2 The financial system

2.1 What’s included in this section

• The role of the financial sector
• The banking system
• Deposit taking and lending
• Liquidity, profitability and capital adequacy
• The central bank
• The money markets
Read Chapter 18, pages 553–571.
THE FINANCIAL SYSTEM
The role of the financial sector
Banks and other financial institutions are known as financial
intermediaries. They provide a link between those who
wish to lend and those who wish to borrow. In other words,
they act as the mechanism whereby the supply of funds is
matched to the demand for funds.
In this process, they provide five important services.

Expert advice
Financial intermediaries can advise their customers on financial
matters: on the best way of investing their funds and on
alternative ways of obtaining finance.

Expertise in channelling funds

Financial intermediaries have the specialist knowledge to
be able to channel funds to those areas that yield the
highest return. They also have the expertise to assess risks
and to refuse loans for projects considered too risky or to
charge a risk premium to others. This all encourages the
flow of saving as it gives savers the confidence that their
savings will earn a good rate of interest. Financial intermediaries
also help to ensure that projects that are potentially
profitable will be able to obtain finance. They help to
increase allocative efficiency.
Maturity transformation
Many people and firms want to borrow money for long
periods of time, and yet many depositors want to be able to
withdraw their deposits on demand or at short notice. If
people had to rely on borrowing directly from other people,
there would be a problem here: the lenders would not be
prepared to lend for a long enough period. If you had £100
000 of savings, would you be prepared to lend it to a friend
to buy a house if the friend was going to take 25 years to pay
it back? Even if there was no risk whatsoever of your friend
defaulting, most people would be totally unwilling to tie up
their savings for so long.
This is where a bank or building society comes in. It borrows
money from a vast number of small savers, who are able
to withdraw their money on demand or at short notice. It
then lends the money to house purchasers for a long period
of time by granting mortgages, which are typically paid back
over 20 to 30 years.
This process whereby financial intermediaries
lend for longer periods of time than they borrow is
known as maturity transformation. They are able to do this
because with a large number of depositors it is highly
unlikely that they would all want to withdraw their deposits
at the same time. On any one day, although some people will
be withdrawing money, others will be making new
deposits.

Risk transformation
You may be unwilling to lend money directly to another
person in case they do not pay up. You are unwilling to take
the risk. Financial intermediaries, however, by lending to
large numbers of people, are willing to risk the odd case of
default. They can absorb the loss because of the interest
they earn on all the other loans. This spreading of risks is
known as risk transformation. What is more, financial
intermediaries may have the expertise to be able to assess
just how risky a loan is.
Transmission of funds
In addition to channelling funds from depositors to borrowers,
certain financial institutions have another important
function. This is to provide a means of transmitting
payments. Thus by the use of debit cards, credit cards, the
Internet and telephone banking, cheques, direct debits,
etc., money can be transferred from one person or institution
to another without having to rely on cash.
The banking system
Types of bank
Banking can be divided into two main types: retail banking and wholesale
banking.
Most banks today conduct both types of business and are
thus known as ‘universal banks’.
Retail banking. Retail banking is the business conducted by
the familiar high street banks, such as Barclays, Lloyds,
HSBC, Royal Bank of Scotland,
. They operate bank accounts for individuals
and businesses, attracting deposits and granting
loans at published rates of interest.
Wholesale banking. The other major type of banking is
wholesale banking. This involves receiving large deposits
from and making large loans to companies or other banks
and financial institutions; these are known as wholesale
deposits and loans.
In the past, there were many independent wholesale
banks, known as investment banks. These included famous
names such as Morgan Stanley and
Goldman Sachs. With the worldwide financial crisis of the
late 2000s, however, most of the independent investment
banks merged with universal banks which conduct both
retail and wholesale activities.
The rise of large universal banks has caused concern, however.
In the UK in 2010, the Coalition government set up the
Independent Commission on Banking (ICB). It was charged
with investigating the structure of the banking system. It
proposed functional separation: the ring-fencing of retail and
wholesale banking. It argued that the core activities of retail
banks needed isolating from the potential contagion from
risky wholesale banking activities.
Building societies
These UK institutions specialise in granting loans (mortgages)
for house purchase. They compete for the savings of
the general public through a network of high street
branches. Unlike banks, they are not public limited companies,
their ‘shares’ being the deposits made by their investors.
In recent years, many of the building societies have
converted to banks .
In the past, there was a clear distinction between banks
and building societies. Today, however, they have become
much more similar, with building societies now offering current
account facilities and cash machines, and retail banks
granting mortgages.

