5.3 Monetary policy and the money markets

have seen, after 1981 the Bank of England was creating a market for bills between

itself and the discount houses. As far as prices and rates of discount were concerned,

however, the effects would probably have been the same, even if the Bank had

dealt with everyone operating in the discount market. Nonetheless, the next step

in the movement towards market-based methods of intervention would involve the

widening of institutions with which the Bank was willing to deal. This came in 1997

and, when it did, it meant of course that the Bank was beginning to deal directly

with those institutions which were experiencing the initial liquidity shortages and

surpluses.

In 1996 the Bank announced that from March 1997 it would deal not just with

discount houses but with banks, building societies and securities houses. Further-

more, instead of conning its transactions to treasury and ‘eligible’ commercial bills

(which were not widely held outside the discount houses), it announced that it would

also enter into repo agreements in government bonds (which were). Strictly speak-

ing, government bonds are not money market instruments. This is because they

are issued for much longer periods of maturity (and we deal with them as capital

market instruments in the next chapter). As we saw in section 5.2, a repo deal is

just another form of collateralised loan. In offering to deal in gilt repos, the Bank

of England was offering to relieve a shortage of liquidity (for example) by purchas-

ing government bonds for a given price and to hold them for a set period (usually

fourteen days), subject to the agreement of the seller to repurchase them on a set

date for a price higher than that for which they were sold. Equation 5.2 shows how

the sale price, the duration and the repurchase price can be used to calculate an

equivalent rate of interest.

In 2005 the Bank announced a further series of reforms to its money market

operations, and these took effect from 18 May 2006. Under these arrangements, the

Bank still supplies liquidity by repo deals, but now of seven-day maturity. However,

these deals are carried out only once a week, instead of daily. Deals are carried out

on Thursdays because the terms of the repo are still intended to be the method by

which the Bank sets interest rates and so the deals have to take place immediately

after any possible decision by the Monetary Policy Committee (which is also made

on a Thursday). With additional liquidity being available only on a weekly basis,

there obviously had to be further changes to accommodate banks’ requirements on

the days in-between.

These came in two forms. Firstly, there was an easing of the liquidity conditions

that banks have to meet. The prudential ratio remains (see section 3.3.2) but instead

of banks having to observe this ratio at the close of business every day, it is now

sufcient that they observe this ratio on averageover the period between Monet-

ary Policy Committee (MPC) meetings. Furthermore, they have a margin of error of

/1 per cent. Also, for the rst time in UK monetary history, the deposits held at

the Bank of England pay interest (at a rate which is the rate set by the MPC at its

last meeting). The penalties for missing the target are that reserves in excess of the

ratio (1 per cent) pay no interest while a shortfall of reserves greater than 1 per cent

of the target leads to the bank being charged interest on the decit charged at a rate

equal to twice the MPC’s current rate.

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Chapter 5 • The money markets

Secondly, the Bank created ‘standing facilities’ consisting of a borrowing and

deposit facilities. The rst of these enables banks to borrow on a day-to-day basis

to top up their reserves when necessary. This costs them the MPC rate +25bp. The

deposit facility enables them to hold ‘spare’ funds at the central bank on which they

can draw to top up reserves. According to the Bank of England, the main purpose of

the reforms is to reduce day-to-day volatility in interbank rates. Notice two things.

Firstly, interbank rates cannot move away from the ofcial rate by more than 25bp

points because banks can always borrow from or lend to the Bank of England at

those rates. Secondly, all these rates (and the interest on reserves and the penalty rate)

are linked directly to the MPC’s rate. Any decision by the MPC to change the ofcial

rates will have an immediate effect on the rate charged to banks for additional reserves

as it has always done.

We should also note that all the reforms of the past ten years (extending its

operating procedures to include most DTIs, switching to the use of gilt repos and

now introducing an averaging requirement with standing facilities) have resulted

in the Bank shifting its money market operations away from their traditional focus

on the discount market, and in so doing has put them on a similar footing to those

in other European centres. It may be signicant that its procedures are now very

similar to those currently used by the European Central Bank.