The central bank-to-bank interbank market

The second IBM is the central bank-to-bank interbank "market", or cb2b IBM. It is also an "administrative" market, and it is at the centre of the vast majority of countries' monetary policy. It represents loans from the central bank to the banks (also called borrowed reserves - BR). The central bank provides these reserves at its KIR. As seen in the balance sheets above:

In most countries monetary policy is aimed at ensuring that the banks are indebted to the central bank at all times so that the KIR is applied and therefore is "made effective" on part of the liabilities of the banks (recall from Figure 2: bank liabilities = BD + BR). The KIR has a major influence on the banks' deposit rates and, via the more or less static bank margin, on the banks' prime rate. This, as we will show later in some detail, is an extremely successful policy protocol.

The bank-to-bank interbank market

The third interbank market is a true market: the bank-to-bank interbank market, or b2b IBM. This market operates during the banking day but particularly at the close of business each day (banks "close off their books" every day). Allow us present an example: a large corporate customer (Company A) withdraws LCC 100 billion of its call money deposits from Bank A and deposits it with Bank B - because Bank B offered a higher call money rate.

How does the settlement of these transactions take place between the two banks? It takes place over the banks' reserve accounts: item B2 in Balance Sheet 1, and item D in the Balance Sheet 2. Balance Sheets 3 - 6 elucidate the story.

BALANCE SHEET 3: COMPANY A (LCC BILLIONS)

Liabilities

Deposit at Bank A Deposit at Bank B

-100 + 100

Total

0

Total

BALANCE SHEET 4: BANK A (LCC BILLIONS)

Assets

Reserve account at CB

-100

Deposits (Company A)

-100

Total

Total

BALANCE SHEET 5: BANK B (LCC BILLIONS)

Assets

Reserve account at CB

+ 100

Deposits (Company A)

+ 100

Total

Total

+100

BALANCE SHEET 6: CENTRAL BANK (LCC BILLIONS)

Assets Liabilities

Reserve accounts: Bank A Bank B

-100 + 100

Total

0

Total

Assuming that at the close of business yesterday the two banks were not borrowing from the central bank (BR = 0) and they did not have any surpluses with the central bank (TR = RR; ER = 0):

• Bank A is now short of RR by LCC 100 billion, and therefore does not comply with the RR (TR < RR).

• Bank B now has surplus reserves (TR > RR or TR - RR = ER = LCC 100 billion).

BALANCE SHEET 7: BANK A (LCC BILLIONS)

Liabilities

Deposits (Company A) Loan (Bank B)

-100 + 100

Total

0

Total

BALANCE SHEET 8: BANK B (LCC BILLIONS)

Assets

Liabilities

Loan to Bank A

+ 100

Deposits (Company A)

+ 100

Total

+100

Total

+100

We assume this is the only transaction that takes place during the day, and that bank B does not have outstanding borrowings from the central bank. We are now at the close of business. The electronic interbank settlement system presents the two banks with the above information that pertains to each of them. Bank A needs to borrow LCC 100 billion and Bank B would like to place its ER somewhere at a rate of interest. The somewhere at the end of the business day is only the other banks (in this case Bank A).

The final interbank clearing process at the end of the business day takes place over these same reserve accounts with the central bank. In this b2b IBM the surplus bank, Bank B, will place its ER of LCC 100 billion with Bank A, and this will take place at the IBM rate (after some haggling). Bank B will instruct the central bank to debit its reserve account and credit Bank As reserve account. The central bank's balance sheet will be unchanged, and the banks' balance sheets appear as in Balance Sheets 7 and 8.

Thus, in the b2b IBM, banks place funds with or receive funds from other banks depending on the outcome of the clearing. Surpluses are placed at the IBM rate. A critical issue here is that this rate is closely related to the KIR (as shown in Figure 12) because banks endeavour to satisfy their liquidity needs in this market before last resort borrowing from the central bank at the KIR. In this example it was possible. Later we will show that when the central bank does a deal in the open market (= open market operations or OMO) it affects bank liquidity. And as you now know, when one speaks of bank liquidity one makes reference to the state of balances on the banks' reserve accounts: the status of TR, RR, ER and BR. As we will demonstrate later, the central bank has total control over bank liquidity, and therefore over interest rates.

interbank markets

Figure 13: interbank markets

In the b2b IBM no new funds are created; existing funds are merely shifted around. New funds (reserves) are created in the cb2b IBM (in the long term). The latter is a function of the ability of banks to create money in the form of deposit money120. This they are able to do without restraint121 and the central bank supports this by the creation of the additional RR (a function of deposit growth). Is it as simple as this? We will answer this essential question a little later.

We portray the interbank markets in Figure 13.

In order to concretize comprehension of the b2b IBM we present another example:

• Company A sells goods to Company B to the value of LCC 100 million; Company A's banker is Bank A.

• Company B borrows LCC 100 million to buy the goods; Company B's banker in Bank B.

It will be evident that this is a case of bank deposit money creation; the balance sheets appear as in Balance Sheets 9-13 just before the final interbank market clearing takes place. Note that we ignore the effect of the transactions on RR for now.

BALANCE SHEET 9: COMPANY A (LCC MILLIONS)

Assets

Goods

Deposits at Bank A

-100 + 100

Total

0

Total

BALANCE SHEET 10: BANK A (LCC MILLIONS)

Assets

Reserve account at CB

+ 100

Deposits (Company A)

+ 100

Total

Total

+100

BALANCE SHEET 11: COMPANY B (LCC MILLIONS)

Assets

Goods

+ 100

Loans from Bank B

+ 100

Total

+100

BALANCE SHEET 12: BANK B (LCC MILLIONS)

Liabilities

Loans to Company B Reserve account at CB

+ 100 -100

Total

0

Total

BALANCE SHEET 13: CENTRAL BANK (LCC MILLIONS)

Assets

Liabilities

Reserve accounts: Bank A Bank B

+ 100 -100

Total

0

Total

The final IBM takes place: Bank A makes an interbank loan to Bank B at the interbank rate, and instructs the central bank to debit its account and credit the account of Bank B. Company A's and Company B's balance sheets do not change; only the banks' do and end up as indicated in Balance Sheets 14-15.

BALANCE SHEET 14: BANK A (LCC MILLIONS)

Liabilities

Loan to Bank B

+ 100

Deposits (Company A)

+ 100

Total

+100

BALANCE SHEET 15: BANK B (LCC MILLIONS)

Assets

Loans to Company B

+ 100

Loan from Bank A

+ 100

Total

Total

+100

It will be evident that the money stock has increased by LCC 100 million (= deposit of Company A) and the BSCoC is the bank credit increase of LCC 100 million; the real cause is the demand for credit by Company B which was satisfied by its banker, Bank B.

 
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