How our economy can come back to life
One of the key tasks of Bangladesh Bank, as for all central banks, is to maintain the proper level of liquidity in the financial system. Most of the recently announced actions of BB have focused on credit matters. More needs to be done to ensure that the instruments for controlling liquidity are readily available.
The objective of these suggestions is to increase BB’s flexibility in managing bank liquidity as the economy recovers from the lockdown period and the rules for commercial banking return to normal.
With the sharp impact on the economy of the Covid-19 pandemic, the commercial banks will face depleted capital, reduced liquidity, greater levels of NPL, leading to potential instability.
BB and the arrangements for managing bank liquidity must be flexible and sure-footed with the procedures well understood by the banks. The very existence of transparent and well-defined channels will do, in itself, a great deal to stabilize the banking system over the year from June 2020 to June 2021.
In a previous article that discussed the circular that reduced interest rates to zero for two months (April and May 2020) for loans sanctioned before April 1, 2020, the importance of being prepared to manage the liquidity position of the private commercial banks was noted.
Into the second half of 2020 and the first half of 2021, many commercial banks are likely to face sudden liquidity challenges. These must be managed rapidly and smoothly to minimize the contagion effects of one bank effecting another. I cannot exaggerate the dangers and challenges.
As the financial system emerges from the pandemic, the capital market, now closed and over-regulated, will be attempting to come back to life; most of the non-banking financial institutions are insolvent and completely lack liquidity, and the government budget will be running a very large deficit and turning to the banks and the central bank for financing.
The growth of deposits will slow
In the face of this uncertainty, the demand for cash will rise; the real return for holding fixed deposits will be zero or negative. Liquidity will stay frozen for the NBFIs and the stock market.
Smart investors will turn to the T bill as the best available asset with a high-interest rate and plenty of liquidity. The term deposit in a bank will not look very attractive.
Banks desperate to increase deposits will raise deposit rates. The BB’s fixed interest rate structure for loans will not survive these tremendous pressures. Liquidity pressures on third and fourth generation banks along with a few older banks will emerge. Dangers of contagion will be widespread. All of this is already on the minds of the bankers, institutional investors, and wealthy individuals.
This article discusses adjusting the plumbing of the banking system to enable BB to handle these issues easily. Unfortunately, little post-January 2020 data is available to the public on monetary policy, so changes taking place in the monetary aggregates are not being made public. This in itself is a source of concern.
The article discusses four areas of liquidity management: The secondary market for government securities; the repo market; the interbank lending market; and the asset deposit ratio.
Secondary market for government securities
By open market operations, I mean the sale and purchase of government securities by the central bank in the secondary market. This market never really developed, as the SLR rule constrained the secondary market. There is buying and selling between commercial banks but these are made on an ad hoc basis and there is no trading platform for such transactions with records open to the public.
At present, the primary market determines a price for new purchases through an auction process. BB rarely participates in this market although it may create and hold the equivalent of T bills on its own account. Opening a secondary market allows new issues sold to primary dealers who buy from BB to resell to buyers including other commercial banks, NBFIs, insurance companies, and the public.
A market with continuous buy-sell offers makes it easy for commercial banks to adjust their liquidity positions. It also enables BB to enter the market to establish an interest rate for the 91 day T bill that would serve as the anchor interest rate representing the most liquid zero risk investment available.
Bangladesh has announced a policy of purchasing a substantial part of government securities held by banks in excess of the SLR to improve bank liquidity. At present with SLR at 13.5% on January 31, 2020, I estimate there wasTk570 billion excess holdings of government securities above requirements.
The BB has announced that it intends to conduct “open market operations” through buying and selling government securities. There is no current information available on the extent to which such purchases have taken place.
To free up more government securities to enter the market the SLR can be immediately reduced to 10%. It is a good monetary policy to reduce the SLR to zero over the next five years. There are two reasons for the SLR: First, the SLR provides potential liquidity if the central bank would purchase or allow sales n emergency situation; although this has never happened the potential gives some confidence to depositors.
Second, the SLR serves to subsidize government borrowing; there is no justification for this in a market economy; it is a relic of the past, unnecessary when there is a sophisticated modern central bank. Reducing the SLR is no threat to liquidity as BB has sufficient power to require commercial banks to maintain adequate levels of liquidity.
We note that BB would play an active role in this fledgling secondary market, with a probable focus on the 91-day bill and the two-year government bond. Eventually, all government securities would trade in this secondary market.
If monetary policy is to establish the risk-free interest rate at the base of the structure of interest rates, it can best be established by the T bill rate in the auction markets and the secondary market.
In seeing the 91-day T bill as the key interest rate and the adjustment of its level establishing the foundation interest rate, the authorities must recognize that setting any other rate is inconsistent with this policy.
BB needs to ensure that banks have ready access to the repo market. The main point suggested here is easing of collateral requirements and in the circumstances of the next year lowering the Repo rate.
Collateral could be: (1) All government securities held by the bank, in contrast to the current situation that only securities above the SLR limit are acceptable collateral; (2) Shareholdings held by the bank valued at 50% of market value and (3) the land security of private sector loans valued at 75% of the value the commercial bank is accepting (If the land is valued at 100 and the bank has accepted 50 towards collateral, then 75% of 50, 37.5 would be the value acceptable for Repo collateral).
These permissions would expand collateral acceptable for the repo market. Banks experiencing liquidity difficulty can turn immediately to the repo market and borrowing should be automatic against authorized collateral.
As the economy comes back to life after the lockdown individual commercial banks may find themselves in liquidity difficulty. The ability to draw quickly on funds through the repo market is essential.
Interbank lending rate
At present banks lend among themselves at a rate that is supposed to be determined by the market. This is an important way to allow banks to adjust their liquidity position in the short term. It is important that this is a real market. Is it? Although BB denies it, this overnight lending rate is controlled by the central bank.
Obviously, a real market is needed and this is the market for lending for three days. However, the lending rate in this market is not known to the public. For a mature central bank such as BB, there is no reason for this attempt to manipulate the interbank market.
Asset deposit ratio
BB uses the asset deposit ratio as an instrument of monetary policy, ie it is a number fixed by BB and must be followed by all banks, regardless of their financial position. This is an inappropriate monetary policy instrument.
The ADR is an excellent off-site supervision instrument imposed on a particular bank to ensure that it corrects its balance sheet when the central bank so requires. But when so used each bank is treated according to its condition, and there is no standard ADR rate. There are two reasons why I think this is an inappropriate monetary policy instrument:
1. The use of the ratio is controversial and BB has experienced repeated difficulty in enforcing an announced level of the ADR. The central bank should not back off once it has set a rule and experience shows that it cannot be enforced. It is a rule that is not a rule.
2. Technically simultaneous use of the ADR and an interest rate objective (or a money supply objective) overdetermines the analytical framework of monetary policy. This is confusing to everyone. The analytic framework for monetary policy presented in the monetary policy statement is not well defined.
For both these reasons, BB should drop the use of the ADR as an instrument of monetary policy and leave it to the off-site supervision teams.
Putting all of this together, BB should develop the secondary market for government securities so that it can conduct open market operations adjusting its holding of government securities to change the foundation interest rate. Second the available collateral in the repo market should be expanded to allow increased liquidity support when needed.
Forrest Cookson is an economist who has served as the first president of AmCham and has been a consultant for the Bangladesh Bureau of Statistics.