A summary of the Bank’s market operations
To deliver the Bank’s statutory responsibilities for monetary and financial stability we use our balance sheet to provide a range of facilities and operations, available on public, market-wide terms to eligible financial firms. These activities all involve the creation or management of central bank money.
Our sterling facilities start with Sterling Monetary Framework (SMF) operations in short-term sterling money markets. These include unsecured deposits and funding instruments, repo (repurchase) operations, and securities lending.
To support our objectives, we can also provide longer term sterling liquidity, in the form of term funding. We can create sterling to undertake asset purchases of high quality liquid assets. And, through our network of bilateral swap lines with other central banks, we can offer liquidity in certain non-sterling currencies.
This is part one of our Market Operations Guide. It explains how we use the assets and liabilities on our balance sheet to achieve our mission.
Part two of our guide gives more details of our individual operations, including who can apply to use them.
Using our balance sheet to support our mission
We are the UK’s central bank. Our balance sheet is special for one key reason – the nature of our liabilities. Central bank money, whether in the form of banknotes or central bank ‘reserves’ (deposits held with us by financial institutions), provides the ultimate means of settlement for all sterling payments in the economy.
This gives our balance sheet a central role in supporting monetary and financial stability.
Maintaining monetary stability
Our monetary policy objective is to maintain price stability in the UK. Subject to that, we support the Government’s economic policy, including its objectives on growth and employment.
We set monetary policy to achieve the Government’s target of keeping inflation at 2%. Our Monetary Policy Committee (MPC) decides what policy action we should take to reach that target.
To maintain monetary stability, we need to influence monetary conditions. This includes, for example, the level of prices of goods and services, and the availability of credit. The MPC currently does this in two main ways. First, it sets Bank Rate (and takes steps to ensure it is passed through to households and businesses). Second, it uses asset purchases, also known as ‘quantitative easing’ (QE).
Bank Rate is the rate of interest, set by the MPC. That determines the interest we pay on reserves balances held with us by eligible financial firms. The MPC sets Bank Rate eight times a year, and its level remains fixed between each MPC announcement.
Since 2009, the MPC has also used asset purchases or QE to help meet the inflation target. We create central bank money and use it to buy UK government debt (‘gilts’) and eligible corporate bonds from private investors in secondary markets. Those assets are held in the Asset Purchase Facility (APF).
We buy assets like government and corporate bonds with the aim of lowering the effective interest rates or ‘yields’ on those assets. This incentivises a re-balancing of investors’ funds into other types of riskier assets. That then in turn pushes down on the interest rates offered on loans, since rates on government bonds tend to affect other interest rates in the economy.
By buying these assets, we aim to make it cheaper for households and businesses to borrow money, which encourages spending. In addition, QE can stimulate the economy by boosting a wide range of financial asset prices.
Maintaining financial stability
Our economy is only healthy if people have confidence in the institutions, markets and infrastructure which make up the UK’s financial system.
We work to maintain financial stability by protecting and enhancing the resilience of the system as a whole. And we supervise banks and insurers, to ensure that individual firms are run in a safe and sound way.
The Financial Policy Committee
Our Financial Policy Committee (FPC) oversees our work on financial stability. It identifies, monitors and takes action to remove or reduce systemic risks to the UK financial system. It also has a secondary objective to support the economic policy of the Government.
The Prudential Regulation Authority
Our Prudential Regulation Authority (PRA) is responsible for the prudential regulation of individual financial firms. These rules require financial firms to hold sufficient financial resources, and have adequate risk controls in place. Close supervision of firms ensures that we have a comprehensive overview of their activities, so that we can step in if necessary.
The Bank is the UK’s Resolution Authority and is responsible for the Resolution Liquidity Framework (RLF). This is a flexible tool which can be used in addition to the published facilities detailed in this guide. The RLF can be used to lend to banks, building societies or certain investment firms, where the entity or its holding company is in a Bank-led resolution.
