Rationale for a liquidity shortage
Let us spend a little time on the ultimate aim of the CB in keeping the banks indebted to it. It is an integral part of the monetary policy process as depicted in Figure 1. The ultimate objective of monetary policy is to create the conditions for sustainably high economic growth. What are the conditions? They are stable inflation at a low level (2% pa is the norm in the developed world) and, not shown on the illustration, financial stability.
The intermediate objective is to "control" the growth rate in bank loans / money stock (and other indicators which depend on this such as the exchange rate). How do they achieve this? Through monetary policy, which can be said is decisions aimed at achieving the objectives just mentioned. It is executed by the CB. However, the CB has a limited but effective range of tools with which to implement monetary policy: through open market operations (OMO) it influences bank liquidity (as measured by NER) to a negative condition where the banks are indebted to the CB. The CB charges them their KIR.
Figure 1: monetary policy
The KIR is a fixed rate administratively determined by the Monetary Policy Committee (MPC) of the CB, and it is changed when deemed necessary. Borrowing from the CB is a liability for the banks, as are deposits. It is by definition the highest rate for one-day money and it has a major influence on deposit rates via the interbank rates. This is so because the banks endeavour at all times to avoid borrowing from the CB.
Each day during business hours the banks compete for deposits, but particularly for call money deposits because these are large blocks of deposits. They "pay up" for these deposits but never more than the KIR because borrowings from the CB are available unlimitedly (in many countries this is called "the borrowing / discount window is always open"). So, the KIR represents a ceiling for one-day call money rates and for the IBM rate. Because the KIR is the highest rate for one-day money and the banks are utilizing the CB borrowing facility, it can be said that it "bites" the banks (see Box 1).
As we have seen, the final market where banks are able to settle their positions is at the final IBM clearing at the end of the day. Here the deficit banks bid for the surplus banks' balances. So the final interbank clearing is where banks balance their books - at the interbank rate. This rate is also market-determined at just below the KIR because, as said, CB borrowings are available at the KIR.
Box 1: banks' view of central bank's KIR
Figure 2: call money rate, IBM rate & KIR
Figure 2 provides fine evidence of the significance of the KIR in monetary policy: it shows the KIR, the interbank rate and the call money rate for a particular country over a 10-year period. The latter two are market-determined while the KIR is fixed by the MPC. It is quite clear that it represents a ceiling rate: as said, it is so because the banks endeavour to avoid borrowing from the CB. This they, collectively, cannot do, because they cannot create CBM.
The KIR, via the interbank rate and the bank call rates, has a powerful impact on the banks' other deposit rates and, via the bank margin (which the banks endeavour to maximise), the prime lending rate of banks (recall that this is a benchmark rate). We know that deposit money is created by the banks' lending activities, and that the demand for loans is largely influenced by the level of prime rate. So, there we have it in a nutshell: monetary policy is aimed at influencing the banks' prime lending rate and through it the demand for loans which, if satisfied by the banks, creates bank deposit money. If this is successfully achieved, inflation is "managed" at a low level, and thus an environment conducive to high and sustainable growth is created.
The difficulty inherent in monetary policy should be evident. It is essentially twofold. Firstly, what is the correct level of prime? Secondly, the demand for goods and services is what drives economic growth. Money growth, which largely underlies higher economic growth, should be allowed to increase at the level at which the economy can expand to meet the increased demand. What is this level? If growth is too high demand is satisfied by imports and the trade account balance (TAB) goes out of kilter (remember: C + I = GDE; GDE + TAB = GDP). The job of the CB is not a walk in the park, especially if the political masters are permitted to snap at the CB Governor's heels.
Figure 3: KIR & prime rate (month-ends over 50 years)
In conclusion, a telling chart is presented (see Figure 3): the relationship between the KIR and prime rate (as at month-ends). This is for a particular country over an almost 50-year period. It shows that the relationship is close indeed (correlation coefficient = 0.99), providing evidence that the KIR has a powerful influence on the banks' prime rate. It also indicates that the CB successfully uses the Profit maximising behaviour of banks to implement monetary policy: they maintain their precious margin whenever the KIR is changed.
A final word: the KIR is only made effective if NER is negative, i.e. if the banks are borrowing from the CB, i.e. if it "bites the banks".