An analysis of bank liquidity

Introduction

Back to the central bank's balance sheet and open market operations (OMO) (see Balance Sheet 4). We have nauseatingly stated that the CB is able to engineer it so that the banks are always indebted to the CB, i.e. have a BR situation (= negative NER) (proviso: in normal circumstances). We now need to substantiate this statement by introducing you to an analysis of the liquidity of the banking system (or money market). Note that this is not fiction: you can do this analysis yourself with access to your central bank's balance sheet data.

BALANCE SHEET 4: CENTRAL BANK (LCC BILLIONS)

Assets

Liabilities

A. Notes and coins

1 000

D. Foreign assets

1 000

B. Deposits

1. Government

900

E. Loans to government

1 100

2. Banks' reserve accounts (TR)

500

(RR = 500)

F. Loans to banks (BR) @ KIR

400

(ER = 0)

C. Foreign loans

100

Total

2 500

Total

2 500

You will recall our view that a good measure of bank liquidity is the net excess reserves (NER) of the banking sector, and that it is made up as follows:

We also know that ER:

and that in most countries it is zero because the CB brings about a negative NER situation in order to make the KIR effective.

As in the case of the money identity we can create a bank liquidity identity and with this analyse the sources of changes in bank liquidity (which are largely under the control of the CB). Because we are working with a balance sheet, NER = ER - BR must be equal to the remaining asset items less the remaining liability items as follows:

We have two sets of related items (items D and C, and items E and B1); if we "net" them we create the identity:

In words, NER (excess reserves, ER, less loans to banks, BR) is equal to:

Foreign assets (FA) - foreign liabilities (FL) = net foreign assets (NFA) + Loans to govt (LG) - govt deposits (GD) = net loans to govt (NLG)

- Notes and coins in circulation (N&C)

- Required reserves (RR) (calculated as: TR - ER).

Presented more clearly we have:

or, even more illuminatingly:

This is similar to the money identity, except that here we work only with the balance sheet of the CB. Using the numbers of Balance Sheet 4 we get (LCC billion):

These are actual or "outstanding" or "stock" numbers, i.e. numbers at a point in time (when the balance sheets is drawn up). It will be clear that from one date to the next (the numbers are usually available as at month ends) we have:

We now have an analysis of bank liquidity. We are able from one date to the next to calculate the extent by which NER changed and what the balance sheet sources of change/s (BSSoC) were. The real causes are the underlying decisions that led to transactions that gave rise to the changes.

It is important to note that some of the items are passive (the CB does not manipulate them) while the rest are operational (the CB does = OMO). The passive items are:

Notes and coins (item A):

The amount of N&C is determined by the extent to which the banks, companies and households desire to hold them.

Government deposits (item B1):

The amount of government deposits at the CB is determined by government. In some countries government also banks with the banks, and these balances can be used to influence NER (but we will not cover this here).

Required reserves (item B2 - ER, i.e. TR - ER):

The amount of RR is determined by the volume of bank deposits; recall that RR = BD x r. So, the CB has indirect control of this item.

The operational (OMO) items are:

Foreign loans (item C):

The CB decides on whether and to what extent foreign loans are undertaken. However, in some developing countries this decision is made by government, and is a real problem in respect of managing NER.

Foreign assets (item D):

Foreign assets are fully under the management of the CB and foreign assets are often used in OMO - in the form of swaps with the banks. However, as in the case of foreign loans, in some developing countries decisions in this regard are made by government. In the case of donor funds a real problem in respect of managing NER is experienced.

Loans to government (item E):

The central bank's portfolio of government securities constitutes the main operational tool (i.e. OMO tool) in managing NER: by selling and buying treasury bills in the main.

In many countries the CB has another and extremely powerful tool in its arsenal: its own securities. We have left this out in the interests of simplicity, but you should be able to simulate its role after the examples presented below.

It should be evident that the main objective of the CB is to bring about a desired level of NER (mostly negative) and that, in order to do so, it is required to make daily forecasts of the passive items. The outcome of this exercise will determine the extent to which it has to take operational action: OMO. A desired level of NER is the outcome!

 
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