In fact, banks and building societies are both examples of

what are called monetary financial institutions (MFIs). This
term is used to describe all deposit-taking institutions,
including central banks (e.g. the Bank of England).
MFIs also lend and borrow wholesale funds to and from
each other, and deposit with and borrow from the central
bank.
Wholesale funds can be distributed
amongst banks by means of a series of financial instruments.
These instruments are typically short term and acquired in
markets known as money markets.
During the financial crisis many forms of inter-bank lending
virtually dried up in many countries. MFIs became
increasingly fearful of other MFIs defaulting on loans. In
response to the crisis, the Bank of England and other central
banks, such as the Federal Reserve Bank in the USA, supplied
extra money to MFIs to ensure the security of these institutions
and the stability of the financial system. It did this by
purchasing various assets from them with money it had, in
effect, created .

Deposit taking and lending

Balance sheets
Banks and building societies provide a range of financial
instruments. These are financial claims, either by customers
on the bank (e.g. deposits) or by the bank on its customers
(e.g. loans). They are best understood by analysing the balance
sheets of financial institutions, which itemise their
liabilities and assets. A financial institution’s liabilities are
those financial instruments involving a financial claim on
the financial institution itself. As we shall see, these are
largely deposits by customers, such as current and savings
accounts. Its assets are financial instruments involving a
financial claim on a third party: these are loans, such as personal
and business loans and mortgages.
Liabilities
Customers’ deposits in banks (and other deposit-taking
institutions such as building societies) are liabilities to
these institutions. This means simply that the customers
have the claim on these deposits and thus the institutions
are liable to meet the claims.
There are five major types of liability: sight deposits, time
deposits, certificates of deposit (CDs), ‘repos’ and capital.

Sight deposits. Sight deposits are any deposits that can be

withdrawn on demand by the depositor without penalty. In
the past, sight accounts did not pay interest. Today, however,
there are many sight accounts that do.
The most familiar form of sight deposits are current
accounts at banks. Depositors are issued with chequebooks
and/or debit cards
that enable them to spend the money directly without first
having to go to the bank and draw the money out in cash. In
the case of debit cards, the person’s account is electronically
debited when the purchase is made. This process is known as
EFTPOS (electronic funds transfer at point of sale). Money can
also be transferred between individuals and businesses through
direct debits, standing orders and Internet banking transfers.
An important feature of current accounts is that banks
often allow customers to be overdrawn. That is, they can
draw on their account and make payments to other people
in excess of the amount of money they have deposited.

Time deposits. Time deposits require notice of withdrawal.

However, they normally pay a higher rate of interest than
sight accounts. With some types of account, a depositor can
withdraw a certain amount of money on demand,
The most familiar form of time
deposits are the deposit and savings accounts in banks and
the various savings accounts in building societies. No overdraft
facilities exist with time deposits.

Certificates of deposit. Certificates of deposit are certificates

issued by banks to customers (usually firms) for large deposits
of a fixed term (e.g. £100 000 for 18 months). They can
be sold by one customer to another, and thus provide a
means whereby the holders can get money quickly if they
need it without the banks that have issued the CDs having
to supply the money.

Sale and repurchase agreements (repos). If banks have a temporary

shortage of funds, they can sell some of their financial
assets to other banks or to the central bank – the Bank of
England in the UK and the European Central Bank in the
eurozone– and later repurchase them on some
agreed date, typically a fortnight later. These sale and repurchase
agreements (repos) are in effect a form of loan – the
bank borrowing for a period of time using some of its financial
assets as the security for the loan. One of the major
assets to use in this way are government bonds (issued when
the government borrows), normally called ‘gilt-edged securities’
or simply ‘gilts’.

Capital and other funds. This consists largely of the share

capital in banks. Since shareholders cannot take their
money out of banks (although they can sell them to other
investors on the stock market), share capital provides a
source of funding to meet sudden increases in withdrawals
from depositors and to cover bad debts.

Assets
A bank’s financial assets are its claims on others. There are
three main categories of assets.

