July 14, 2017

Barry Topf

Cranberry Consultants

A Brief Introduction to Central Banking:

Monetary Policy and Reserves Management

CONTENTS:

• 1-Objectives of a Central Bank

• 2-Design of Monetary Policy
o The Exchange Rate Regime
o The Wider Context
o Central Bank Capacity
• 3- Monetary Operations
o The Policy Interest Rate
o Tools and Instruments
▪ Market Tools
▪ Additional Tools
▪ Supporting Elements
o Monetary Operations in Theory and in Practice
• 4-Management of Foreign Exchange Reserves
• Appendixes
▪ Appendix 1: Monetary Operations at the Bank of Israel
▪ Appendix 2: Asset Allocation of International Reserves
▪ Appendix 3: History of International Currencies
▪ Appendix 4: Abbreviations
 1-Objectives of a Central Bank

The Objectives of Central Banks have changed over time (see Box 1).

Today, central banks can be characterized as single mandate1 or dual (or multiple) mandate
Banks:

o Single mandate central banks usually have price stability (low and stable
inflation) as their sole or primary objective. (Examples: the ECB, Bank of Israel)
▪ Sometimes stability of the currency is the sole mandate.
o Multiple mandate banks can have additional objectives, such as full
employment, financial stability, supporting economic growth. (example: Federal
Reserve)
o Most central banks have additional roles, such as: manager of foreign exchange
reserves; bank supervision; issuer of banknotes; manager of payment system;
fiscal agent of the government; banker of the government; development bank.
o Central Banks are the monopoly supplier of Base Money.

For the past two decades, a consensus has evolved that a central bank’s primary (and often
exclusive) goal should be price stability maintained through inflation targeting. This is especially
the case for developed country central banks but increasingly for emerging markets as well.
However, since the crisis of 2008, a more nuanced view has emerged, giving weight to additional
factors such as the exchange rate, financial stability and general welfare. However, this has not
yet found widespread acceptance in central banking practices.

1
Some single mandate banks have other additional objectives, but these are clearly subordinated to the
primary objective (i.e. Bank of Israel)
 BOX 1: A SHORT HISTORY OF CENTRAL BANKS
Central Banks came into being with the advent of fiat money. Governments and rulers regulated coinage *, but
as long as only tangible or commodity money existed, there was no need for a monetary authority.
The first central bank was established in Sweden, the Riksbank, in 1668; the Bank of England was established in
1696. They were private (joint stock) companies, and they did not have the functions of modern central banks
– their prime purpose was to fund the government, issue banknotes, sometimes as a monopoly, and serve as
clearinghouses.
In the 18th and 19th century they gradually assumed new roles, including banker to the banks and therefore
“Lender of Last Resort” (LOLR), with implied responsibility for banking stability. Regarding money, their
primary function was preserving the external stability of the currency by managing the Gold Standard.
After World War One, and to a greater extent after the Great Depression, they assumed a role in supporting
internal stability as well – employment and output, although fiscal policy played the main role. The Bank for
International Settlements (“BIS”), the “central bank for central banks” was established in 1930, originally to
deal with German reparation payments.
The breakdown of the US Dollar based period of fixed exchange rates (Bretton Woods) and surge of inflation in
the 1970s led to a new emphasis on monetarism and monetary policy and in additional functions and increased
roles for central banks. They assumed greater independence and powers, both de jure and de facto.
Maintaining price stability first through monetary targeting and later by means of Inflation Targeting became
widespread. Central Banks became the “first responders” to the great recession of 2008.
There has been criticism of the wider role and powers wielded by central banks, regarding lack of democratic
accountability and transparency and favoring “Wall Street over Main Street”. They face many challenges: slow
growth, low inflation, asset price inflation; ensuring financial stability; the impact of globalization; and changing
technology.
There is no one-to-one correspondence between countries, currencies and central banks. There are countries
with no central bank (Panama); central banks with no currency (Ecuador); and central banks with no country
(ECB).

*See for example: ‫ מאזני צדק‬:‫ “לא תעשו עול במשפט במידה במשקל ובמשורה‬35-36 :‫ויקרא יט‬
"‫אבני צדק איפת צדק והין צדק יהיה לכם‬
 2-Design of Monetary Policy
MONETARY POLICY DESIGN

The design of monetary policy involves determining2 (see

Diagram 1):

• The Final Goal or Target;

TOOLS AND
• Intermediate Target INSTRUMENTS
• Operating Target
• Instruments

The Final Target is the ultimate aim of CB policy; today usually OPERATING
price stability. Since in a market economy the CB cannot
directly affect prices, it needs a transmission mechanism. The
TARGET
final goal is a policy choice. Alternative final goals of monetary
policy have included the exchange rate, real output, and
employment. Suggestions have been made that targeting price
levels or nominal GDP would be superior to IT.

Intermediate targets are observable variables and /or

INTERMEDIATE
indicators which the central bank can affect (using its TARGET OR
operating targets and tools); that have a stable relationship to INDICATOR
the ultimate Target, and which it can use to achieve its
ultimate target. Examples include expected inflation; exchange
rates; the yield curve; money or credit aggregates.

The Operating Targets are the financial variable which the CB

can directly affect using its tools and instruments in the FINAL TARGET
framework of monetary operations. Examples include short
term interest rates, bank reserves, and base money.

Instruments are the tools the central bank employs in its operations, which
can include policy interest rates; open market operations (OMOs) supply of
liquidity; ER intervention and recently, quantitative expansion (QE) and
forward guidance. In a market economy, most CB instruments involve
changes in the Balance Sheet of the CB.

