Management of Financial Institutions

POLICY INSTRUMENTS:Open Market Operations, Capital Requirements

<< CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions
BALANCE OF TRADE:Balance of Payments Equilibrium, Public Policy and Financial Stability >>
Management of Financial Institutions - MGT 604
Lecture # 4
The main monetary policy instruments available to central banks are open market operation,
bank reserve requirement, interest-rate policy, re-lending and re-discount (including using
the term repurchase market), and credit policy (often coordinated with trade policy). While
capital adequacy is important, it is defined and regulated by the Bank for International
Settlements, and central banks in practice generally do not apply stricter rules.
To enable open market operations, a central bank must hold foreign exchange reserves
(usually in the form of government bonds) and official gold reserves. It will often have
some influence over any official or mandated exchange rates: Some exchange rates are
managed, some are market based (free float) and many are somewhere in between
("managed float" or "dirty float").
Interest Rates
By far the most visible and obvious power of many modern central banks is to influence
market interest rates; contrary to popular belief, they rarely "set" rates to a fixed number.
Although the mechanism differs from country to country, most use a similar mechanism
based on a central bank's ability to create as much fiat money as required.
The mechanism to move the market towards a 'target rate' (whichever specific rate is used)
is generally to lend money or borrow money in theoretically unlimited quantities, until the
targeted market rate is sufficiently close to the target. Central banks may do so by lending
money to and borrowing money from (taking deposits from) a limited number of qualified
banks, or by purchasing and selling bonds. As an example of how this functions, the Bank
of Canada sets a target overnight rate, and a band of plus or minus 0.25%. Qualified banks
borrow from each other within this band, but never above or below, because the central
bank will always lend to them at the top of the band, and take deposits at the bottom of the
band; in principle, the capacity to borrow and lend at the extremes of the band are
unlimited. Other central banks use similar mechanisms.
It is also notable that the target rates are generally short-term rates. The actual rate that
borrowers and lenders receive on the market will depend on (perceived) credit risk, maturity
and other factors. For example, a central bank might set a target rate for overnight lending
of 4.5%, but rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of
inverted yield curves, even below the short-term rate. Many central banks have one primary
"headline" rate that is quoted as the "Central bank rate." In practice, they will have other
tools and rates that are used, but only one that is rigorously targeted and enforced.
"The rate at which the central bank lends money can indeed be chosen at will by the central
bank; this is the rate that makes the financial headlines." - Henry C.K. Liu, in an Asia Times
article explaining modern central bank function in detail He explains further that "the US
central-bank lending rate is known as the Fed funds rate. The Fed sets a target for the Fed
funds rate, which its Open Market Committee tries to match by lending or borrowing in the
money market.... a fiat money system set by command of the central bank. The Fed is the
head of the central-bank snake because the US dollar is the key reserve currency for
international trade. The global money market is a US dollar market. All other currencies
markets revolve around the US dollar market." Accordingly the US situation isn't typical of
central banks in general.
Management of Financial Institutions - MGT 604
A typical central bank has several interest rates or monetary policy tools it can set to
influence markets.
Marginal Lending Rate (currently 5.00% in the Eurozone) a fixed rate for
institutions to borrow money from the CB. (In the US this is called the Discount rate).
Main Refinancing Rate (4.00% in the Eurozone) this is the publicly visible interest
rate the central bank announces. It is also known as Minimum Bid Rate and serves as a
bidding floor for refinancing loans. (In the US this is called the Federal funds rate).
Deposit Rate (3.00% in the Eurozone) the rate parties receive for deposits at the
These rates directly affect the rates in the money market, the market for short term loans.
Open Market Operations
Through open market operations, a central bank influences the money supply in an
economy directly. Each time it buys securities, exchanging money for the security, it raises
the money supply. Conversely, selling of securities lowers the money supply. Buying of
securities thus amounts to printing new money while lowering supply of the specific
The main open market operations are:
Temporary lending of money for collateral securities ("Reverse Operations" or
"repurchase operations", otherwise known as the "repo" market). These operations are
carried out on a regular basis, where fixed maturity loans (of 1 week and 1 month for the
ECB) are auctioned off.
Buying or selling securities ("Direct Operations") on ad-hoc basis.
Foreign exchange operations such as forex swaps.
All of these interventions can also influence the foreign exchange market and thus the
exchange rate. For example the People's Bank of China and the Bank of Japan have on
occasion bought several hundred billions of U.S. Treasuries, presumably in order to stop the
decline of the U.S. dollar versus the Renminbi and the Yen.
Capital Requirements
All banks are required to hold a certain percentage of their assets as capital, a rate which
may be established by the central bank or the banking supervisor. For international banks,
including the 55 member central banks of the Bank for International Settlements, the
threshold is 8% (see the Basel Capital Accords) of risk-adjusted assets, whereby certain
assets (such as government bonds) are considered to have lower risk and are either partially
or fully excluded from total assets for the purposes of calculating capital adequacy. Partly
due to concerns about asset inflation and term repurchase agreements, capital requirements
may be considered more effective than deposit/reserve requirements in preventing indefinite
lending: when at the threshold, a bank cannot extend another loan without acquiring further
capital on its balance sheet.
Reserve requirements
Another significant power that central banks hold is the ability to establish reserve
requirements for other banks. By requiring that a percentage of liabilities be held as cash or
deposited with the central bank (or other agency), limits are set on the money supply.
