Open Market Operations against Interbank Discount Rate

Bank reserves are predetermined quantities of unreleased currency deposits made by clients. These are kept for the sake of possible lump sum withdrawals, ensuring that the bank is always adequately set. Interbank rates can be used to facilitate short-term borrowing and lending between commercial banks (Martin and Mila’s 2012). Banks with higher necessary reserves are less likely to suffer during a financial crisis and are more likely to benefit from lending during such a crisis. Market reserves for banks in the sector characterize commercial banks’ borrowing and lending interactions, as well as the dynamics that influence them. This market is highly dynamic as the inter bank rate can change as often as on a daily basis (Martin and Milas, 2012). The LIBOR for instance, is determined every day. Open Market Operations allow free market forces to take charge of the lending and borrowing process. On the other hand, discount rates are introduced by the Central Bank to aid desperate situations and require care maneuvering by commercial banks.

Market Reserves

Since the financial markets are driven by the need to control money supply in the economy through monetary policy, bank reserves are extremely important tools to maintain operation. Liquidity is a crucial basis for operation both for functionality and as a legal requirement by regulators. The basis of all bank lending and borrowing aims at controlling the economy. Such control and regulation flows from the Central Bank to commercial banks and the economy as a whole (Breeden and Letzenberger, 2014). Central banks take advantage of interest rates such as the Federal fund rate to control the amount of money in the economy (Mc Andrews et al., 2016). They achieve this by determining purchases and sale of government securities. Such sale and purchasing occurs through open market operations. In this market operation, it is possible to salvage a financial crisis by manipulating existing forces. While most common and efficient monetary policy action, it is not as effective as maneuvering the discount rates.

Advantages of Discount Rates

The advantage of discount rates over OMOs, lies in the ability to act within shorter spans of time. Banks are in a better position to repay their loans better and faster when they have the option of a discount rate (Ihrig et al., 2015). It is also an incentive to plan more effectively seeing, as discount rates are not as impromptu and rigid as events of OMOs. OMOs are determined by predictable forces albeit unavoidability ones and can render a bank completely helpless during a financial crisis. Discounts on the other hand, allow banks to act swiftly as borrowers and are as profitable for lenders. Evidently, Open Market Operations leave banks no choice of actions, as available moves are limited for survival. In OMOs, the interbank rate is also prone to issues such as rigging. In 2015 for instance, a scandal unfolded with rigging of the LIBOR rate. It is an unfortunate event seeing as the amounts of money changing hands in such transactions range from $5 trillion and are also occasionally in billions. Moreover, this particular rate is responsible for almost seven currencies of which are among the most powerful ones in the economy (Martin and Milas 2012). The currencies that include the Euro, Swiss Franc, US Dollar, and Japanese Yen among others have a great impact on the global economy. Moreover, overnight rates greatly affect the forex market as well. For this reason, the interbank rate must be viewed as an extremely sensitive index. Even the slightest change in this rate translates into great economic repercussions through a ripple effect.

Open Market Operations

Opened Market Operations allow Central Banks to control rates of commercial banks through ensuring that they maintain control over bank reserves. In so doing, short-term interests are easier to manipulate (Butter 2007). Interbank interest rates are also determined by the Central Bank in the same manner. These rates are extremely important as they determine all other interest rates in the economy. The Federal fund rate determines home loan rates, mortgage, and car loan rates among all others. During an inflation in a financial crisis introduction of a contractionary monetary policy becomes necessary. In this, the Central Bank of a nation raises interest rates by selling government securities. Such a move causes loss of money in circulation into the Central Bank (Header et al., 2015). Interest rates atomically but become high with such action. In an expansionary monetary policy move, the Central Bank uses private bond dealers to purchase government securities. Through this, money is injected into the bank systems as payment is sent to bank accounts of organizations and individuals that sell these bonds. In such a manner, the Central Bank of a nation increase bank reserves for involved banks (Buter 2007). This all decreases interest rates on borrowing allowing money to flow from banks into the economy. Nevertheless, the primary focus of such an act is to ensure that banks maintain reasonable bank reserves.

The danger that stands in the event of lesser bank reserves is the risk if dysfunctionality in the event of a large withdrawal by clients. An excess in bank reserves is not common as banks normally maintain requested and excess reserves. Yet another risk is apparent in the event of a very large amount of excess bank reserves (Heifer et al., 2015). Banks would suffer loss where excess reserves are massive following the fact that these bear zero interest and are affected by inflation. For this reason, banks prefer to keep a minimum value of excess reserves. Interbank rates are indicators of the level of liquidity a bank holds. While it is risky to maintain higher excess reserves, these have proven beneficial to certain banks and may be considered in anticipation of a crisis (Goodfriend and McCallum, 2014). For lenders, during a financial crisis, discount rates encourage higher borrowing. The Central Bank of a country uses these rates to ensure a cash inflow in the banking system. A disadvantage of the discount rate is lower profits. Its purpose nevertheless, is not always to encourage profit making but to regulate rates through encouraging an increase in borrowing that reduces deflation.

Conclusion

Open Market Operations are extremely useful in the event of financial crisis. They are, nonetheless, too dynamic for critical situations and can lead banks into a corner as such. Financial crises such as the 2007 one were also partly because of Open Market Operations. Owing to the great importance of interbank rates, it is crucial to undertake the most certain way for success and in salvaging bank crises. The interbank rate is basis for bank liquidity and a form of security for its client by regulation. Banks must therefore always resort to the discount rate prior to awaiting the OMO in the event of financial crisis. Maneuvering this is likely to save them billions or even trillions of dollars.

Reference

Burter, W.H. (2007), Lessons from the 2007 Financial Crisis, CEPR Discussion Paper No. DP6596

Goodfriend, M. and McCallum, B.T., 2014. Banking and interest rates in monetary policy analysis: A quantitative exploration. Journal of Monetary Economics, 54(5), pp.1480-1507.

Heider, F., Hoerova, M. and Holthausen, C., 2015. Liquidity hoarding and interbank market rates: The role of counterparty risk. Journal of Financial Economics, 118(2), pp.336-354.

Ihrig, J.E., Meade, E.E. and Weinbach, G.C., 2015. Rewriting Monetary Policy 101: What’s the Fed’s Preferred Post-Crisis Approach to Raising Interest Rates?. The Journal of Economic Perspectives, 29(4), pp.177-198.

Martin, C. and Milas, C., 2012. Quantitative easing: a sceptical survey. Oxford Review of Economic Policy, 28(4), pp.750-764.