Cash and reserve balances in the central bank (Bank of

England in the UK, ECB in the eurozone). Banks need to hold
a certain amount of their assets as cash. This is largely used
to meet the day-to-day demands of customers. They also
keep ‘reserve balances’ in the central bank. In the UK these
earn interest at the Bank of England’s repo rate (or ‘Bank
Rate’ as it is called), These are like the banks’ own current
accounts and are used for clearing purposes (i.e. for settling
the day-to-day payments between banks). They can be withdrawn
in cash on demand. With inter-bank lending being
seen as too risky during the crisis of the late 2000s, many
banks resorted to depositing surplus cash in the Bank of England,
even though Bank Rate was lower than the inter-bank
lending rate or LIBOR (‘London inter-bank offered rate’)
Short-term loans. These are in the form of market loans,
bills of exchange or reverse repos. The market for these various
types of loan is known as the money market.
■ Market loans are made primarily to other financial institutions.
This inter-bank lending consists of (a) money
lent ‘at call’ (i.e. reclaimable on demand or at 24 hours’
notice); (b) money lent for periods up to one year, but
typically a few weeks; (c) CDs (i.e. certificates of deposits
made in other banks or building societies).
■ Bills of exchange are loans either to companies (commercial
bills) or to the government (Treasury bills).
Since bills do not pay interest, they are sold
below their face value, i.e. at a ‘discount’, but redeemed on
maturity at face value. This enables the purchaser, in this
case the bank, to earn a return. The market for new or existing
bills is therefore known as the discount market.
The price paid for bills will depend on demand and
supply. For example, the more Treasury bills that are
offered for sale (i.e. the higher the supply), the lower will
be their equilibrium price, and hence the higher will be
their rate of return (i.e. their rate of interest, or ‘rate of
discount’).
Normally, a bank will buy commercial bills only if
they have been first ‘accepted’ by another financial institution
(typically an investment bank). This means that
the investment bank will redeem the bill (i.e. pay up) on
the maturity date, if the firm issuing the bill defaults on
payment. Of course the investment bank charges for this
insurance (or ‘underwriting’). Bills that have been
accepted in this way are known as bank bills.
■ Reverse repos. When a sale and repurchase agreement is
made, the financial institution purchasing the assets (e.g.
gilts) is, in effect, giving a short-term loan. The other
party agrees to buy back the assets (i.e. pay back the loan)
on a set date. The assets temporarily held by the bank
making the loan are known as ‘reverse repos’. Reverse
repos are typically for one week, but can be for as little as
overnight or as long as one year.
Longer-term loans. These consist primarily of loans to customers,
both personal customers and businesses. These
loans, also known as advances, are of four main types:
fixed term (repayable in instalments over a set number of years –
typically, six months to five years), overdrafts (often for an
unspecified term), outstanding balances on credit card
accounts, and mortgages (typically for 25 years).

Banks also make investments. These are partly in government

bonds (gilts), which are effectively loans to the government.
The government sells bonds, which then pay a
fixed sum each year as interest. Once issued, they can then
be bought and sold on the stock exchange. Banks are normally
only prepared to buy bonds that have less than five
years to maturity (the date when the government redeems
the bonds). Banks also invest in various subsidiary financial
institutions and in building societies.
Taxing the banks

Bank levy. In January 2011, the UK introduced the bank levy:

a tax on the liabilities of banks and building societies operating
in the UK. For banking groups with their headquarters in
the UK the levy applies to their global balance sheet; for subsidiaries
of non-UK banks it applies just to their UK activities.
The tax is founded on two key principles. First, the revenues
raised should be able to meet the full fiscal costs of any future
support for financial institutions. Second, it should provide
banks with incentives to reduce risk-taking behaviour and so
reduce the likelihood of future financial crises.
The UK bank levy has two rates: a full rate on taxable liabilities
with a maturity of less than one year and a half rate on
taxable liabilities with a maturity of more than one year. This
differential is intended to discourage excessive short-term
borrowing by the banks in their use of wholesale funding.
Not all liabilities are subject to the levy. First, it is not
imposed on the first £20 billion of liabilities. This is to
encourage small banks
Second, various liabilities are excluded. These are:
(a) gilt repos; (b) retail deposits insured by public schemes
such as the UK’s Financial Services Compensation Scheme,
which guarantees customers’ deposits of up to £85 000;
(c) a large part of a bank’s capital known as Tier 1 capital

Bank corporation tax surcharge. The 2015 Budget also saw the
announcement of a new 8 per cent corporation tax surcharge
on banks. This marked a shift in the tax base from
banks’ balance sheets to their profits. The 8 per cent surcharge
was introduced in January 2016 for all banks with
annual profits over £25 million. With the main corporation
tax rate at 18 per cent when introduced, the surcharge on
banks meant that their effective corporation tax rate was 26
per cent.

Liquidity, profitability and capital adequacy

Profitability
Profits are made by lending money out at a higher rate of
interest than that paid to depositors. The average interest
rate received by banks on their assets is greater than that
paid by them on their liabilities.

