In the previous section, we concentrated on modeling the demand of the commercial banking sector for central bank reserves. We've seen the key concept that explains the determination of the interbank interest rate as a liquidity gap between the demand for reserves and the available supply of reserves. The central bank as the issuer of reserves effectively sets the supply. In this section, we'll try to answer two questions; How do central banks set the supply of liquidity and what is the impact from liquidity supply changes? Bank reserves are held at the central bank. The central bank changes the quantity of reserves by buying or selling market assets from banks using reserve accounts as a vehicle. The central bank engages in open market operations, buying or selling government securities, and crediting and debiting counter-party reserve accounts appropriately. We'll learn to use T accounts to depict the change in the banks balance sheets induced by a transaction. Open market operations are implemented in two basic ways; outright operations which change reserve liquidity, and repo operations to stabilize reserves on a temporary basis. After viewing this segment, you should be able to; one, use T accounts describe the impact of a transaction on the bank's balance sheet, two, identify the types of open market operations, and three, model the effects of changes in the supply of reserves. Let's get started. Consider this weekly data on reserve money issued by the Bank of Thailand. We see the supply of reserves is growing over time but also changes sharply from week to week. This indicates that we cannot think about inter-bank interest rates without thinking about changes in the supply of reserves. The primary way that central banks change the level of reserves is through open market operations. Open market operations are the purchase or sale of financial assets by the central bank. We will describe three types of operations; outright operations, repo operations, and additional operations. An open market purchase occurs when the central bank buys financial assets from commercial banks. The central bank credits the counter-party with additional funds in the counterparty's reserve accounts. This expands the monetary base and creates more liquidity. An open market sale occurs when the central bank sells their financial assets to commercial banks and debits the counter-party banks reserve accounts. Open market sales reduce the monetary base and drain liquidity. Open market operations can be observed through their impact on central bank balance sheets. T accounts are visual aid for understanding the impact of a transaction on the balance sheet of the entities engaging in the transaction. Set up the T account by drawing a simple T. Label the left hand side as assets and put liabilities on the right side. Now we have a mini balance sheet which can contain the balance sheet effects of any transaction. Remember, balance sheets always balance, so any transaction must have either equal impacts on assets or liabilities, or zero net effect on either. Consider how we might depict the impact of an open market operation on the balance sheets of the central bank and any counter-party to the transaction. First draw a T account representing the central bank balance sheet. Then draw a T account for a commercial bank that will act as a counter-party to the transaction. Consider a hypothetical example; A central bank open market purchase of 100 worth of debt securities from a commercial bank. The central bank adds 100 insecurities to its portfolio. The counter-party bank was also credited assets by the same 100 worth of securities that they sell. The central bank makes payment using its reserve account, the central bank adds 100 to the reserve accounts of the counter-party bank, this increases central bank liabilities. The counter-party bank gets an extra amount of reserves and loses an equal amount of securities, so there is zero net effect on its total assets. However, the composition of its assets has changed. Now they have actual reserves which might be held or lent to other banks. The central bank has increased its assets and liabilities equally so its accounts remain in balances as well. Notice that at the end of the transaction, the overall supply of the monetary base of reserves has expanded. The interbank rate is a market rate agreed upon by borrowers and lenders in the private sector. Like any market rate, it is determined by the forces of supply and demand. But the central bank determines the overall supply of liquidity available for lending and thus can dominate market conditions. If the central bank engages in an open market purchase of securities, they will pump more money into the system and increase the supply of liquidity. The excess liquidity surplus available in the inter-bank market will push down interest rates until they get low enough for banks to prefer to hold the available liquidity in their own inventory rather than try to lend it out at the new lower interest rate. This new interest rate will then become the new market equilibrium. Likewise, when the central banks sell securities, they reduce the amount of the monetary base that is available to commercial banks. Consider an open market sale in which the central bank sells 100 of debt securities to a counter-party bank. The central bank finds a private bank that is looking to buy some securities. If the central banks sell 100 worth of securities, they can debit the reserve accounts of this counter-party. The central bank loses some assets, but also reduces liabilities. In the end, this shrinks the monetary base of reserves and all accounts remain in balance. If the central bank sells assets