The transmission mechanism refers to the channels by which CB operations

impact targets, and determines which monetary operations are feasible and
effective. The transmission mechanism is not necessarily stable over time,
and is a function of institutional factors (banking and market structure,
financial stability, financial markets, available technology, infrastructure,

2
There are, of course, alternative classification schemes.
financial innovation). There are variable lags in response times, lack of
information and uncertainty regarding the effect on the economy of
operations.

The transmission mechanism can include the exchange rate pass-through;

aggregate demand - cost of borrowing and lending (“the real channel”),
quantity of money and credit, and wealth effects.

Diagram 1: The Monetary Policy Framework

Source: A hundred ways to skin a cat: comparing monetary policy operating procedures in the United States, Japan and the euro
area ,C E V Borio, Bank for International Settlements, Basel

The exchange rate regime

Monetary policy must always be a function of the ER regime, for the simple reason that in
certain ER regimes, there cannot be an independent monetary policy (see the “trilemma”, next
section). In all other ER regimes, monetary policy must either support the ER regime, or the
nature and function of the ER regime are important factors in designing monetary policy.
ER regimes can be seen on a scale, with totally fixed at one end, and totally free at the other:

FIXED FLOATING

ER No Currency Peg Crawls Other Float Free

regime separate Board and Managed Float
legal Bands
tender
number 14 11 44 14 20 40 31
examples Panama Bulgaria Denmark Croatia China India US,
Euro

The classification3 is somewhat arbitrary and far from fixed. The IMF has 10 classifications (here
consolidated); and many distinctions (i.e. between “float” and “free float”4 ) are unclear and
subject to political considerations.5

The more the ER is fixed, the more monetary policy is subordinated to the ER, with the extreme
case being no separate currency or a currency board, where there is no independent monetary
policy. The more flexible the ER, the less monetary policy must target the ER, but then the ER
becomes an important factor in calibrating monetary policy.

Many factors determine the choice of ER: size; trade relationships, geographic location6, degree
of development, capital controls, institutional capacity and stability and political alignment. As a
rule of thumb countries subject to real shocks tend to adopt floating rates, while countries
subject to nominal shocks adopt fixed rates.

The Wider Context

The choice and design of monetary policy is always constrained by the “Trilemma” – a country
cannot maintain a fixed exchange rate, free capital flows and an independent monetary policy
rate at the same time: it must choose two of the three and abandon the third. See diagram 2.

The choices are not binary: there are degrees of capital mobility and degrees of monetary
independence, as we have already seen regarding the ER regime. However, the tradeoffs are
clear in direction if not in degree.

3
IMF: Annual Report on Exchange Arrangements and Exchange Restrictions, 2016
4
Since the abandonment of Bretton Woods “fear of floating” has made “free floats” a loose concept.
5
Israel is classified as a “float” due to the extent of intervention, after having been a free float previously.
Since independence it has had in different periods each of the many regimes, sometimes more than once.
6
These three factors are thought to determine an “optimum currency area”.
 Diagram 2: The Trilemma

Although the primary determinants of an independent monetary policy are the choice of ER
regime and degree of capital mobility, there are many other constraints and factors which affect
the design of monetary policy. A critical component is absence of fiscal dominance. Where
there is a lack of budgetary discipline and fiscal policy is too expansive, it overwhelms monetary
policy and reduces or eliminates its effectiveness. Absence of fiscal dominance is a necessary
condition for effective monetary policy. Other factors include:

• Institutional development
• Supporting elements: accounting, tax policy, legal considerations
• Market development
• Human and technical infrastructure
• Political structure
• International agreements
• Distributional issues, social welfare, consumer protection

The adoption of IT brought with it a philosophy of “one goal, one tool” – an exclusive focus on
maintaining price stability by using the policy interest rate - was the best way of conducting
monetary policy. Recent developments have challenged that consensus, as the Crisis of 2008
made clear that there were other important goals (financial stability, the exchange rate) and
that CBs needed additional tools to deal with them (“capital flow management tools”,
unconventional monetary policy, macro-prudential tools). Thus, “flexible inflation targeting” has
assume a role alongside strict IT.
CBs often claim to maintain a separation between monetary policy and financial stability.
Monetary “purists” insist that institutional stability should play no role in formulating monetary
policy. This poses considerable practical issues, since many banks have formal jurisdiction over
banking supervision, and sometimes systemic financial stability as well. Beyond the formal
issues, the extremely high costs of financial crisis make it unreasonable to assume CBs can
ignore them: in fact, recent experience shows that stability issues can take precedence over
price stability, notwithstanding the formal priority given price stability in many CB mandates.