Liquidity
The liquidity of an asset is the ease with which it can be
converted into cash without loss. Cash itself, by definition,
is perfectly liquid.
Some assets, such as money lent at call to other financial
institutions, are highly liquid. Although not actually cash,
these assets can be converted into cash virtually on demand
with no financial penalty. Other short-term inter-bank lending
is also very liquid
The only issue here is one of confidence that the
money will actually be repaid. This was a worry in the financial
crisis of 2008/9 when many banks stopped lending to
each other on the inter-bank market for fear that the borrowing
bank might become insolvent.
Other assets, such as gilts, can be converted into cash
straight away by selling them on the Stock Exchange, but
with the possibility of some financial loss, given that their
market price fluctuates. Such assets, therefore, are not as
liquid as money at call.
Other assets are much less liquid. Personal loans to the general
public or mortgages for house purchase can be redeemed
by the bank only as each instalment is paid. Other advances
for fixed periods are repaid only at the end of that period.
Banks must always be able to meet the demands of their customers
for withdrawals of money. To do this, they must hold
sufficient cash or other assets that can be readily turned into
cash. In other words, banks must maintain sufficient liquidity.
The balance between profitability and liquidity
Profitability is the major aim of banks and most other financial
institutions. However, the aims of profitability and
liquidity tend to conflict. In general, the more liquid an
asset, the less profitable it is, and vice versa. Personal and
business loans to customers are profitable to banks, but
highly illiquid. Cash is totally liquid, but earns no profit.
Thus financial institutions like to hold a range of assets with
varying degrees of liquidity and profitability.
For reasons of profitability, the banks will want to ‘borrow
short’ (at low rates of interest, as are generally paid on current
accounts) and ‘lend long’ (at higher rates of interest, as
are normal on personal loans). The difference in the average
maturity of loans and deposits is known as the maturity gap.
In general terms, the larger the maturity gap between loans
and deposits, the greater the profitability. For reasons of
liquidity, however, banks will want a relatively small gap: if
there is a sudden withdrawal of deposits, banks will need to
be able to call in enough loans.
The ratio of an institution’s liquid assets to total assets is
known as its liquidity ratio. For example, if a bank had £100
million of assets, of which £10 million were liquid and £90
million were illiquid, the bank would have a 10 per cent
liquidity ratio. If a financial institution’s liquidity ratio is too
high, it will make too little profit. If the ratio is too low, there
will be the risk that customers’ demands may not be able to
be met: this would cause a crisis of confidence and possible
closure. Institutions thus have to make a judgement as to
what liquidity ratio is best – one that is neither too high nor
too low.

Secondary marketing and securitisation

As we have seen, one way of reconciling the two conflicting
aims of liquidity and profitability is for financial institutions
to hold a mixture of liquid and illiquid assets. Another way is
through the secondary marketing of assets. This is where
holders of assets sell them to someone else before the maturity
date. This allows banks to close the maturity gap for liquidity
purposes, but maintain the gap for profitability purposes.
Certificates of deposit (CDs) are a good example of secondary
marketing. CDs are issued for fixed-period deposits
in a bank (e.g. one year) at an agreed interest rate. The bank
does not have to repay the deposit until the year is up. CDs
are thus illiquid liabilities for the bank, and they allow it to
increase the proportion of illiquid assets without having a
dangerously high maturity gap. But the holder of the CD in
the meantime can sell it to someone else (through a broker).
It is thus liquid to the holder. Because CDs are liquid to the
holder, they can be issued at a relatively low rate of interest
and thus allow the bank to increase its profitability.
Another example of secondary marketing is when a financial
institution sells some of its assets to another financial
institution. The advantage to the first institution is that it
gains liquidity. The advantage to the second one is that it
gains profitable assets. The most common method for the
sale of assets has been through a process known as
securitisation.
Securitisation occurs when a financial institution pools
some of its assets, such as residential mortgages, and sells
them to an intermediary known as a special purpose vehicle
(SPV). SPVs are legal entities created by the financial institution.
In turn, the SPV funds its purchase of the assets by issuing
bonds to investors (noteholders). These bonds are known
as collateralised debt obligations (CDOs). The sellers (e.g.
banks) get cash now rather than having to wait and can use
it to fund loans to customers. The buyers make a profit if the
income yielded by the CDOs are as expected. Such bonds can
be very risky, however, as the future cash flows may be less
than anticipated.
Also, there is an increased danger of banking collapse. If
one bank fails, this will have a knock-on effect on those
banks which have purchased its assets. In the specific case of
securitisation, the strength of the chain is potentially weakened
if individual financial institutions move into riskier
market segments, such as sub-prime residential mortgage
markets. Should the income streams of the originator’s assets
dry up – for instance, if individuals default on their loans –
then the impact is felt by the whole of the chain. In other
words, institutions and investors are exposed to the risks of
the originator’s lending strategy.