In addition to our policy, supervisory and resolution activities, we stand ready to use our balance sheet to provide liquidity support.
In normal times, firms typically rely on private markets to ensure that liquidity is distributed appropriately across the system, finding its way to those that need it. But those markets may not always be sufficient or work smoothly, particularly during periods of market volatility or dysfunction. And the cost of self-insuring against liquidity risks which are very low probability but high impact (‘tail’ risks) can be prohibitively high.
Our presence means firms know that, as long as they meet threshold conditions and have the right type and amount of collateral, they will have access to predictable and reliable sources of liquidity, at a predictable price, both on a day to day basis and when they experience or anticipate an interruption to private markets.
By offering these market-wide facilities, we aim to reduce the cost of disruption to critical financial services, including the liquidity and payment services that some participants provide to the broader economy.
How we implement monetary policy
The Bank’s balance sheet is used to implement the Monetary Policy Committee’s (MPC) decisions in order to meet the inflation target. Once the MPC makes a decision, the Bank’s Markets Directorate implements that policy. This section explains how we do that.
The main way in which monetary policy is implemented is by paying interest, of Bank Rate, on deposits placed with us overnight by eligible firms in reserves accounts.
In turn, the level of Bank Rate is the key reference rate for all other sterling interest rates. Bank Rate (and expectations about the future level of Bank Rate) influences the interest rates that financial institutions pay to borrow from one another in wholesale money markets. And this in turn affects the rates paid more widely on commercial bank loans to, and deposits from, households and businesses.
Changes in longer-term interest rates can affect the price of bonds and other financial assets. And changes in domestic monetary conditions can also influence the exchange rate.
Taken together, all of these impacts on financial markets and associated changes in expectations affect spending decisions and inflationary pressures in the economy.
Purchasing assets – quantitative easing (QE)
Since 2009, the MPC has also used asset purchases to help meet the inflation target.
Central bank purchases of assets like government and corporate bonds are intended to lower the effective interest rates or ‘yields’ on those assets. This pushes down on the interest rates offered on loans because rates on government bonds tend to influence other interest rates in the economy.
So, one of the ways in which QE works is by making it cheaper for households and businesses to borrow money, encouraging spending.
Our purchases also incentivise investors that previously held the bonds we purchased to move their funds into other assets. This increase in demand for a broader range of financial assets will tend to boost prices (and hence lower the yields) of those assets, which encourages spending.
The role of term funding in monetary policy transmission
In August 2016, the MPC introduced a Term Funding Scheme (TFS). Its primary objective was to reinforce the pass through of the cut in Bank Rate at that time to the interest rates faced by households and companies in the wider economy. This allowed the reduction from 0.5% to 0.25% to have broadly the same impact as cuts made when rates were further from zero.
The design of the scheme reflected this primary objective, and it was calibrated so that the reduction in Bank Rate could have a broadly neutral impact on lenders’ margins in aggregate.
By offering funding for up to four years to lenders at rates lower than the prevailing market rates, the TFS ensured that the change in Bank Rate was transmitted to interest rates on deposits and loans.
The scheme closed to new lending in February 2018, having made £127 billion of loans. Read more about it in our Quarterly Bulletin article.
Further details on the monetary policy framework
Our Monetary Policy Committee (MPC) decided to start asset purchases (Quantitative Easing) in March 2009. Since then, the aggregate level of central bank reserves has been largely determined by the quantity of asset purchases, rather than the amount of reserves eligible financial firms would choose to deposit at the Bank to manage their day-to-day liquidity needs.
In the current environment of abundant reserves, to ensure that short term wholesale money market interest rates remain stable around the level of Bank Rate, the MPC’s policy decision is implemented using a so-called ‘floor system’. This involves reserves being remunerated at Bank Rate (with one minor exception).
Chart: The floor system under the current framework
This system keeps wholesale market interest rates close to Bank Rate. That happens because if rates fall significantly below Bank Rate, firms can theoretically borrow reserves cheaply in the market and earn Bank Rate by depositing them with us. In practice, because of the relative costs of borrowing in wholesale money markets, wholesale market rates have tended to settle a little below Bank Rate.