Central Bank Capacity

The CB must have the capacity to design and implement monetary policy. This includes

• Legal powers
o Statutory or de facto independence 7
o Instrument independence
o Governance
• Financial capacity8
o Adequate capital
o Balance sheet
o Ability to bear the costs of monetary policy
• Professional capacity
o Modeling and forecasting
o Adequate data, statistics and information
o Communication policy
• Credibility

An important issue in the design of monetary policy is the “Rules versus Discretion” or “Model
versus Judgement” question. Rules have sometimes been adopted but were observed more in
the breach than in fact, and given the limitations of current models they are seen as one input
into decision making along with many other factors. In practice, given lack of information,
uncertainty regarding the effect of policy, variable lags and other considerations, most CBs use a
mixture of rules and discretion, with judgement having a greater weight than models or
mechanical rules. See Box 2

7
Along with IT there has been an emphasis on establishing and reinforcing the independence of CBs,
which some view as a prerequisite for effective Monpol. The argument is of time inconsistency, i.e.
monetary policy needs to be implemented on a longer- term horizon than political leaders, afflicted with
short-termism, can maintain, so it is best left to the professional independent central bankers unaffected
by short term or electoral considerations. It also establishes a separation of powers between monetary
and fiscal authorities. On the other hand, it raises issues of accountability and democratic process.
8
There is a long and contentious debate concerning central bank balance sheets. There is a claim that
central banks need adequate capital to ensure that they can undertake the appropriate policy without
regard to (their)costs, and maintain credibility. On the other hand, many central banks have accumulated
losses and have negative capital- for example, Poland, the Czech Republic and Israel.
 Box 2: The Taylor Rule
The outstanding proposed rule for monetary policy was proposed by John Taylor in 1992.
In its simplest version, it proposes that the real interest rate should be a function of the
divergence of actual inflation from target inflation and the divergence of actual GDP
from potential GDP:
Target Rate = Neutral Rate + ά (GDPe − GDPt) + ά (πe − πt)
Where:
Target rate is the short-term interest rate which the central bank should target;
Neutral rate is the short-term interest rate that prevails when the difference between
the actual rate of inflation and target rate of inflation and difference between expected
GDP growth rate and long-term growth rate in GDP are both zero;
GDPe is expected GDP growth rate;
GDPt is long-term GDP growth rate;
πe is expected inflation rate; and
πt is target inflation rate
empirically it has been found to closely describe many CB’s policies over considerable
periods of time

3- Monetary Operations

Monetary Operations- the actions a CB can take to affect operating and intermediate targets
and achieve its final target-can be either Administrative Tools (direct tools) or Market Tools
(indirect tools). Additional macro-prudential and counter-cyclical tools have found (renewed)
use since 2008. In developed economies market tools are used almost exclusively, with
administrative tools used only in emergencies9 or in less developed economies. see diagram 3.

9
For example, Wage and price controls were used in Israel in 1985 as part of the Stabilization Plan, and in
the US in 1974 during the Vietnam War/Inflation surge (but were quickly abandoned); Interest rate
ceilings in the US- Regulation Q- were totally eliminated in 1986.
 Diagram 3: Monetary Tools

ADMINISTRATIVE TOOLS MARKET TOOLS ADDITIONAL TOOLS

•WAGE/PRICE CONTROLS •RESERVE REQUIREMENTS •CAPITAL REQUIREMENTS

•CREDIT CEILINGS •STANDING FACILITIES •COUNTER-CYCLICAL CAPITAL
•INTEREST RATE •DEPOSIT FACILITY REQUIREMENTS
CEILINGS/FLOORS •LENDING FACILITY •LEVERAGE RATIOS
•DIRECTED CREDIT •OPEN MARKET •LTV REQUIREMENTS
OPERATIONS •GENERAL AND SPECIFIC
•DIRECT SALES OR PROVISIONS
PURCHASE OF SECURITIES •QE
•REPO •FORWARD GUIDANCE
•DEPOSIT OR LENDING •LIQUIDITY COVERAGE
AUCTIONS RATION
•CB BILLS •NET STABLE FUNDING
•FX OPERATIONS RATIO
•OUTRIGHT
•SWAP

Market tools are used to affect to affect operating and intermediate targets. The operating
targets can be either

• Quantities
• Interest rates
• Exchange rates

If the CB has a quantity target (monetary or credit aggregates) than the prices (i or er) become
endogenous; if it is targeting a price, then quantities become endogenous. Targeting the
quantity of money was common in the 1980’s but became problematic since it requires stability
of money demand and the multiplier, which could not be assumed in an era of rapid
technological change and financial innovation. Therefore, most central banks target short term
interest rates, with a “nod and wink” towards exchange rates. Quantity targets are in use in
lessor developed countries where financial markets are not efficient and interest rates do not
have a predictable impact on economic activity.

The Policy Interest Rate -The accepted and most widespread practice is to establish a policy
rate10 (‘official rate”) as the operating target, and use market tools to maintain that rate. This is
usually done by adding or absorbing reserves to or from the banking system, thereby lowering

10
Often known as the base rate, CB rate, Fed Funds rate (in the U.S.) etc.
or raising the interest rates at which banks lend to one another. The policy rate is best thought
of as the marginal cost of funds between commercial banks, which becomes the benchmark for
determining other short- term rates. These short -term rates then affect other financial and
economic variables in the desired direction to achieve the final target. See Diagram 4.

Diagram 4: Short -term Interest Rate Transmission

Market Tools - The following market tools are used by CBs in managing the policy rate.

Reserve requirements: commercial banks are required to deposit a percentage of liabilities11

(the reserve ratio) at the central bank. The ratio can be standard or differ by maturity, type and
currency of liability. They can be remunerated or unremunerated. Banks can have excess
reserves with the CB: however, a deficit in reserves is a major infraction and usually heavily
fined. RRs originally had a significant prudential role, but today are primarily monetary
instruments. They are only infrequently changed and are not an active tool; some banks have
reduced the RR to zero on all or some liabilities.

11
Usually only deposits, with the RR declining as the term of the deposit lengthens. RRs have at times,
infrequently, been imposed on commercial bank assets (loans) and even derivatives.
Standing Facilities are continuously available operations initiated by the commercial bank.

o Deposit facility, where commercial banks can deposit excess funds with the CB
o Borrowing (“Lombard” or Discount window) where commercial banks can
borrow from the CB.