Capital adequacy
In addition to sufficient liquidity, banks must have sufficient
capital (i.e. funds) to allow them to meet all demands
from depositors and to cover losses if borrowers default on
payment. Capital adequacy is a measure of a bank’s capital
relative to its assets, where the assets are weighted according
to the degree of risk. The more risky the assets, the greater
the amount of capital that will be required.
A measure of capital adequacy is given by the capital
Adequacy ratio (CAR). This is given by the following formula:
CAR = (Common Equity Tier 1 capital +
Additional Tier 1 capital + Tier 2 capital)/ Risk@weighted assets

Common equity Tier 1 capital includes bank reserves

(from retained profits) and ordinary share capital (equities),
where dividends to shareholders vary with the amount of
profit the bank makes. Such capital thus places no burden on
banks in times of losses as no dividend need be paid. What is
more, unlike depositors, shareholders cannot ask for their
money back.
Additional Tier 1 (AT1) capital consists largely of preference
shares. These pay a fixed dividend (like company
bonds). But although preference shareholders have a prior
claim over ordinary shareholders on company profits, dividends
need not be paid in times of loss.
Tier 2 capital is ‘subordinated debt’ with a maturity
greater than five years. Subordinated debt holders only have
a claim on a failing company after the claims of all other
bondholders have been met.
Risk-weighted assets are the value of assets, where each
type of asset is multiplied by a risk factor. Under the internationally
agreed Basel II accord, cash and government
bonds have a risk factor of zero and are thus not included.
Inter-bank lending between the major banks has a risk
Factor of 0.2 and is thus included at only 20 per cent of its
value; residential mortgages have a risk factor of 0.35;
personal loans, credit card debt and overdrafts have a risk
factor of 1; loans to companies carry a risk factor of 0.2, 0.5,
1 or 1.5, depending on the credit rating of the company.
Thus the greater the average risk factor of a bank’s assets,
the greater will be the value of its risk-weighted assets, and
the lower will be its CAR.
The greater the CAR, the greater the capital adequacy of a
bank. Under Basel II, banks were required to have a CAR of at
least 8 per cent (i.e. 0.08). They were also required to meet
two supplementary CARs. First, banks needed to hold a ratio
of Tier 1 capital to risk-weighted assets of at least 4 per cent
and, second, a ratio of ordinary share capital to risk-weighted
assets of at least 2 per cent. It was felt that these three ratios
would provide banks with sufficient capital to meet the
demands from depositors and to cover losses if borrowers
defaulted. The financial crisis, however, meant a rethink.

Strengthening international regulation of capital

adequacy and liquidity
Capital adequacy. In the light of the financial crisis of
2008/9, international capital adequacy requirements were
strengthened by the Basel Committee on Banking Supervision,
with a first draft in 2010/11 and a final agreement in
December 2017. The new ‘Basel III’ capital requirements, as
they are called, will be phased in by 2022.
From 2013, banks continued to need a CAR of at least 8
per cent (i.e. 0.08). But, by 2015 were required to operate with
a ratio of CET1 to risk-weighted assets of at least 4.5 per cent.
From 2016 began a phased introduction of a capital conservation
buffer raising the CET1 ratio to no less than 7 per cent by
2022. This increases the overall CAR to at least 10.5 per cent.

Liquidity. The financial crisis highlighted the need for

banks not only to hold adequate levels of capital but also to
manage their liquidity better. The Basel III framework
includes a liquidity coverage ratio (LCR). This requires that
financial institutions have high quality liquid assets
(HQLAs) to cover the expected net cash flow over the next
30 days. From its implementation in 2015, the minimum
LCR ratio (HQLAs relative to the expected 30-day net cash
flow) will rise from 60 per cent to 100 per cent by 2022.
Net stable funding ratio (NSFR). As part of the Basel III
reforms, a net stable funding ratio (NSFR) was to become a
regulatory standard from 2018. This takes a longer-term
view of the funding profile of banks by focusing on the reliability
of liabilities as a source of funds, particularly in circumstances
of extreme stress. The NSFR is the ratio of stable
liabilities to assets likely to require funding (i.e. assets where
there is a likelihood of default).
On the liabilities side, these will be weighted by their
expected reliability– in other words, by the stability of these
funds. This weighting will reflect the maturity of the liabilities
and the propensity of lenders to withdraw their funds.
For example, Tier 1 and 2 capital will have a weighting of 100
per cent; term deposits with less than one year to maturity
will have a weighting of 50 per cent; and unsecured wholesale
funding will have a weighting of 0 per cent. The result of
these weightings is a measure of stable funding.
On the assets side, these will be weighted by the likelihood
that they will have to be funded over the course of one
year. This means that they will be weighted by their liquidity,
with more liquid assets requiring less funding. Thus cash
will have a zero weighting, while more risky assets will have
weightings up to 100 per cent. The result is a measure of
required funding.
Banks will need to hold a stable-liabilities-to-required funding
ratio (NSFR) of at least 100 per cent.