This system has proved successful in ensuring overnight rates in wholesale markets remain stable and close to Bank Rate. Overnight wholesale interest rates were closer to Bank Rate on average in the years following the introduction of the floor system than at any point in the preceding twenty years.
As described in part two of this guide, the Operational Standing Facility (OSF) exists to allow eligible firms to borrow overnight against high quality collateral at a spread of 25 basis points above Bank Rate. This facility is intended to limit the volatility in market interest rates by providing an alternative source of borrowing in case overnight market rates are significantly higher than Bank Rate. But, in practice, the OSF has rarely been used in the current environment of abundant reserves.
A further advantage of the floor system is that it can keep overnight interest rates close to Bank Rate despite large changes in the supply of, or demand for, reserves. This means it is robust to MPC decisions to increase or decrease the quantity of asset purchases.
The regime in place prior to the MPC launching its policy of QE, known as ‘reserves averaging’, was also successful at controlling interest rates when the stock of reserves was relatively stable. But it did not cope as well when demand for reserves spiked, so we injected large quantities of reserves for liquidity insurance purposes during the crisis.
The Bank’s future balance sheet
Just as asset purchases increased the quantity of central bank reserves following the financial crisis, there may be a point at which the MPC decides to reduce the stock of asset purchases (so-called ‘Quantitative Tightening’ (QT)). This decision would lower the aggregate quantity of reserves in the system.
In the early stages of QT, while reserves are still plentiful, the MPC’s policy goals would likely best be met by maintaining the current floor system. But at some point, the supply of reserves could fall below the level that reserve account holders demand. This scarcity would likely begin to make short-term market rates more volatile, pushing them above Bank Rate. At this point, if the Bank did not make additional reserves available, the existing framework would not be effective at controlling interest rates.
In a Discussion Paper published in August 2018, we said that at the appropriate time we would propose to switch from using the current floor system to a framework in which we allowed reserves holders to determine how many reserves they need. Under this approach, we would stand ready to lend reserves, at Bank Rate, in unlimited amounts against high quality collateral, through periodic Open Market Operations (OMOs). For more details, see this speech.
Underpinning financial stability
Central bank reserves are the most liquid assets in the UK economy. They play a critical role in financial stability by facilitating payments and as part of a bank’s supply of sterling liquidity.
In normal times, private markets typically ensure that liquidity is distributed appropriately across the system, finding its way from those with a surplus to those that need it.
But those markets may not always be effective or work smoothly, particularly during periods of heightened uncertainty or market dysfunction.
Regulators require banks and other financial intermediaries to hold a ‘buffer’ of liquid assets to self-insure against any unexpected outflows. But the cost of self-insuring against ‘tail’ risks which are very low probability but high impact can be prohibitively high.
So, we stand ready to use our balance sheet to complement the self-insurance firms maintain under our liquidity regime.
We do this by offering a range of liquidity insurance facilities. These allow firms who meet our supervisory standards, and who have the right collateral, to access reliable supplies of liquidity at a predictable cost.
Firms can choose to use these liquidity insurance facilities on a day-to-day basis. But the pricing of those facilities means they are likely to be of particular benefit when an interruption to private markets occurs.
What is liquidity risk?
Liquidity risk is the risk that a company cannot meet its financial obligations as they fall due. All companies face this risk in some form and scale.
Banks and some other types of financial intermediary – by virtue of their business models – are exposed to a higher degree of liquidity risk than most types of company. Liquidity risk crystallising in a bank can also have wider impacts on customers and other institutions who find their own funds tied up. If liquidity risk crystallises in a number of financial intermediaries at the same time, this could endanger the stability of the financial system as a whole.