The deposit facility will have an interest rate below the policy rate and the borrowing facility a
rate above the policy rate (usually symmetric but not always); they are usually one-day
“overnight” facilities. They establish upper and lower limits (corridor) for interbank interest
rates. They are usually changed along with the policy rate but can also be changed
independently, sometimes for signaling purposes. They also play a role in the functioning of
payment systems. Banks sometimes refrain from using the Lombard facility so as not to indicate
liquidity shortages.

Open Market Operations are operations initiated by the CB, usually in the secondary market but
sometimes in the primary market. To be effective they need relatively developed and efficient
markets (in securities and FX). In developed countries, they are the primary means of
implementing monetary policy, and can be used for “fine-tuning” the policy rate.

o Outright purchase or sales of securities absorb or add reserves permanently

o Repo (and reverse repos) absorb or add reserves temporarily (for the duration
of the transaction)
o Deposit and lending auctions absorb or add reserves. They can be done in
different terms and varying frequencies, and can be single price or multiple
price auctions
o Central Bank Bill issuance – the CB can issue its own securities, absorbing
reserves until they mature. They are usually somewhat longer term, from one to
52 weeks. They are frequently used to manage a “structural liquidity surplus”.
o FX operations can but do not necessarily affect the ER. Ceteris Paribus they will
affect the quantity of reserves in the system. They are frequently used where
money markets are not well developed and it is difficult to use other OMOs.
▪ Outright Sales or purchase of FX 12 absorb or add reserves permanently,
in addition to their effect on the ER. See Diagram 5
▪ Swaps absorb or add reserves temporarily. They do not affect the ER
and are purely a funding transaction, similar to repo.

12
Spot or forward
 Diagram 5: Exchange Rate Transmission

Additional (“unconventional”) tools

The great recession and financial crisis of 2008 created a need for additional, sometimes
unconventional, tools to implement monetary policy. Three factors were most compelling:

• The unprecedented reduction of interest rates to zero or even negative (zero interest
rate policy or bound), eliminating any further use of policy rates;
• Restraints on use of fiscal policy due to debt constraints and imposed austerity
• Persistence of below target inflation rates in the face of conventional steps

Some of these tools had been used for prudential or macro-prudential purposes, but were now
accorded a supporting role in monops; others were purely monetary in nature.

Capital requirements, the amount of capital commercial banks must hold against risky
assets, are primarily a prudential tool ensuring bank stability. Since they influence the
amount and type of credit banks extend, they have a monetary role as well. Differential
capital requirements, for example on real estate lending, have been used to manage
aggregate demand and in that way become a monetary tool.

Counter-cyclical capital requirements calibrate capital requirements with the business

cycle: they increase during upswings, building up banks’ capital, which can be used to
cushion banking activity during downturns. They are thus used to manage the business
cycle, along with other monetary tools.
 Leverage ratios limit the absolute amount of debt banks can assume, regardless of risk
weights, providing another limit on credit expansion.

Loan-to-value (LTV) regulations also limit credit expansion; along with provisioning, they
essentially provide the CB with a method of influencing interest rates in a more granular
fashion, rather than overall interest rates affecting all sectors as conventional monops
do.

Provisions are funds the bank must set aside to cover possible loan losses. General
provisions restrict credit extension uniformly, whereas specific provisions can restrict
lending to specific sectors, i.e. real estate.

Quantitative expansion was introduced when central banks hit the zero-interest rate
bound. Unable or unwilling to push short term rates lower, they began to directly
influence the yield curve by purchasing longer term securities, usually but not
exclusively government bonds. They also targeted specific sectors, such as mortgage
backed securities in the U.S. to spur the housing sector.

Forward Guidance- In addition to keeping short-term rates low, CBs pronounced their
intention of keeping them low for prolonged periods, thus reducing uncertainty and
presumably providing a spur to investment and consumption.

Liquidity Coverage Ratio and Net Stable Funding Ratio13 are rules proposed (but not yet
in force) to ensure that banks have adequate liquidity to meet all their liabilities under
reasonable circumstances. Although they have not been used as monetary tools, they
will affect monops and might eventually become explicit tools of monetary policy.

Supporting Elements

Transparency and Communication

CB policy transparency14 and communication policy are today seen as being a key part of
successful operations. Public understanding of CB goals and operations reinforce their
effectiveness, promote stability and strengthen CB credibility, an essential component of
successful policy. CBs devote considerable efforts to explaining their stance and actions-
pronouncements, speeches, press conferences, seminars and press releases.

Liquidity forecasting and management. CBs use their market tools to establish the policy interest
rate; the link between the tools and the policy rate is provided by liquidity management.
Commercial banks must maintain required reserves, the CB needs to ensure that systemic

13
Basel III principles
14
This is in sharp distinction to the traditional approach which was common until fairly recently which
emphasized secrecy and “surprises”.
liquidity- the total amount of reserves available to the banking system- is adequate, and that the
marginal rate at which banks can obtain reserves is the policy rate.

The CB estimates (liquidity forecasting) the amount of required reserves needed and available
during the relevant period15. The quantity of reserves is affected by several factors, primarily the
government budget and its funding, but also by the amount of cash in circulation. The CB then
uses its tools to add or withdraw reserves, so that the amount available to the banking system is
at equilibrium at the policy rate. Commercial banks undertake their own liquidity forecasting,
and manage their liquidity to maintain the desired level of reserves.