The central bank

The Bank of England is the UK’s central bank. The European
Central Bank (ECB) is the central bank for the countries
using the euro. The Federal Reserve Bank of America (the
Fed) is the USA’s central bank. All countries with their own
currency have a central bank. They fulfil two vital roles in
the economy.
The first is to oversee the whole monetary system and
ensure that banks and other financial institutions operate as
stably and as efficiently as possible.
The second is to act as the government’s agent, both as its
banker and in carrying out monetary policy.
The Bank of England traditionally worked in very close
liaison with the Treasury, and there used to be regular meetings
between the Governor of the Bank of England and the
Chancellor of the Exchequer. Although the Bank may have
disagreed with Treasury policy, it always carried it out. In
1997, however, the Bank of England was given independence
to decide the course of monetary policy. In particular,
this meant that the Bank of England and not the government
would now decide interest rates.
Another example of an independent central bank is the
European Central Bank (ECB), which operates the monetary
policy for the eurozone countries. Similarly, the Fed is independent
of both the President and Congress, and its chair is
generally regarded as having great power in determining the
country’s economic policy. Although the degree of independence
of central banks from government varies considerably
around the world, there has been a general move in recent
years to make central banks more independent.

Within their two broad roles, central banks typically have

a number of different functions.
It issues notes
The Bank of England is the sole issuer of banknotes in England
and Wales. (In Scotland and Northern Ireland, retail
banks issue notes.) The issue of notes is done through the
Issue Department, which organises their printing. This is
one of two departments of the Bank of England. The other
is the Banking Department, through which it deals with
banks.
The amount of banknotes issued by the Bank of England depends largely on
the demand for notes from the general public. If people draw
more cash from their bank accounts, the banks will have to
draw more cash from their balances in the Bank of England.
These balances are held in the Banking Department. The
Banking Department will thus have to acquire more notes
from the Issue Department, which will simply print more in
exchange for extra government or other securities supplied
by the Banking Department.

It acts as a bank
To the government. It keeps the two major government
accounts: the ‘Exchequer’ and the ‘National Loans Fund’.
Taxation and government spending pass through the Exchequer.
Government borrowing and lending pass through the
National Loans Fund. The government tends to keep its
deposits in the Bank of England to a minimum. If the deposits begin to
build up (from taxation), the government will probably
spend them on paying back government debt. If, on the other
hand, it runs short of money, it will simply borrow more.

To banks. Banks’ deposits in the Bank of England consist of

reserve balances and cash ratio deposits .
The reserve balances are used for clearing purposes between
the banks but are also a means by which banks can manage
their liquidity risk. Therefore, the reserve balances provide
banks with an important buffer stock of liquid assets.

To overseas central banks. These are deposits of sterling made by overseas

authorities as part of their official reserves and/or for purposes of
intervening in the foreign exchange market in order to influence
the exchange rate of their currency.

It operates the government’s monetary policy

The Bank of England’s Monetary Policy Committee (MPC)
sets Bank Rate at its regular meetings. This nine-member
committee consists of four experts appointed by the Chancellor
of the Exchequer and four senior members of the
Bank of England, plus the Governor in the chair.
By careful management of the liquidity of the financial
system the Bank of England aims to keep interest rates in line
with the level decided by the MPC. It is able to do this
through operations in the money markets. These are known
as open-market operations (OMOs). If shortages of liquidity
are driving up short-term interest rates above the desired
level, the Bank of England purchases securities (gilts and/or
Treasury bills) on the open market: e.g. through reverse repos
(a repo to the banks). This releases liquidity into the financial
system and puts downward pressure on interest rates. Conversely,
if excess liquidity is driving down interest rates, the
Bank of England will sell more securities. When these are
purchased, this will reduce banks’ reserves and thereby put
upward pressure on interest rates.
In normal times the Bank of England manages the
aggregate amount of reserves through weekly auctions of
1-week repos. It also agrees with commercial banks an average
amount of overnight reserve balances they would hold
over the period between MPC meetings. Individual banks
are then able to deposit or borrow reserves using the Bank
of England’s operational standing facilities. Banks deposit
reserves at the deposit facility rate if they have an excess of
reserves or borrow reserves from the Bank of England if
they are short of reserves through overnight repo operations
priced at the lending facility rate. The deposit rate is
set below the Bank Rate, while the borrowing rate is set
above the Bank Rate. This process is known as reserve
averaging.
The operational standing facilities are designed to provide
banks with excess or surplus reserves an incentive to trade
them with other banks. Banks would prefer to borrow
reserves at a lower interest rate or deposit reserves at a higher
interest rate than they can through the operational standing
facilities. By managing the aggregate amount of reserves,
agreeing an average overnight holding of reserves and providing
operational standing facilities, the Bank of England
aims to establish a ‘corridor’ for inter-bank rates between its
lending and deposit rates.

