5.2.7The signicance of the parallel markets

In section 3.3.2 we noted that central banks generally implement monetary policy by

setting the rate of interest at which they make reserve assets available to the banking

system. As we shall see in a moment, one signicance of the parallel markets is that

they make a central bank’s monetary control operations, at least in principle, more

difcult and they do this in at least two ways. A second feature of these markets

is their widening of the range and reduction in the cost of lending and borrowing

facilities. We shall look at each of these in turn.

Firstly, the development of parallel markets has diminished the impact of the

Bank of England’s ofcial operations. In the gilt repo market (and previously in the

discount market) the Bank of England takes advantage of day-to-day ows of funds

between the public and private sectors to indicate the way in which it wishes to

see short-term interest rates move. It is able to do this because the repo market is

a front-line source of liquidity to banks in the event of a shortage. When banks are

short of funds or require earlier borrowing to be renanced, the Bank of England

relieves the shortage at that rate of interest in the repo market which it thinks appro-

priate, nudging rates upwards perhaps to reduce the demand for bank lending or

lowering them to counteract a rising exchange rate.

With the growth of the parallel markets, however, there are many sources of

funds immediately available to individual banks and the Bank of England need no

longer be the immediate source of funds to any nancial institution. As we have

seen above, all deposit-takers have substantial short-term funds lent to each other.

In Table 3.3 these are shown under assets as ‘market loans and CDs’. In these markets

the Bank has no direct control over interest rates. Individual banks (and other nan-

cial intermediaries) can alleviate liquidity shortages through these markets without

the Bank having an opportunity to inuence rates. Some indication of the relative

importance of the parallel as opposed to traditional markets is the widespread use

of LIBOR, rather than repo rate, by nancial institutions as a basis for calculating

their lending and deposit rates. Furthermore, in a period of a domestic monetary

squeeze, it will be possible, and may be cheaper, to borrow in eurocurrency markets.

With a well-developed sterling spot market and no exchange control, it is then a

simple and cheap operation to swap foreign currency for sterling from the Exchange

Equalisation Account. Unless the authorities react by selling government debt to the

non-bank private sector on a sufcient scale (with whatever interest rate consequences

may follow), the money supply will increase.

Of course, a general liquidity shortage cannot be alleviated by banks withdrawing

loans from each other. Eventually the Bank will be required as lender of last resort.

But the existence of numerous alternative markets for short-term funds means the

opportunity for intervention may be subject to a time lag.

Granted that the parallel markets may reduce the ability of short-term interest rate

changes to inuence monetary growth, by changing the relationship between money

and spending (i.e. velocity), they may also alter the signicance of any monetary

growth which does occur.

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