Intra-day liquidity is needed to ensure the smooth functioning of payment systems. Especially in
real time gross settlement systems (RTGS) in wide use today, gridlock can result from a “first
mover” problem. Properly managed, intra-day liquidity should have no monetary impact.

Collateral-Almost all central bank lending is fully secured, either by law or by practice. Required
collateral is of a high standard usually government securities, with a haircut as additional
security.

Emergency Liquidity Assistance (ELA) is extended by a CB to a bank experiencing temporary

liquidity difficulties. The CB acts as “market -maker of last resort”. Although this is undertaken as
a step to ensure banking stability, it has monetary consequences. It is usually extended outside
the framework of regular monops. Again all lending is against collateral, although the standards
might be relaxed in this case.

Lender of Last Resort (LOLR) is a key function of central banks, in their role of ensuring bank and
payment system stability. The CB acts as a LOLR for banks which are solvent but illiquid. Lending
is against collateral and at a penalty interest rate.16

Cost of Monetary Operations and Sterilization

Implementing monetary policy has costs and can be very expensive. This is especially the case
when the CB is pursuing a disinflationary policy and when there is a structural liquidity surplus17,
conditions which frequently coincide. Sterilization refers to the “mopping up” of excess liquidity,
a result of government deficit spending or the CB’s own activities, for example FX intervention.

The central bank must raise domestic interest rates to lower inflation and absorb excess
liquidity; the CB will usually be paying a higher interest rate on its liabilities (in domestic
currency) than it earns on its assets (usually low-yielding government bonds in domestic
currency or low interest rate foreign exchange reserves.) Even when the CB pays a lower
interest rate on its domestic currency than it earns on foreign currency, (i.e. Switzerland and
recently Israel), this does not consider ER revaluations or the risks they incur in their FX
portfolios. Many CBs essentially have enormous currency risks in their balance sheets: their

15
There are various methods of computing RR, usually averaging over a given period, on either a lagged or
cotemporaneous basis.
16
Insolvent banks are dealt with in other ways, (bank resolution) which should have fiscal implications
rather than monetary effects.
17
A long-lasting excess of systemic liquidity in domestic currency, usually a result of accumulated
government deficit spending and/or purchase of foreign exchange by the CB.
liabilities are mainly in domestic currency, while the bulk of their assets are in foreign currency-
a huge mismatch.

Monetary Operations in Theory and in Practice

In practice, CB’s act in a variety of ways, employing different mixes and combinations of tools at
different times and in different intensities and frequency. The operating policy of the CB will
always consider the structure of the economy, the level of development of the banking system
and financial markets, available technology, and the infrastructure, physical and human. The
international environment is increasingly important, as well as social concerns.

The prevailing practice today is simple and elegant in theory if not always in practice:

• The CB maintains inflation at the target18 by using its monetary tools to raise and
lower the policy interest rate19:
• When inflation is too high and/or the economy is overheating, higher policy rates
raise market interest rates, appreciate the currency and lower asset prices. This
reduces demand and investment, slowing the economy, reducing inflationary
expectations and actual inflation.
• Conversely, when inflation is too low and or the economy is operating under
capacity20, lower policy interest rates lead to lower market rates, a depreciating
currency and higher asset prices, which should increase demand and investment,
stimulate the economy, and raise expected and actual inflation.
• The CB injects or absorbs liquidity using its OMOs. Ideally, the system should have
adequate reserves or be slightly short of reserves. If there is a structural deficit or
surplus, the CB uses longer term instruments (CB Bills, longer term auctions,
swaps, outright OMOs) to bring the system near balance. The CB can then use
short term instruments (repo, short term auctions) to “fine tune” the policy rate
and bring it quickly to the stable desired level.
• Standing facilities signal an acceptable range for the policy rate, and absorb
temporary fluctuations. When there is a need to adjust systemic liquidity, due to
structural changes, behavioral changes, or government activity, permanent
reserves can be added or removed using outright transactions. Reserve
requirements are infrequently changed, since their impact is dependent on
unstable functions such as the velocity of money and the money multiplier.
• CBs have a variety of methods to intensify policy moves or signal policy changes:
Larger than standard policy steps; unusual timing (“inter-meeting decisions”) of
steps; communication (“open mouth operations”).

18
Usually a range, sometimes a point or ceiling
19
As already mentioned, in some LDCs quantities (money or credit) are the operating and/or intermediate
targets, due to the lack of market development, but this is viewed as inferior to the use of a policy interest
rate.
20
i.e. a recession or high unemployment
 • Most CBs will use a combination of tools to implement policy. Moreover, CBs can
use tools operating in different directions, expansionary and contractionary,
simultaneously21.

In actual practice, it is not so simple.

• There is a lack of information concerning the state of the economy and lags (and lack of
reliability) in data
• Measures of inflation differ and can be inaccurate.
• There is uncertainty regarding the impact of monetary tools.
• Behavior of economic agents is unpredictable and unstable.
• It is difficult to differentiate between structural and cyclical changes.
• Fluctuations in inflation rates can be either one-off adjustments or changes in trend.
• The response to causes of inflation might be differential, i.e. administered prices, taxes,
imported inflation.
• There are variable lags in the impact of monetary tools.
• Although inflation is the target, the impact of monetary policy on other factors must be
considered: the exchange rate, employment, output, asset prices.
• There is a preference for “smoothing” interest rate changes, and avoiding unnecessary
volatility in the markets.
• Exogenous factors are not under CB influence: foreign monetary policy, trade
developments, commodity prices, “imported inflation”.
• Technological and political changes can alter reaction functions.
• There is always “event risk”: economic, political, financial, geo-political.
• Financial stability is a binding constraint.