The advent of quantitative easing. March 2009 saw the

Bank begin its programme of quantitative easing (QE)
. The aim was to increase the amount of
money in the financial system and thereby stimulate
bank lending and hence aggregate demand. QE involved
the Bank creating electronic money and using it to purchase
assets, mainly government bonds, predominantly
from non-deposit-taking financial institutions, such as
unit trusts, insurance companies and pension funds.
These institutions would then deposit the money in
banks, which could lend it to businesses and consumers
for purposes of spending.
Given this large quantity of ‘new money’ being supplied
to the banking system it was decided to end the practice of
banks voluntarily setting their own reserve targets between
meetings of the MPC. Instead, all reserves were now to be
remunerated at the official Bank Rate. The effect of remunerating
all reserves was to replace the ‘corridor system’
with a ‘floor system’ since no commercial bank would be
willing to lend surplus reserves at any rate lower than the
Bank Rate. Therefore, the inter-bank rate would not fall
below the Bank Rate.
The Bank of England’s programme of asset purchases were
conducted by a subsidiary of the Bank of England, known as
the Asset Purchase Facility (APF).

It provides liquidity, as necessary, to banks

Financial institutions engage in maturity transformation.
While most customer deposits can be withdrawn instantly,
financial institutions will have a variety of lending commitments,
some of which span many years. Hence, the Bank of
England acts as a ‘liquidity backstop’ for the banking system.
It attempts to ensure that there is always an adequate
supply of liquidity to meet the legitimate demands of
depositors in banks.
Banks’ reserve balances provide them with some liquidity
insurance. However, the Bank of England needs other means
by which to provide both individual banks and the banking
system with sufficient liquidity. The financial crisis, for
instance, saw incredible pressure on the aggregate liquidity
of financial system. The result is that the UK has three
principal insurance facilities:

Index long-term repos (ILTRS). Each month the Bank of England

provides MFIs with reserves for a six-month period
secured against collateral and indexed against the Bank Rate.
Financial institutions can borrow reserves against different
levels of collateral. These levels reflect the quality and liquidity
of the collateral. The reserves are distributed through an
auction where financial institutions indicate, for their particular
level of collateral, the number of basis points over the
Bank Rate (the ‘spread’) they are prepared to pay. Successful
bidders pay a uniform price: this is the clearing price at
which the Bank of England’s preparedness to lend reserves
has been met. The Bank of England will provide a greater
quantity of reserves if, from the bids, it observes a greater
demand for it to provide liquidity insurance.

Discount window facility (DWF). This on-demand facility

allows financial institutions to borrow government bonds
(gilts) for 30 days against different classes of collateral. They
pay a fee to do so. The size of the fee is determined by both
the level of collateral and the size of the collateral being
traded. Gilts are long-term government debt instruments
used by government as a means of financing its borrowing.
Gilts can be used in repo operations as a means of securing
liquidity. In this way, financial institutions are performing
a liquidity upgrade of their collateral. However, the Bank
may agree to lend cash rather than gilts if gilt repo markets
cease to provide the necessary amount of liquidity, perhaps
because the cost of doing so becomes prohibitively high.
Financial institutions can look to roll over the funds
obtained from the DWF beyond the normal 30 days.

Contingent term repo facility (CTRP). This is a facility which

the Bank of England can activate in exceptional circumstances.
As with the ILTRS, financial institutions can obtain
liquidity secured against different levels of collateral
through an auction. However, the terms, including the
maturity of the funds, are intended to be more flexible.

It oversees the activities of banks and other financial

institutions
The Bank of England requires all recognised banks to maintain
adequate liquidity: this is called prudential control.
In May 1997, the Bank of England ceased to be responsible
for the detailed supervision of banks’ activities. This responsibility
passed to the Financial Services Authority (FSA). But
the financial crisis of the late 2000s raised concerns about
whether the FSA, the Bank of England and HM Treasury
where sufficiently watchful of banks’ liquidity and the risks
of liquidity shortage. Some commentators argued that a
much tighter form of prudential control needed to be
imposed.
In 2013, a new regulatory framework came into force,
with an enhanced role for the Bank of England.
First, the Bank’s Financial Policy Committee became
responsible for macro-prudential regulation. This type of
regulation takes a broader view of the financial system. It
considers, for instance, its health or resilience to possible
shocks and its propensity to create macroeconomic instability
through credit creation.
Second, the prudential regulation of individual firms was
transferred from the FSA to the Prudential Regulation Authority,
a subsidiary of the Bank of England.
Third, the Financial Conduct Authority (FCA) took responsibility
for consumer protection and the regulation of markets
for financial services. The FCA is an independent body
accountable to HM Treasury. The FSA was wound up.
It operates the government’s exchange rate policy
The Bank of England manages the country’s gold and foreign
currency reserves on behalf of the Treasury. This is
done through the exchange equalisation account. The Treasury
sets the Bank an annual remit for the management of
the account (for example, setting a limit on changes in the
level of reserves).
By buying and selling foreign currencies on the foreign
exchange market, the Bank of England can affect the exchange
rate. For example, if there were a sudden selling of sterling
the Bank of England could help to
prevent the pound from falling by using reserves to buy up
pounds on the foreign exchange market.