Management of Financial Institutions - MGT 604
In practice, many banks are required to hold a percentage of their deposits as reserves. Such
legal reserve requirements were introduced in the nineteenth century to reduce the risk of
banks overextending themselves and suffering from bank runs, as this could lead to knock-
on effects on other banks. See also money multiplier, Ponzi scheme. As the early 20th
century gold standard and late 20th century dollar hegemony evolved, and as banks
proliferated and engaged in more complex transactions and were able to profit from
dealings globally on a moment's notice, these practices became mandatory, if only to ensure
that there was some limit on the ballooning of money supply. Such limits have become
harder to enforce. The People's Bank of China retains (and uses) more powers over reserves
because the Yuan that it manages is a non-convertible currency.
Even if reserves were not a legal requirement, prudence would ensure that banks would hold
a certain percentage of their assets in the form of cash reserves. It is common to think of
commercial banks as passive receivers of deposits from their customers and, for many
purposes, this is still an accurate view.
This passive view of bank activity is misleading when it comes to considering what
determines the nation's money supply and credit. Loan activity by banks plays a
fundamental role in determining the money supply. The money deposited by commercial
banks at the central bank is the real money in the banking system; other versions of what is
commonly thought of as money are merely promises to pay real money. These promises to
pay are circulatory multiples of real money. For general purposes, people perceive money as
the amount shown in financial transactions or amount shown in their bank accounts. But
bank accounts record both credit and debits that cancel each other. Only the remaining
central-bank money after aggregate settlement.
Final Money - can take only one of two forms:
physical cash, which is rarely used in wholesale financial markets,
Central-bank money.
The currency component of the money supply is far smaller than the deposit component.
Currency and bank reserves together make up the monetary base, called M1 and M2.
Exchange Requirements
To influence the money supply, some central banks may require that some or all foreign
exchange receipts (generally from exports) be exchanged for the local currency. The rate
that is used to purchase local currency may be market-based or arbitrarily set by the bank.
This tool is generally used in countries with non-convertible currencies or partially-
convertible currencies. The recipient of the local currency may be allowed to freely dispose
of the funds, required to hold the funds with the central bank for some period of time, or
allowed to use the funds subject to certain restrictions. In other cases, the ability to hold or
use the foreign exchange may be otherwise limited.
In this method, money supply is increased by the central bank when the central bank
purchases the foreign currency by issuing (selling) the local currency. The central bank may
subsequently reduce the money supply by various means, including selling bonds or foreign
exchange interventions.
Table of Contents:
  1. Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS
  2. FINANCIAL INSTITUTIONS:Non Banking Financial Companies
  3. CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions
  4. POLICY INSTRUMENTS:Open Market Operations, Capital Requirements
  5. BALANCE OF TRADE:Balance of Payments Equilibrium, Public Policy and Financial Stability
  6. STATE BANK OF PAKISTAN:History, Regulation of Liquidity, Departments
  10. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Human Resources Department
  13. PAKISTAN ECONOMIC AID & DEBT:Macroeconomic Stability, Strengthening Institutions
  14. INCREASING FOREIGN DIRECT INVESTMENT:Industrial Sector, Managing the Debt
  15. ROLE OF COMMERCIAL BANKS:Services Typically Offered by Banks, Types of banks
  16. ROLE OF COMMERCIAL BANKS:Types of investment banks, The Management of the Banks
  17. ROLE OF COMMERCIAL BANKS:Public perceptions of banks, Capital adequacy, Liquidity
  19. ROLE OF COMMERCIAL BANKING:Private Deposit Insurance,
  20. BRANCH BANKING IN PAKISTAN:Remittances, Online Fund Transfer
  22. Mutual funds:Types of international mutual funds, Mutual funds vs. other investments
  23. Mutual Funds:Criticism of managed mutual funds, Money Market Fund
  24. Mutual Funds:Balanced Funds, Growth Funds, Specialized Funds, Measuring Risks
  25. Mutual Funds:Cost of Ownership, Redemption Fee, Reports to Shareholders
  26. Mutual Funds:Internet Fraud, The Pyramid Scheme, How to Avoid Investment Fraud
  27. Mutual Funds:Investing In International Mutual Funds, How to Pre-Select a Mutual Fund
  28. Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest
  29. Letter of Credit:Elements of a Letter of Credit, Commercial Invoice, Tips for Exporters
  30. Letter of Credit and International Trade:Terminology, Risks in International Trade
  31. Foreign Exchange & Financial Institutions:Investment management firms, Exchange Traded Fund
  32. Foreign Exchange:Factors affecting currency trading, Economic conditions include
  33. Leasing Companies:Basic Purpose of Leasing, Technological Benefits
  34. The Leasing Sector in Pakistan and its Role in Capital Investment
  35. Role of Insurance Companies:Indemnification, Insurer’s business model
  36. Role of Insurance Companies:Life insurance and saving
  37. Role of financial Institutions in Agriculture Sector:What is “Revolving Credit Scheme”?
  38. Agriculture Sector and Financial Institutions of Pakistan:What is SMEs
  39. Can Government of Pakistan Lay a Pivotal Role in this Sector?:Business Environment
  40. Financial Crimes:Process of Money Laundering, Terrorist Financing
  41. DFIs & Risk Management:Managing Credit Risk, Managing Operational Risk
  42. Banking Fraud & Misleading Activities:Rogue Traders, Uninsured Deposits
  43. The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions
  44. Classic Financial Scandals:Corruption, Discovery, Black Wednesday