The current situation illustrates this well.

• The international environment of ultra-low interest rates and expansive monetary

policies restrain any one CB from deviating too far from prevailing policies, lest it
provoke an extreme reaction.
• Extremely expansionary monetary policy has led to competitive depreciations
(“currency wars”).
• ZIRB has essentially eliminated any further use of lowering policy interest rates as a
stimulus.
• Adjusting system reserves is a-symmetric: absorbing reserves will almost always be
restrictive, but adding reserves is not always a stimulus: they can lay idle.22
• There is a concern that ZIRP is distorting risk premiums and causing asset price inflation-
financial assets everywhere, real estate in Israel, Canada, New Zealand.

21
For example, the ECB simultaneously adding long-term reserves while withdrawing them in the short-
term; BOI raising domestic interest rates while intervening to weaken the domestic currency, 2009.
22
This is called the “pushing on a string” problem.
 4- Management of Foreign Exchange Reserves

The Uses of Reserves

Foreign exchange reserves are held for many purposes:

o Backing the national currency: not common today, but was in the past (gold
standard); still is in the case of currency boards
o Self- insurance -liquid national savings available in the case of emergency:
natural disaster, war, unexpected short-fall of export earnings, seasonal
shortfalls of FX (commodity dependent countries)
o Monetary policy: As a monetary tool, especially for managing the exchange rate
o Crisis prevention and mitigation
o Additional benefits: Support financial stability; improve credit rating
The Framework

o Institutional: Reserves are almost always managed by the CB, sometimes with
an advisory or oversight roleof the MoF. Organizationally they are either
managed along with the monetary/markets unit of the CB, or in an independent
unit, which is becoming more common as they have increased in size. They
should always be segregated from other state assets 23, as they have distinct
roles and management needs.
o Actual reserve holdings could be supplemented and or replaced by of other
sources of liquidity: other assets such as SWFs or liabilities such as increased
government borrowing, central bank swap lines, or borrowing from the IMF,
contingent credit lines from banks. However, these cannot provide the
immediacy, control and unconditionality of reserves.
o Legal: Although managed by the CB and on the CB’s balance sheet, ownership is
usually the government. Therefore, profits usually are transferred to the
government, although exact arrangements vary considerably.
o Investment: Traditionally, as they are public funds and need to be immediately
available, the priorities have been24
▪ Safety (preservation of principle)
▪ Liquidity
▪ Return
o However, as they have increased in size, both absolute and relative, a higher
priority has been placed on earning a reasonable return, r necessitating some
reduction in liquidity and safety. As a result, the almost exclusive use of low risk
assets (government securities, prime bank deposits, gold25) has expanded to
include equity, corporate debt, and derivatives.

Optimal Reserves; Reserve Adequacy

Academic literature has tried to identify an optimal level of reserves, with little success
and even less real -world applicability. Therefore, most efforts seek to identify an adequate level
of reserves as an analytical and policy tool.

o Rules of thumb are widely used to assess adequacy and make cross country and
intertemporal comparisons:
▪ Months of import cover (3 as a minimum, 6 preferred)

23
Sovereign Wealth Funds, Commodity stabilization funds, future generation funds, pension funds.
24
Or, as has been stated, “The Art of Reserve Management is Avoiding the Unacceptable Loss”
25
Gold is not actually a low risk asset, but is considered a reserve asset.
 ▪ Coverage of short term external debt26
▪ Coverage of Banking system FX liabilities
▪ Coverage of broad money- M2
▪ Percentage of GDP
▪ Reserves per capita
o Models: Attempts have been made to develop formal models as well
▪ Demand models are empirical regression models with precautionary
factors as the independent variables
▪ Cost benefit models attempt to identify tradeoffs
▪ Generalized equilibrium models/utility maximization models based on
welfare losses due to crisis, loss in output and consumption,
opportunity costs and risk aversion
o The IMF has developed a “Reserve Adequacy Metric”27 which considers
▪ Export earnings
▪ Liability shocks- short term debt
▪ Liability shocks -medium/long term debt and equity
▪ Capital flight risk- broad money
▪ Country specific adjustments for Ems and Capital control measures
o Benchmarks can be used to assess adequacy:
▪ Market based benchmarks such as Credit Default Swap (CDS) rates,
sovereign bond spreads
▪ Peer comparison to similar countries
▪ Scenario analysis to assess outcomes in different stress situations
▪ Subjective assessments such as analysts’ views, rating agency
recommendations, IMF Article IV reports

Reserve Currencies

o There were Approximately USD 10.8 trillion dollars of official reserves 28at year-
end 2016, 92% of which were in FX and 8% in gold. Reserves have grown rapidly
this century, increasing approximately 200% since 2004 and 60% since 2008, but
have leveled off since 2013.
o The largest holders of reserves are
▪ China -$3,520.4
▪ Japan-$1,321
▪ Euro Area-$819.9
▪ Switzerland-$661.2
▪ Saudi Arabia-$580.7

