Interest rate floor

Anonymous1987

The Fed today suggested the possibility of increasing the interest paid on reserve balances to help set a floor under interest rates

I just want to make sure I know how this works. If the Fed increases the interest paid on balances it will encourage banks to hold more cash at the Fed thus reducing the supply of credit in the open market and increasing interests rates, right? So really the Fed isn't really setting a floor rather they are outlining possible ways of increasing the interest rate if they need to?

Économiste Monétaire

The Fed couldn't pay interest on reserve balances until last year. It's just the standing facilities concept; the 'deposit facility' in ECB terms. Remember the marginal lending facility being a ceiling for which banks would borrow money? I.e. any short-term (overnight) money market rate above this wouldn't be accepted, because the central bank will lend money to the banks for less, ergo it sets a ceiling on rates. The 'floor' is based on the same concept, just the central bank sets a bottom on overnight rates for borrowings.

Right now, the Fed is paying 0.25% on both required reserves and excess reserves, you simply increase the amount you're paying on excess reserves and this becomes more attractive than lending to the private sector. It's just another way to soak up the excess liquidity, the Fed issuing its own debt could also work. The ECB can do this, too.

Anonymous1987

Ok I think I understand it better now, basically the Fed has a set a minimum return on deposits and a limit on interest costs to borrowing for banks so the Fed effectively limits market interest rates within this range.

Économiste Monétaire

Yep, just think of it as a tunnel, with the marginal lending facility (or a discount window, in Fed terms) being the ceiling and the deposit facility as the floor. Raising the rate paid on excess reserves just makes it more expensive for the private sector to borrow, because, at any rate below this, the banks will get a better return by simply leaving it with the Fed.

Anonymous1987

In a dramatic step dubbed “stimulus by stealth” in financial markets, the ECB lent €442.2bn for 12 months to more than 1,100 banks at its current benchmark interest rate of 1 per cent.

Taken from
http://www.ft.com/cms/s/0/2d9300c0-60a2-11de-aa12-00144feabdc0.html

I'm just wondering how this stimulus to the financial markets differs from the marginal lending facility is it just the time difference i.e. overnight v one year or is there more to it?

Économiste Monétaire

That's the 12 month longer-term refinancing operation (LTRO) from last month. The banks borrowed for a 12 month period at the fixed 1% rate. The rate on the marginal lending facility is above the 1% rate on MROs and LTROs; right now it's at 1.75%.

Anonymous1987

Économiste Monétaire wrote: »

That's the 12 month longer-term refinancing operation (LTRO) from last month. The banks borrowed for a 12 month period at the fixed 1% rate. The rate on the marginal lending facility is above the 1% rate on MROs and LTROs; right now it's at 1.75%.

So what is being referred to when the benchmark interest rate is said to be held at 1% is this just the market interest rate target that the ECB is trying to maintain?

Économiste Monétaire

That's the rate at which the Eurosystem auctions money on a weekly basis for main refinancing operations (MROs), and the market rate is usually hovering around this ECB rate (like the overnight rate, EONIA) when money markets are functioning normally—they also auction money on a longer-term basis, like the one year LTRO last month and that's done at the fixed rate aswell. When you hear on RTÉ that the ECB has 'lowered interest rates', that benchmark rate is what they're referring to—it's usually referred to as the 'minimum bid rate' because that's the lowest rate at which banks can bid for money at the auctions (the 1% rate that the FT are citing in the article). Since October last year, all bids have been accepted at a single rate, before this there were three different rates to look at in auctions; for example:



So, even though the ECB headline interest rate was 4.25%, the average rate that a bank was paying for funding (the weighted average per euro received) was well above this, and that was a problem.

Interbank lending froze up around the time of Lehman Brothers and some banks (like Irish Life & permanent) fund themselves, to a large extent, based on short-term money market borrowings. When this money stopped flowing, banks were bidding up the available money from the ECB/Eurosystem. The difference between 3 month Euribor (the interbank rate for €) and the ECB rate is often cited as a measure of risk. The ECB money is considered 'secured' because collateral is used when banks borrow from the ECB.



After the one year LTRO, interbank rates have fallen quite a bit, so anyone without the eligible collateral to borrow from the Eurosystem can still do so at the target rate, just from a different lender. Basically, banks are awash with money at the moment, which is what the ECB wants. Lower money market rates usually means lower variable mortgage rates, and that (hopefully) means more consumption by households.