The money markets

We now turn to the money markets where participants,
including financial institutions, are able to lend and borrow
to and from each other. In these markets debts typically
have maturities of less than one year.
Central banks are also important participants in money
markets. It is through the money markets that a central bank
exercises control over interest rates.
The discount and repo markets
The discount market. The discount market is the market for
commercial or government bills. In the UK, government
bills are known as Treasury bills and operations are conducted
by the Debt Management Office, usually on a weekly
basis. Treasury Bills involve short-term lending, say for one
or three months, which, in conjunction with their low
default risk, make them highly liquid assets. These markets
are examples of discount markets because the instruments
being traded are issued at a discount. In other words, the
redemption price of the bills is greater than the issue price.
The redemption price is fixed, but the issue price depends
on demand and supply in the discount market. The rate of
discount on bills can be calculated by the size of the discount
relative to the redemption value and is usually
expressed as an annual rate.
The discount market is also known as the ‘traditional
market’ because it was the market in which many central
banks traditionally used to supply central bank money to
financial institutions. For instance, if the Bank of England
wanted to increase liquidity in the banking system it could
purchase from the banks Treasury bills which had yet to
reach maturity. This process is known as rediscounting. The
Bank of England would pay a price below the face value, thus
effectively charging interest to the banks. The price could be
set so that the ‘rediscount rate’ reflected the Bank Rate.

The repo market The emergence of the repo market is a more

recent development dating back in the UK to the 1990s. As
we saw earlier, repos have become an important source of
wholesale funding for financial institutions. But they have
also become an important means by which central banks
can affect the liquidity of the financial system both to implement
monetary policy and to ensure financial stability.
By entering into a repo agreement the Bank of England can
buy securities, such as gilts, from the banks (thereby
supplying them with money) on the condition that the banks
buy them back at a fixed price and on a fixed date. The repurchase
price will be above the sale price. The difference is the
equivalent of the interest that the banks are being charged for
having what amounts to a loan from the Bank of England.
The repurchase price (and hence the ‘repo rate’) is set by the
Bank of England to reflect the Bank Rate chosen by the MPC.
The Bank of England first began using repo operations to
manage the liquidity of the financial system in 1997 when it
undertook daily operations, with the repurchases of securities
usually occurring two weeks after the initial sale. This
system was refined so that in 2006 operations became weekly
and the repurchase period typically shortened to one week.
However, the financial crisis caused the Bank to modify
its repo operations to manage liquidity for both purposes of
monetary policy, but increasingly to ensure financial stability.
These changes included a widening of the securities eligible
as collateral for loans, a move to longer-term repo
operations and a suspension of short-term repo operations.
So central banks, like the Bank of England, are prepared
to provide central bank money through the creation of bank
reserves. Central banks are thus the ultimate guarantor of
sufficient liquidity in the monetary system and, for this
reason, are known as the lender of last resort.

The parallel money markets

Like repo markets, complementary or parallel money markets
have grown rapidly in recent years. In part, this reflects
the opening up of markets to international dealing, the
deregulation of banking and money market dealing and the
desire of banks to keep funds in a form that can be readily
switched from one form of deposit to another, or from one
currency to another.
Examples of parallel markets include the markets for certificates
of deposit (CDs), foreign currencies markets (dealings in
foreign currencies deposited short term in the country) and
the inter-bank market.
The inter-bank market. The inter-bank market involves
wholesale loans from one bank to another over periods
from one day to up to several months. Banks with surplus
liquidity lend to other banks, which then use this as the
basis for loans to individuals and companies.
The rate at which banks lend to each other is known as
the IBOR (inter-bank offered rate). The IBOR has a major
influence on the other rates that banks charge. In the eurozone,
the IBOR is known as Euribor. In the UK, it is known as
the LIBOR (where ‘L’ stands for ‘London’). As inter-bank
loans can be anything from overnight to 12 months, the
IBOR will vary from one length of loan to another.
Inter-bank interest rates tend to be higher than those in
the discount and repo markets and sensitive to the aggregate
level of liquidity in the financial system.