Liquidity risk can arise in the financial system a number of ways:
- Commercial banks and building societies engage in ‘maturity transformation’ by accepting short term deposits (eg liabilities in the form of money held in current accounts) and making loans at longer maturities (eg assets in the form of mortgages). This allows households and businesses to finance purchases and investment. But it also increases liquidity risk for the bank if there is unexpected demand for short term liabilities – for instance in the form of a bank ‘run’.
- Broker-dealers intermediate in capital markets and provide risk management products that help others to make more efficient use of their resources. Broker dealers are not exposed to the same ‘run’ as retail banks, but can find themselves facing volatile liquidity conditions in the repo (repurchase) markets from which they obtain funding.
- Central counterparties (CCPs) sit between counterparties to contracts traded in one or more financial markets, becoming the buyer to every seller and the seller to every buyer. By doing so, they can reduce credit and liquidity risk by netting off and simplifying multilateral financial exposures. CCPs seek to mitigate credit risk by collecting collateral, (‘margin’), from all counterparties (‘clearing members’). However, if a clearing member defaults, particularly when markets are volatile, there is a risk the CCP will face challenges in liquidating collateral quickly enough to meet its payment obligations. Equally, during such conditions (even absent a default), a CCP can collect greater than anticipated margin amounts that it will wish to deposit securely.
We expect firms to self-insure against liquidity risk
The first line of defence against liquidity risk is the buffers of assets that banks and other financial firms hold to absorb shocks or unexpected outflows.
We have set out (through the Prudential Regulation Authority (PRA)), the size and quality of buffers that regulated firms should build up to deliver a prudent level of self-insurance against a range of stressed outflows. Further information on our liquidity rules can be found here.
Changes to liquidity regulation introduced following the financial crisis mean UK banks are now much better placed to withstand liquidity risks. They hold large buffers of cash and liquid assets, calibrated against the Liquidity Coverage Ratio (LCR) but also taking into account longer term factors and idiosyncratic risks. In total, liquidity buffers are now worth a substantive proportion of the UK banks’ balance sheets.
At the same time, reliance on the riskiest forms of funding has also fallen sharply. The shortest duration wholesale funding, which was revealed to be a significant vulnerability when it dried up during the crisis, has fallen significantly as a proportion of total funding for UK banks.
But we also provide liquidity insurance
UK banks and other financial intermediaries are required by regulators to maintain strong liquidity. But it would not be realistic or efficient to expect them to self-insure against every conceivable shock or stress.
For that reason, we stand ready to use our balance sheet to complement the buffers firms maintain on their own balance sheets.
We do this by offering liquidity insurance facilities that allow eligible firms to borrow cash (in the form of reserves) or to swap illiquid assets for more liquid ones (a collateral ‘upgrade’).
We operate a range of published facilities that do this, on both bilateral and market-wide terms. These take place at various frequencies:
- At routine intervals. Firms have the opportunity to bid for reserves (borrow cash) in regular collateralised lending transactions called repo operations, run to a set schedule. For sterling, this is done via the regular Indexed Long-Term Repo (ILTR) facility. We also lend through repo operations in selected non-sterling currencies.
- On demand by firms. In our bilateral Discount Window Facility (DWF) we offer to swap less liquid collateral for more liquid assets. In some cases, these assets may take the form of central bank reserves. In others, they may take the form of securities, which can then be used as higher quality collateral to borrow cash in the wider market.
- At our discretion, as warranted by economic and market conditions. Depending on conditions in private markets, we can provide additional liquidity, by varying the terms of our regular routine operations, or by launching a Contingent Term Repo Facility (CTRF). We have also previously made available longer term funding through our Term Funding Scheme (TFS), Funding for Lending Scheme (FLS) and Special Liquidity Scheme (SLS).
We do not expect firms to rely on us for a large part of their liquidity on a day-to-day basis. But our facilities are also not intended to be only a last resort. We have priced them so that in normal times they are, on the whole, unlikely to be cheaper than private markets.