26
The Guidotti-Greenspan rule
27
See: http://www.imf.org/external/datamapper/ARA/index.html
28
Not including IMF assets such as the SDR and quotas, which would add about 3%
 o There is no formal definition of a reserve currency, but it must be widely used,
liquid, stable, convertible have large and efficient capital markets, and have the
backing of a stable country with reliable governance, laws, and enforcement.
o The US dollar is the preeminent reserve currency, with a stable share29 of two
thirds of all reserves since the advent of floating exchange rates. About one
quarter are in Euro, 5% in Sterling, and 3% in Yen
o The growth of reserves has led to further diversification, with less than 1% each
in Swiss Francs, Canadian dollars, Australian dollars, and Renminbi (and trace
amounts in Shekels). See Diagram 6
o The currency composition of reserves is the major source of financial risk in
most reserve portfolios. The largest risk is unavoidable: the mismatch between
the domestic currency and the foreign currencies in which reserves are held.
o The composition of foreign currencies held is typically the largest determinant
of the return on the portfolio. Rather than maximizing returns, most
management is concerned with reducing risk. Approaches include
▪ Matching FX liabilities
▪ Holding a basket of currencies (SDR, the market portfolio)
▪ Matching uses (imports, capital flows)
▪ Synthesizing the domestic currency

Diagram 6: Currency Composition of International Reserves

• Gold is the only non- currency asset in reserves. Its share has declined
substantially over time, and currently varies mostly as a result of price changes.
Its role in reserves is traditional but controversial.

29
Figures are approximate, since some countries (China) do not divulge data.
Asset Allocation

o Until recently reserve assets were invested in only the most liquid, lowest risk
assets available- short term government bonds and bank deposits30. The growth
in reserves allowed reserve managers to add riskier and less liquid assets.
o The low interest rate environment was another incentive to seek higher returns
by moving out of traditional assets. In addition, modern portfolio theory had an
impact as a new generation of reserve managers moved into decision making
positions.
o Reserve portfolios now include equities; asset backed securities; longer term
government bonds; corporate bonds and agency bonds and derivatives. See
Appendix 2
o Risk is controlled and performance measured and evaluated by using
benchmarks: broad market indices or custom-made blends of indexes. Returns
are disaggregated into market (passive) and active (manager contribution)
components. CBs also utilize external managers in various capacities.

Risk Management

Actual reserve portfolio management is to a large extent concerned with risk measurement and
assessment. The major risks include financial or market risk; operational risk and other risks.

o Financial risks include:

▪ Credit risk- controlled by ratings, limits and quotas; trading and
settlement restrictions
▪ Currency – controlled by diversification and neutral compositions
▪ Interest rate risk -controlled by duration and convexity limits
▪ Spread or asset specific risks-controlled by benchmark deviation limits,
partial duration
▪ At the portfolio level, various aggregate risk measures are employed:
VaR, CoVar, stress testing; scenario analysis, shortfall and drawdown;
factor analysis.

o Operational risks – every financial process carries numerous operational risks.

The large amounts involved in reserve management and the sensitivity of CBs
requires them to deal rigorously with potential operational risks. These include
errors; unauthorized activity; ethical infractions; business disruptions.
▪ Strict guidelines, rules, operating manuals
▪ Strict selection, scanning and screening of staff
▪ Constant controls and auditing in concentric levels
▪ Separation of functions; multiple authorizations

30
Deposits in commercial banks are, for obvious reasons, no longer considered low-risk assets, and their
role in reserves management has declined.
 ▪ System and Data backups and alternative sites
▪ Cyber-security
▪ Disaster recovery plans and exercises.

o Legal risks must be managed. In addition to the legal issues involving any
financial transaction, the status of central banks and the inherently cross-border
nature of reserve management raises additional concerns. CBs seek to protect
their assets with the same level of sovereign immunity that governments enjoy.
This is sometimes granted de jure but not universally. Questions of applicability
of sanctions and or boycotts have been raised regarding CB ownership of assets.

o Other- Tax issues must be addressed. The management of reserves can

sometimes become a sensitive issue in terms of diplomatic relationships.

Costs and Benefits.

o The central bank carries the reserves on its balance sheet; any losses
will reduce CB capital. As already mentioned the implementation of monetary
policy will often be costly, sometimes extremely so. In addition to the current
costs recorded in the P&L, there will often be large unrealized losses due to
revaluation accounts (the currency mismatch). Views differ as to the importance
of these “accounting” losses.
o The economy might also bear costs. Insofar as there are losses by the
central bank, they will eventually impact the government budget in one form or
another (the “quasi-fiscal deficit”). Another possibly greater concern is the
opportunity cost of holding reserves. Resources are held and invested abroad,
rather than in the domestic economy, where they could likely generate much
higher returns – in infrastructure, education, etc.
o Of course, the economy also benefits from holding reserves- and more
importantly, avoids the very high cost of holding insufficient reserves. Some
benefits are somewhat measurable, such as a higher credit rating and lower
borrowing costs31. Others are more difficult to quantify, such as avoiding crisis
and mitigating damage from crises that occur, or reduced risk due to the
insurance aspect of holding reserves.
o In a certain sense, it can be said that the costs are borne by the CB, while the
benefits go to the entire economy.

31
And possibly improved growth, output, and employment due to better monetary and ER management.
 Appendix 1: Monetary Operations at the Bank of Israel

FRAMEWORK

• The Government sets the inflation target (currently 1-3% p.a.)

• Eight times a year the BOI announces its policy interest rate32, and estimates demand
for the monetary base.
• The BOI estimates liquidity needs for the coming month and plans monetary operations
accordingly.
• The BOI meets this demand with a variety of monetary instruments.

