Appendix V. Selected Country Experiences with Interbank Market Development

Bernard Laurens
Published Date:
December 2005
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The experiences of India, Italy, Korea, Thailand, and Turkey are analyzed regarding the involvement of the central bank in the process, participants in the interbank market, and the degree of centralization of the interbank market.1

Involvement of the Central Bank

The development of the interbank market is a stage-by-stage process and the experience of Italy, Korea, Thailand, and Turkey show that the central bank can play an active role in using the interbank market as a “playground” where monetary policy operations can be conducted and in which it could become an important player.

In Turkey, in the 1980s the banking system was highly segmented, with public banks reluctant to lend to private banks, in part because of political considerations. Similarly, private banks tended to minimize their transactions with other commercial banks for competitive reasons, in a context where many of them belonged to different industrial groups. Competition and rivalry among industrial groups often made their banks reluctant to deal with each other directly. As a result, activity in the interbank market was very limited. However, banks were willing to participate if the central bank was the counterpart. This situation prompted the central bank to develop a framework for an interbank market in which it acted as a blind broker, that is, as the counterpart of all transactions; it operated as a broker in that it borrowed only when it could on lend the proceeds at the same interest rate. In order to cover the credit risk, all transactions intermediated by the central bank had to be backed by acceptable collateral, such as government securities.

In Thailand, a repurchase market with the central bank was created in 1979, with a view to further developing the fledging money market and provide the central bank with a mechanism to monitor and, if necessary, to intervene in the market. Participants were allowed to place buy and sell orders with the central bank, indicating the amount, interest rate, and maturity of the desired transactions. Then, the central bank tried to match the orders and determine a single “market” repurchase rate (that is, a fixing). If needed, the central bank intervened to absorb or inject liquidity.

In Italy, although an over-the-counter interbank market was operating for a long time, the central bank was prompted to take action because oligopolistic behavior led to segmentation of the market. Also, the subsequent excessive volatility of the market was an impediment to using interest rates as a channel of transmission for monetary policy. In 1990, the central bank promoted the establishment of a screen-based interbank market, participation in which was on a voluntary basis. This was accompanied by a modernization of the payment system, enabling real-time and direct movement of funds on banks’ centralized accounts with the central bank.

In Korea, in the late 1980s, the central bank promoted the establishment of brokers and dealers for call transactions in order to enhance the adjustment function of the interbank market and break the segmentation of the existing call market between bank and nonbank financial institutions (NBFIs).

Participants in the Interbank Market

The interbank market is the segment of the money market where financial institutions can trade their deposits held at the central bank. Consequently, participation in the interbank market is generally confined to financial institutions with a current account at the central bank, and it may or may not include NBFIs, depending on whether or not they are authorized to maintain current accounts with the central bank. In Korea, however, although NBFIs did not maintain a settlement account with the central bank, they were allowed to participate in the interbank market. While participation of NBFIs could have contributed to enhancing market liquidity, eventually it resulted in market segmentation because of differences in the pattern of transaction behavior. The integration of the interbank market with the over-the-counter market among NBFIs was eventually achieved at the end of the 1980s, with the nomination of brokers and dealers for call transactions as mentioned above.

In India, the call money market was predominantly an interbank market until 1990. The Reserve Bank’s policy relating to entry into the call money market was gradually liberalized to widen participation and provide more liquidity. In particular, entities that could provide evidence of surplus funds were permitted to route their lending through Primary Dealers (PDs). The minimum size of operations for routing transactions was also gradually reduced in order to increase the number of participants. In this context, banks and PDs are operating as both lenders and borrowers, while a large number of financial institutions and mutual funds are operating only as lenders. In May 2001, the central bank started phasing out his participation in the call market. The move has been made to develop a pure interbank call money market and to facilitate a further deepening of the term money market.

Degree of Centralization of the Interbank Market

Although central banks play a catalytic role in interbank market development, typically they do not intend to centralize transactions on their books. When that occurs, as in the case of Turkey with the establishment of the “official” interbank market intermediated by the central bank, direct transactions among banks should be permitted. Moreover, the establishment of a centralized interbank market in Turkey was seen only as a temporary arrangement to “educate” participants and thus facilitate direct transactions. In the case of Italy, participation in the centralized market was on a voluntary basis, and the market operated outside the central bank, which only provided settlement arrangements in support of market transactions.

Prepared by Bernard Laurens, based on Mehran, Laurens, and Quintyn (1995) for Italy, Korea, Thailand, and Turkey; and Reddy (1999) for India.

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