Monetary Policy and Money Markets an European perspective

1
Monetary Policy and Money Marketsan European
perspective

• Abel M. Mateus
• Banco of Portugal Board Member (MPC)
• Executive Director for Monetary Operations and IT
• (1992-1998)

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• An efficient money market is an absolute
  prerequisite for a well functioning bond market

3

• We will present what in our view is an optimal
  monetary policy framework, considering monetary
  theory, the state of the art of CBs, based on
  experience of European central banks
• Today, the SECB comprises ECB and NCB
• So, these models will correspond better to NCB
  just before the euro started

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Outline

• Framework for Monetary Policy
• Money market infrastructure
• Money market operations
• Criteria for market efficiency
• Treasury/MOF and Central Bank relationship
• Market surveillance

5
Outline

• Framework for Monetary Policy
• Money market infrastructure
• Money market operations
• Criteria for market efficiency
• Treasury/MOF and Central Bank relationship
• Market surveillance

6
Basic principles (based on the recent advances in
optimal monetary policy models and the European
Monetary Union experience)

• Independent Central Bank (setting objectives,
  politically independent, free from government
  pressure, Board Members cannot be dismissed,
  accountability)
• Clearly defined nominal anchor
• Central Bank has complete freedom and all the
  instruments required to attain objectives
• Prohibition of government credit and buying
  directly bonds from the government
• All these rules should be enshrined on the
  Constitution and/or Central Bank Charter

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Monetary Policy Rules

• Inflation targeting
• Inflation depends on real interest rate
• Real interest rate depends on nominal interest
  rate and inflation expectations
• Nominal interest rate can be manipulated thru
  bank reserves
• Pa. (Real Interest Rate, GDP-Normal GDP)
• Exchange rate targeting
• Policy pursued by most of EU countries in the
  1990s,
• Interest Rate Parity

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Monetary Programming

• Macroeconomic Forecasting Exercise (IS-MR, AD-IA)
• Or, more traditionally, fix intermediate monetary
  aggregates (LM compatible with MR)
• Control of bank reserves to reach a certain
  monetary aggregate, compatible with a given
  interest rate

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Central Bank Instruments

• Setting key interest rates
• Money market interventions thru repo and reverse
  repo operations
• Money market interventions thru open market
  operations
• Money market interventions thru foreign exchange
  markets
• Set bank reserve requirements

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Central Bank Interest Rate Structure
Permanent Credit Facility
Repo rate
Permanent Absorption Facility
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• Framework for Monetary Policy
• Money market infrastructure
• Money market operations
• Criteria for market efficiency
• Treasury/MOF and Central Bank relationship
• Market surveillance

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Money market infrastructure
Central Bank System for Auctions, MP
Control and Market Surveillance
Depository, Electronic Registrar and
Clearing System
Interbank Money Market
RTGS
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In most of the EU countries

• All this platforms should be integrated and its
  functioning and integrity are responsibility of
  Central Bank or agencies that depend directly on
  Central Bank

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Portuguese case

• SITEM is an electronic system for auctioning
  liquidity between participants and BP(ECB)
• Brokering liquidity among participants (handles
  all call market)
• Keeps track of all operations,e.g. informs
  participants of operations condition and warns of
  date of payment
• Informs of market conditions, rates and indices
• linked to RTGS, settlement of all operations
• is a central registrar and clearing/settlement
  for TBs. Other paper is registered at CVM linked
  to these systems in real time.

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• Framework for Monetary Policy
• Money market infrastructure
• Money market operations
• Criteria for market efficiency
• Treasury/MOF and Central Bank relationship
• Market surveillance

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• Regular money market intervention at beginning of
  reserve period
• Following closely market indicators (interest
  rate in spot markets for different terms), excess
  supply/demand of liquidity
• Following closely exchange rate developments
• If needed, non-regular interventions in the money
  markets

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Basic good bank reserve programming

• Problem Treasury operations
• in some European countries Single Treasury
  account at CB
• in others Treasury accounts with commercial
  banks

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Money and exchange rate

• Money market and
• Exchange rate management
• SHOULD GO HAND IN HAND
• In countries that give some importance to
  exchange rate stability, even more important than
  quantitative planning of monetary aggregates is

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Interest Rate Parity

• Uncovered interest rate parity
• Domestic Interest Rate
• International Interest Rate
• Expected Devaluation
• Sovereign Risk

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Who should have access to Central Bank liquidity
windows?