and debits the counter-party's reserve accounts, this will drain money from the system. The supply of reserves will shrink. This will create a liquidity shortage in the inter-bank market. The short supply of liquidity in the inter-bank market will push up interest rates for borrowers. The decline in reserves creates a shortage of liquidity that will push up the equilibrium interest rate. Open market operations set off a chain of events. An open market purchase will create a liquidity surplus which will reduce inter-bank rates. An open market sale will create a liquidity shortage and rising inter-bank rates. Open market operations can be divided into two categories. The first are outright operations when central banks permanently purchase or sell assets most typically government securities, central banks engage in outright operations intermittently in order to change the level of reserves over an indefinite horizon. Open market operations are typically conducted with government or central bank issued securities. However, in theory and practice, open market operations can be conducted with purchases or sale of any tradable asset. More than 100 years ago, central bank operations were mostly conducted with transactions in gold or silver bullion. In the current period, it is also common for central banks in the region to engage in purchases or sales of foreign currency. This can also change the level of bank reserves. Also, some central banks engage in unconventional measures like the purchase or sale of private sector securities. The second category of open market operations are repo operations which are short term lending and borrowing by the central bank. Central banks conduct repo operations at regular intervals, usually weekly, daily, or even more frequently in order to stabilize liquidity on an ongoing basis. They are implemented using a type of open market instrument called repurchase agreements. When central banks want to adjust their monetary base on a temporary basis, they do so using repurchase agreements, nicknamed repos. What is a repurchase agreement? A repo is a financial contract that is the functional equivalent to short term lending. The repo may or may not be implemented through a third party market maker, but have the same basic form regardless. The simple repo has three important dates. At the immediate deal date, all terms are specified including the price and size of their purchase agreement along with the date of repurchase. On the near date, cash is transferred to the account of the seller while short term bonds are sold to the buyer. On the far date, the bonds are repurchased by the seller at the original purchase price plus a little extra interest. This transaction is equivalent to the buyer taking a loan with interest. The buyer acts as a lender providing cash up front and the seller is a borrower repaying on the far date with interest. The advantage of a repurchase agreement over a traditional loan, is that the lender takes possession of the security upfront which mitigates the risk since the security functions as a form of collateral. Using repurchase agreements, the central bank can add or drain liquidity quickly and smoothly. Let's wrap up the topic of liquidity management with a discussion of some additional types of open market operations which can stabilize liquidity. Beyond outright operations and repo operations, some other types of open market operations are conducted to manage liquidity. One of these is the direct issuance of debt securities by the central banks in the region. Central banks in many Asian economies directly issue securities to investors. This is done for several reasons, including financing foreign reserves or developing the depth of bond markets. Another reason is to absorb liquidity when there is a structural excess of liquidity in the inter-bank market. When the central bank issue securities, they offer them to counter-party commercial banks who pay for the asset with reserves. The issuance of central bank securities reduces the size of the liquid monetary base. Though the overall amount of central bank liabilities are unchanged, these liabilities are switched away from liquid liabilities which can be used for inter-bank payments toward less liquid, longer term instruments. Central banks may also guide liquidity by accepting term deposits from commercial banks and sometimes making loans over a period of a month or more. When their central bank accepts deposits, this reduces liquidity in the inter-bank market. When the central bank makes loans, this will increase liquidity. The central bank engages in these longer term operations. They believe there is some structural misalignment between the supply of reserves and the demand reserves at the current policy rate. By shifting reserves to term deposits, they can reduce the liquidity available for lending in the inter-bank market. Banks might accept term deposits in order to get a higher interest rate. After completing this segment, you should be able to; one, use T accounts to describe the impact of a transaction on a bank's balance sheet. Two, identify the types of open market operations and three, model the effect of changes in the supply of reserves. As we wrap up, let's conclude by summarizing the key questions. How do central banks adjust liquidity and what is the impact? The central bank can manage the liquidity available for inter-bank transactions through open market operations. An open market purchase increases liquidity and pushes down interest rates. An open market sale drains liquidity and puts upward pressure on interest rates. All of those are implemented through outright operations or through temporary repurchase agreements.