Anonymous1987

Économiste Monétaire wrote: »

That's the rate at which the Eurosystem auctions money on a weekly basis for main refinancing operations (MROs), and the market rate is usually hovering around this ECB rate (like the overnight rate, EONIA) when money markets are functioning normally—they also auction money on a longer-term basis, like the one year LTRO last month and that's done at the fixed rate aswell. When you hear on RTÉ that the ECB has 'lowered interest rates', that benchmark rate is what they're referring to—it's usually referred to as the 'minimum bid rate' because that's the lowest rate at which banks can bid for money at the auctions (the 1% rate that the FT are citing in the article). Since October last year, all bids have been accepted at a single rate, before this there were three different rates to look at in auctions; for example:

If all bids will be accepted at a single rate does this mean that if the demand for credit increases above the marginal lending facility of 1.75% the ECB is forced to raise more of its own debt to fund liquidity in the markets?

Économiste Monétaire wrote: »

So, even though the ECB headline interest rate was 4.25%, the average rate that a bank was paying for funding (the weighted average per euro received) was well above this, and that was a problem.

Interbank lending froze up around the time of Lehman Brothers and some banks (like Irish Life & permanent) fund themselves, to a large extent, based on short-term money market borrowings. When this money stopped flowing, banks were bidding up the available money from the ECB/Eurosystem. The difference between 3 month Euribor (the interbank rate for €) and the ECB rate is often cited as a measure of risk. The ECB money is considered 'secured' because collateral is used when banks borrow from the ECB.

After the one year LTRO, interbank rates have fallen quite a bit, so anyone without the eligible collateral to borrow from the Eurosystem can still do so at the target rate, just from a different lender. Basically, banks are awash with money at the moment, which is what the ECB wants. Lower money market rates usually means lower variable mortgage rates, and that (hopefully) means more consumption by households.

So basically the financial market is so liquid right now banks are comfortable enough to lend to one another below the ECB minimum bid rate? When you say borrow from a different lender do you mean borrowing from another bank v the ECB? Also why the decision to remove the collateral requirement? is this just a move to loosen the rules in order to increase liquidity sounds a bit risky.

Économiste Monétaire

Anonymous1987 wrote: »

If all bids will be accepted at a single rate does this mean that if the demand for credit increases above the marginal lending facility of 1.75% the ECB is forced to raise more of its own debt to fund liquidity in the markets?

The marginal lending facility would be accessed in the intervening period between auctions. So, on an average week, the Eurosystem MROs are settled on a Wednesday (money transferred to the accounts of the participating counterparties) and consider, just as an example, that a bank needs extra reserves and this happens to occur on a Thursday/Friday. Then a bank would access the marginal lending facility if it can't get an overnight rate below the ECB marginal rate.

To raise the €442bn for the LTRO last month the Eurosystem just credited the individual accounts that banks hold with the national central banks by computer, it's about as simple as that. Want to increase the reserves held by bank X based on an MRO? Just alter the amount in their reserve account by typing in the number.

The ECB didn't issue its own debt certificates here; that would occur in a situation where they want to soak up liquidity and the holdings of government securities (or other acceptable securities to the banks) by the Eurosystem isn't sufficient to meet the needs of such a large open market operation (OMO) or permanent OMO.

Anonymous1987 wrote: »

So basically the financial market is so liquid right now banks are comfortable enough to lend to one another below the ECB minimum bid rate? When you say borrow from a different lender do you mean borrowing from another bank v the ECB? Also why the decision to remove the collateral requirement? is this just a move to loosen the rules in order to increase liquidity sounds a bit risky.

Pretty much. The floor on rates would be 0.25%, which is the deposit facility rate from the ECB. If lending to customers for mortgages/other investments and consumption isn't appealing (say, default rates don't justify the return) they can lend to other banks rather than leave it at the ECB for 0.25%. (By 'other lenders' I mean other banks, in this context.) The spread between lending to customers and what they paid for money from the ECB will help to build up provisions for losses that banks have yet to realise.

The ECB hasn't removed the need for collateral in its refinancing operations, I'm referring to unsecured interbank lending (i.e. where collateral isn't used for short-term lending between two banks).

Anonymous1987

Thanks for answering my questions with such clarity. I wounder though when the time comes for the ECB to soak up credit by issuing its own debt where does it get its funding from and won't there be a substantial amount of debt to be acquired given the large injections into the system such as LTRO operation?