• All banking institutions (that can take deposits
  or make loans of liquidity) should have access to
  Central Bank liquidity window
• Moreover, all institutions that are subject to
  minimum reserve requirements

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Conditions for participating in CB liquidity
windows

• Fully compliant financial institution (RTGS,
  brokerage and/or dealership regulations)
• Be solvent and financially sound (supervisory
  institution certified)
• Signs a contract with Central Bank with rights
  and responsibilities
• Is subject to surveillance and timely audits by
  Money Market Department staff

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• Most of European countries have abandoned
  rediscounting (too much risk taking, and risk
  assessment) - only France maintains important
  window
• Bulk of operations with Treasury Paper (mainly
  Tbills)
• But more recently, in order not to bias
  preference for public paper use top grade
  corporate bonds

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Problem of risk assessment of paper

• Risk assessment is easy for TBs usually very
  small hair cuts
• Hair cuts would be higher for long term bonds (10
  year Tbonds)
• But id usually difficult to compute hair cuts for
  corporate bonds due to lack of liquidity (30
  haircut was common in this case)
• At BP we have developed an interesting model
  valuation

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• Framework for Monetary Policy
• Money market infrastructure
• Money market operations
• Criteria for market efficiency
• Treasury/MOF and Central Bank relationship
• Market surveillance

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Efficient money market

• Full market mechanisms, transparent and with
  frequent transactions
• Not excessive volatility of market interest
  rates, and market interest rates reflecting CB
  targeting
• But it should respond to shocks in real and
  monetary markets, as well as inflationary
  expectations
• Adjustment more thru quantity than price
• Settlement risk reduced to a minimum and well
  defined distribution

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• Efficient and secure market infrastructure
• Market reference rates frequent and easily
  available
• Very small spreads in Interbank rates
• Articulation between wholesale and retail money
  markets
• Fluidity between money, foreign exchange and
  bonds markets
• Excellent market stability and surveillance

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Money market reference rates

• All the money markets have an Interbank Money
  Rate that is used as a reference to money markets
  (LIBOR, PIBOR, MIBOR, LISBOR, etc.)
• These rates are quoted every business day by a
  set of relevant market participants, that
  subscribe a contract, bid and ask rates for 1
  week, 1 month, 3 months, 6 months, 1 year.
• These rates are then publicized by Reuters, etc.
  (usually Central Bank encourages launching, but
  it should be seen as a purely market rate)

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In most of European markets

• Private contracts take the ?IBOR rates as a base
  for defining interest rates
• E.g. LIBOR, in dollars, is used in quite a number
  of countries to define banking rates (deposit and
  lending) for US dollars
• E.g. in mortgage indexed contracts, the 6-month
  ?IBOR is used
• Most of these national rates have been replaced
  by EURIBOR rates

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Defining the yield curve

• The short-end (up to 1 year) is usually defined
  by ?IBOR, or/and TBs secondary market rates
• After 1 up to 10 years -by TBs - in secondary
  active markets (importance of liquid markets,
  fungibility, etc.)
• Who publishes the data?

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• Framework for Monetary Policy
• Money market infrastructure
• Money market operations
• Criteria for market efficiency
• Treasury/MOF and Central Bank relationship
• Market surveillance

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Two conflicting objectives

• Central Bank wants monetary stability
• Treasury wants minimum cost for Treasury financing

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But for Treasury to act tru the market and assure
a steady and stable financing environment

• Needs to build trust with market participants,
  transparency, minimum regulation, need of trained
  operators and knowledgeable investors
• Create a sufficient array of instruments that
  allow risk diversification
• Promote savings (institutional and private)

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But for Treasury to act tru the market and assure
a steady and stable financing environment