THE OPERATING TARGET

• Changes in the monetary base come from two sources:

• Government monetary injections;
• BOI injections.
• BOI plans its operations so that the demanded change to the monetary base is provided
at an interest rate that is as close as possible to its policy rate.
• The operating target is for the system to have small Net Free Reserves (NFR) at the
policy rate: ER-BR=RR-NBR=NFR

FACTORS AFFECTING BASE MONEY

• Change in government deposits33 - injection/absorption:

• Domestic payments (salaries, benefits etc.);
• Tax collection; autonomous factors
• Redemption / Issue of government bonds ;
• Privatizations.

• Injection/absorption by BOI:
• Use of Monetary instruments ; monetary tools
• foreign currency purchases/sales;
• Redemption / Issue of Makam (central bank bills) ;

Monetary Policy Implementation – Decision Making Process

32
0.10% since early 2015
33
all government deposits are held with the BOI
Monetary Operations– Decision Making Process

TOOLS

Reserve Requirements

• Reserve Requirements oblige the banks to deposit with the BOI a certain proportion of
the money deposited with them by the public.
• The reserve ratio:
• Cash balances - 6%;
• Deposits – one week till one year - 3%;
• Deposits over one year - 0%.
• BOI does not pay interest on required reserves.
 • There are identical ratios for FX Deposits.
• Maintenance period: 7-8 weeks;
• BOI key rate announcement - 2 days before the end of the maintenance period;
• Averaging mechanism for required reserves over the maintenance period;
• Penalty rate - BOI key interest rate + 4%.

Main instrument: Monetary auctions

• (daily & weekly, discriminatory auctions):

o Monetary Loans auction - minimum bid rate (against eligible collateral);
o Monetary Deposits auction - maximum bid rate;
• The type of the auction depends on the banking system liquidity needs (surplus/deficit);
• Repo auctions;
• Loan & Deposit window: deposit window 0.0%, lending Window 0.2%
• Makam (Central Bank bills).

Collateral

• Eligible for all credits:

o Government bonds;
o Makam;
o Deposits with the BOI (NIS & foreign exchange).

The portfolio of collateral is marked to market on a daily basis.

Hair-cuts:

• Government bonds and Makam: 2%-8%.

• NIS deposits: 0%.
• FX deposits: 5%.
 CURRENT USE OF TOOLS

Current Tools: MAKAM ₪ 98 + Deposits ₪ 172 =₪ 270 billion ≈

$ 76 billion absorbed
At policy rate of 0.10%

The Banking Corporations' Monetary Deposits and their

Costs, 2017c
Deposits in the Bank of Cost of deposits in the
Israel, NIS million Bank of Israela, percent
Period Monthly Weekly Daily Total Monthly Weekly Daily Total b
26/01/2017-01/03/2017 35,000 63,000 62,787 160,787 0.11 0.10 0.10 0.10
02/03/2017-12/04/2017 35,000 63,333 74,596 172,929 0.11 0.10 0.10 0.10
13/04/2017-31/05/2017 35,000 65,000 72,809 172,809 0.10 0.10 0.10 0.10
a Effective nominal interest rate
b Weighted by quantity
c. The periods presented in this table are according to the liquidity periods that are consistent with the Bank of
Israel interest rate announcements.
SOURCE: Bank of Israel,
Information and Statistics
Department.
 Bank of Israel * Information & Statistics Department *
Banking, Capital Market and Insurance Unit

Makam Balances: 29/06/2017

(NIS million, face value)

Date of Days to
Series maturity maturity Held by public

717 7/5/2017 5 11,000.0

817 8/3/2017 34 11,000.0
917 9/6/2017 68 11,000.0
1017 10/4/2017 96 9,000.0
1127 11/8/2017 131 7,000.0
1217 12/6/2017 159 7,000.0
118 1/3/2018 187 7,000.0
218 2/7/2018 222 7,000.0
318 3/7/2018 250 7,000.0
428 4/11/2018 285 7,000.0
518 5/2/2018 306 7,000.0
618 6/6/2018 341 7,000.0
Total 98,000.0
SOURCE: Bank of Israel Information & Statistics
Department

Makam closing data for 7/11/2017

Days to Closing Yield Closing Price

Series
maturity (Percent)

0817 22.00 0.17 99.99

0917 56.00 0.13 99.98

1017 84.00 0.09 99.98

1127 119.00 0.12 99.96

1217 147.00 0.12 99.95

0118 175.00 0.08 99.96

0218 210.00 0.10 99.94

 0318 238.00 0.09 99.94

0428 273.00 0.12 99.91

0518 294.00 0.11 99.91

0618 329.00 0.13 99.88

0718 357.00 0.12 99.88

Appendix 2: Asset Allocation of International Reserves

Source: IMF Working Paper 13/99 Survey of Reserve Managers: Lessons from The Crisis, Aideen Morahan
and Christian Mulder

Note: AC= Advanced Country, MIC= Middle Income Country, LIC= Low Income Country
Appendix 3: History of International Currencies
 Appendix 4: Abbreviations
CB Central Bank
ECB European Central Bank
EM Emerging Market (country)
ER or er Exchange Rate
FX Foreign Exchange
GDP Gross Domestic Product
i interest rate
IT Inflation Targeting
LCR Liquidity Coverage Ratio
LDC Less Developed Country
LTV Loan to Value (ratio)
MOF Ministry of Finance
Monops Monetary operations
Monpol Monetary policy
NSFR Net Stable Funding Ratio
OMO Open Market Operations
P&L Profit and Loss statement
RR Reserve Requirements
ZIRB Zero Interest Rate Bound
ZIRP Zero Interest Rate Policy