Interbank rate model

The IBR model is a variation of the firm-BR model. It is a model where a number of central banks position themselves in terms of monetary policy. They set a target range for the second stage of the monetary policy transmission mechanism (MPTM): the interbank rate. You will recall that this is the b2b IBM, which takes its cue from the KIR, provided that the banks are indebted to the CB (have a +BR number in their balance sheets). The argument is that when the "short" banks in the interbank clearing are attempting to avoid borrowing from the CB they are willing to pay interbank rates that are a fraction below the KIR.

There is a proviso to this, and that is when the banking system is in balance (no surplus with the CB (no ER) and no borrowing from the CB (no BR) (= an unusual state because CB forecasts cannot be precise), just the mere threat of borrowing from the CB is sufficient to make the KIR effective. Furthermore, there are central banks that allow ERs to exist and make their interest rate policy effective by paying an interest rate on these amounts. The effective rate then becomes this rate [let's call this the KIR-D - for KIR for bank deposits (ER); while the CB lending rate becomes the KIR-L (i.e. for BR)]. Thus, through this mechanism the CB can create a "tunnel of KIRs" and this becomes the cue or the target for the b2b IBM rate. Clearly the KIR-L forms the upper level of the tunnel and the KIR-D the bottom level.

A good example of this method on monetary policy is Canada. The Bank of Canada states:"

"The Bank carries out monetary policy by influencing short-term interest rates. It does this by raising and lowering the target for the overnight rate.

"The overnight rate is the interest rate at which major financial institutions borrow and lend one-day (or "overnight") funds among themselves; the Bank sets a target level for that rate. This target for the overnight rate is often referred to as the Bank's key interest rate or key policy rate.

"Changes in the target for the overnight rate influence other interest rates, such as those for consumer loans and mortgages. They can also affect the exchange rate of the Canadian dollar.

"The instrument that the Bank uses to ensure that inflation remains within this target range is the Bank Rate - the rate of interest that the Bank charges on short-term loans to financial institutions.

"More specifically, the Bank sets a target band for the market rate for overnight transactions. The upper end of the band is the Bank Rate, the rate charged on loans to financial institutions participating directly in the payments system. The bottom end of the band is the rate the Bank pays on settlement balances held by participating financial institutions"

The essence of the European Central Bank's (ECB's) monetary policy style is to create a "corridor" of interest rates within which the "overnight market interest rate" (that is, the b2b IBM rate) is determined (i.e. same as explained earlier). It announces its "key interest rates" (it actually terms its rates as such) from time to time, thus broadcasting its monetary policy stance.

As in the case of Canada, it has two KIRs: the interest rate on the marginal lending facility (i.e. for overnight loans), which constitutes the ceiling rate for the overnight b2b IBM rate (as KIR-L above), and the interest rate on the deposit facility (for overnight deposits when the banking system has a surplus = ER), which constitutes a floor rate for the overnight b2b IBM rate (as KIR-D above). These transactions (lending and taking of deposits) are not undertaken by the ECB itself, but by the individual National Central Banks (NCBs).

The US monetary policy system operates in a similar fashion. The Federal Reserve targets the "Federal funds - Fedfunds - rate", which is a b2b IBM rate, and they steer the liquidity of the banking system such that they at most times utilize the lending facility (there are 3), called the discount window, at the "discount rate". Given a liquidity shortage, this rate has a powerful influence on the b2b IBM rate, and so influences the banking sector's deposit and lending rates (and the exchange rate).

< Prev   CONTENTS   Next >