When the day begins, banks have deposits (reserves) in Norges Bank of a certain size. During the day, banks' customers transfer money to one another. Unless these customers have accounts at the same bank, this means that different banks transfer money to one another. This is done using Norges Bank's settlement system. When bank A transfers money to bank B, bank A's deposits in Norges Bank are reduced, and bank B's deposits are increased by the same amount. This settlement process takes place three times daily in Norges Bank's settlement system. In Norway, banks have unlimited access to interest-free loans during the day (against collateral). If a bank needs to transfer more to other banks during the day than it has on deposit in Norges Bank, it can borrow the necessary amount from Norges Bank (intraday loan). At the end of the day, bank deposits in Norges Bank will have changed in line with the sum of net transactions that have gone through the settlement system. Banks that have a reserve deficit at the end of the day, and have therefore drawn on the intraday facility, must repay the intraday loans to Norges Bank. This can be done in two ways. One is to borrow the necessary amount from other banks in the interbank market and use this to repay the intraday loan from Norges Bank. The other is to borrow overnight (D-loan) from Norges Bank at a higher rate of interest. This happens automatically if the bank has a reserve deficit and does not redeem its intraday loan by the end of the day. The larger their deposits in Norges Bank, the less likely it is that banks will need to borrow reserves from other banks, and the less likely it is that banks will require D-loans. The idea behind a floor system is that interbank settlement is largely conducted through adjustments to banks' deposit accounts in the central bank. As a result, the higher the deposits in the central bank, the less need there is for banks to redistribute reserves in the interbank market, and thus the lower the level of activity in this market.

In a corridor system, the total amount of reserves (over and above any minimum reserve requirement) is zero. (This means that the central bank needs to counteract autonomous changes in total reserves so that the amount of reserves is equal to zero. For example, if the government has an account in the central bank, and payments into the government's account reduce the amount of reserves in the system, the central bank must inject sufficient reserves to bring the total amount to zero once the payments into the government account have taken place.) Settlement between banks is achieved by banks borrowing reserves from one another. The system is organised as follows:

  • At the beginning of the day, banks have a zero balance on their accounts in the central bank.
  • During the day, interbank transactions take place. As with a floor system, this is done by adjusting bank deposits in the central bank. Banks that need to transfer funds to other banks, and do not have sufficient deposits in the central bank, will need to borrow intraday from the central bank. (This means that the central bank needs to counteract autonomous changes in total reserves so that the amount of reserves is equal to zero. For example, if the government has an account in the central bank, and payments into the government's account reduce the amount of reserves in the system, the central bank must inject sufficient reserves to bring the total amount to zero once the payments into the government account have taken place.)
  • At the end of the day, all intraday loans must be paid back to the central bank. Once these have been repaid, some banks will have a reserve deficit, while others will have a surplus. The sum of these surpluses is equal to the sum of the deficits, as total reserves are equal to zero.
  • Banks with deficits borrow from banks with surpluses. If a deficit bank does not borrow from other banks, it will have borrow overnight from the central bank at a rate that is normally higher than the market rate, which is the rate that banks pay when redistributing reserves between themselves. Banks with surpluses will endeavour to lend their reserves to other banks at the market rate, as the alternative is to deposit the surplus reserves in the central bank at a lower rate.
  • In this way, the corridor system gives banks an incentive to redistribute reserves in the interbank market and contributes to increased activity in this market.

A key aspect of reserves is that banks cannot themselves influence the total amount in the system. (The total amount of reserves is reduced if banks purchase notes and coins or borrow overnight, but this is not a significant factor when it comes to understanding the systems for the management of bank reserves.)

At the end of the day, banks collectively must always hold on deposit at the central bank the level of reserves that the central bank has supplied to the banking system. The individual bank may want to reduce its deposits in the central bank and increase its loans to households and businesses or buy various types of securities. The bank's deposits in the central bank will then fall, but other bank deposits in the central bank will rise accordingly. The distribution of bank deposits in the central bank can change during the day, but the total amount of reserves in the banking system is the same and is determined by the total amount of reserves supplied by the central bank.

Literature:

Published 30 June 2011 15:00