We offer liquidity insurance options on an ‘open for business’ basis, to eligible financial firms which meet our prudential requirements. This means that firms know they will have access to a reliable source of liquidity at a predictable price during periods of actual or expected market stress.
And we convene markets to help ensure they function efficiently
We take an active interest in the effectiveness of financial markets. Markets are more likely to be efficient and effective if they are competitive. So we only allow firms access to our services if they act in a way that supports competitive and fair sterling markets.
An effective way to demonstrate commitment to this is to sign the UK Money Markets Code. We endorse it and commit to its standards and principles. We strongly encourage all participants in our financial market operations to do the same (including firms which are members of the Sterling Monetary Framework (SMF)). Read more about our work on fair and effective markets.
Liquidity insurance: ‘open for business’
The idea that the Bank should step in when private markets stutter is not new, originating from at least the time of Walter Bagehot, who recognised how a clear framework for central bank involvement in markets could help to reduce the frequency and severity of financial crises.
Our current suite of shorter-term liquidity insurance facilities – encapsulated in our Sterling Monetary Framework (SMF) – is a more recent development, and is one element of a wider response to the last global financial crisis.
Since 2009 regulators in the UK and globally have introduced a complementary package of reforms. These were intended to fix the fault lines that caused the last crisis, and help end the problem of ‘too big to fail’.
These reforms are underpinned by stronger capital and liquidity standards and more proactive micro-prudential supervision; supplemented by macro-prudential tools to account for systemic risks; and supported by resolution regimes that protect financial stability – and public money – from the failure of an insolvent firm.
In the context of those reforms, and on the back of recommendations made by Bill Winters in his review of our system, we made significant changes to our approach to liquidity insurance. As a result, we now offer money and collateral over longer terms, against a wider range of assets as collateral, and at lower cost.
From a market perspective, eligible financial firms have more choice now than they did previously in being able to draw on support according to their needs and preferences:
- They can borrow against a wider range of collateral, including less liquid assets such as raw loans;
- They can borrow over a longer term, when we deem it appropriate; and
- They can borrow in certain non-sterling currencies.
The changes made since the Financial Crisis mean that the financial sector’s ability to continue supporting the economy in bad times as well as good is reinforced at three levels:
- First, by the large buffers of assets firms hold in case private markets cannot provide the liquidity they need (these have increased both at individual firm level and in aggregate);
- Then, by the Bank’s insurance facilities, provided firms are solvent and can meet prudent collateral requirements;
- And finally by resolution, so a firm is able to fail in an orderly way should a shock mean it cannot continue to operate.
To fully realise these financial stability benefits, firms must be willing to manage their liquidity actively and prudently. This guide is intended to support that by explaining the Bank’s facilities. But it also serves to reinforce a very important point: our facilities are there to be used by firms. We are open for business.
In summary, ‘open for business’ means that participant firms which meet regulatory threshold conditions for authorisation, and which have the appropriate type and amount of collateral, have the flexibility to use our facilities as and when they deem appropriate.
When and how to use market sources of funding, existing liquidity buffers, or the ILTR or DWF is a decision for firms to make, based on their expert knowledge of their own liquidity needs and the availability and cost of options.
Provided firms meet threshold conditions and have adequate collateral, they do not have to justify their decision to use these facilities to the Bank or to the PRA. There is no specific or limited list of cases in which firms may use our facilities. And, there is no fixed order in which we expect firms to use one form of liquidity over another.
Banks, building societies, major investment firms, credit unions, and insurers; not all of these will be eligible financial firms. While these firms are supervised by the PRA, the Bank is responsible for the direct supervision of market infrastructures such as Central Counterparties (CCPs) and Central Securities Depositories (CSDs).
The reserves of CCPs which are in excess of their pre-agreed target balance are remunerated at 25 basis points below Bank Rate.
Walter Bagehot (1826-1877) was a British businessman, writer and former editor of The Economist magazine. In his notable work, Lombard Street, he detailed how during financial crises, the central bank should lend early and freely, to solvent firms, against good collateral, and at high rates.