• Develop appropriate derivative instruments for
  hedging, risk spreading and risk shifting
  (essential for efficient modern real sector)
• Efficient debt management (domestic and foreign)
• Markets have to be created and steadily nurtured
  (not to be tapped erratically, or when Treasury
  needs money)

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Global markets how to graduate from emerging
market

• Treasury should establish a reputation of
  excellent borrower and capital market
• Thru
• Regular operations
• Good international rating (appropriate macro
  policies)
• Road shows
• Establish privileged relationship with major
  global banks (link external operations with
  performance in domestic markets)

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• Central Bank-money markets short end of the
  market- up to 1 year
• Treasury-capital markets debt instruments with
  more than 1-year

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To harmonize objectives and prevent market
segmentation

• Al short term instruments issued are Treasury
  Bills (TB) 3, 6, 9 and 12 months.
• Treasury sets regular calendar for each issue
• But leaves the amounts and rates to be chosen by
  CB
• Central Bank issues TB and puts revenues in an
  account in Treasury name
• When Treasury needs the money, it can use it but
  pays the rate of the TB (LIFO)

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• Central Bank can either issue TBs or make repos
  with TBs (that have not yet matured)
• Fiscal issue TBs should be nontaxable
• TBs can be used outside the banking or financial
  system. In several countries they are extensively
  used even by firms and households.

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• Framework for Monetary Policy
• Money market infrastructure
• Money market operations
• Criteria for market efficiency
• Treasury/MOF and Central Bank relationship
• Market surveillance

39
Basic regulatory framework

• Money market and banking regulation perspective
  (Central Bank)
• Bond, stocks and capital market regulation
  perspective (stock exchanges)
• Insurance industry (conglomerate or cross-selling)

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Regulation of

• Spot markets
• Derivatives and futures markets
• In Portugal all the basic regulatory instruments
  for these markets were drawn-up by a commission
  with all supervisory agencies, plus Central Bank
  and MoF.
• Professional associations were consulted
• Regulations issued by Supervisory Commission (in
  Portugal CMVM)

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Some important principles

• Integration of supervision functions
• Conglomerates and global approach
• Strict collaboration in operational and
  supervision aspects
• Self-regulation and governance are fundamental
• eg. Need a code of conduct for brokers and
  dealers in bonds, stocks, mutual funds

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Bond market regulation institutional
responsibilities

• Basic principle Supervisory Agency for Capital
  Markets is the main regulatory an supervisory
  body.
• To the extent that may influence liquidity
  markets Central Bank should be consulted
• Institution that handles bond auctions (e.g.
  Central Bank) should maintain conditions for
  competitive behavior (e.g. NYFED is responsible
  for watching conditions that may led to
  cornering)

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Bond market regulation

• Obligation of maintaining full accounts of
  primary dealers, with rates offered and
  transactions made
• Sample supervision to avoid cornering market
• Professional examination
• Code of conduct information of clients, unduly
  risk taking, etc.

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What are basic regulatory instruments

• Derivatives standard contracts repo,
  short-sales, standard futures or forward
  contracts.
• Market indices on futures and forward interest
  and exchange rates (and stock futures)
• Be sure that all the codes of law and auxiliary
  regulations are compatible with international
  standard practices

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Derivatives market regulations

• Regulations on margins
• Standard contracts

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But markets will not develop if operators are not
fully knowledgeable

• In Portugal we set up a Capital Markets
  Development Institute -linked to futures stock
  exchange, whose functions were
• Make studies supporting basic contracts and best
  practices (review worldwide experience) - hired
  about dozen PhDs and MAs in Finance
• Courses for market operators with foreign experts
  (mostly experts from English Universities at
  master or doctoral level)

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But markets will not develop if operators are not
fully knowledgeable

• Seminars for Central bank, commercial banks, at
  technical level
• Seminars at executive and management level to
  raise awareness on derivatives role and working
• Universities introduced courses on derivatives
• It took us 2 1/2 years of intensive training
  before negotiation in futures stock exchange was
  inaugurated (we know that other Asian countries
  like Malaysia did the same)