Money market transactions

76. The central bank influences short-term interest rates through its transactions in the money market, specifically the market for Treasury bills. The Bank places non-competitive bids at auctions of Treasury bills and offers two-way prices on the secondary market for such bills. This market is the most important channel for the Bank in terms of traded volume, both for outright purchases of Treasury bills and for the sale of such bills. The deposit money banks (DMBs) make use of this market to adjust their most liquid reserves and to maximize their earnings on liquidity. The central bank offers the DMBs reverse repos of Treasury bills at predetermined interest rates. Also available to the DMBs are certain central bank notes, but usually these play a negligible role. The Bank would only make the notes attractive if for some reason Treasury bills were to lose their importance for the conduct of monetary policy. The above-mentioned transactions of the central bank are seen as a way of influencing interest rates, but at the same time the Bank is either providing or absorbing liquidity. The Bank does not make a clear distinction between these two roles. By monitoring several monetary aggregates, the Bank makes its decisions about its bid and offer yields in the secondary market. Changes in the yields are often based on a judgement that the direction of the flow of liquidity should change.

Limits on discount and other credit facilities

77. The central bank provides the economy with liquidity through (a) the purchase of foreign exchange, (b) the purchase of Treasury bills and government bonds, and (c) by granting financial institutions some access to central bank financing. The last channel includes limited discount facilities at low interest rates and repurchase agreements (repos) at predetermined interest rates which are slightly higher than the discount rate. Treasury bills are the most common instrument in repos with the DMBs. There is no formal limit. The maturity in each case is 14 days. The central bank has also granted limited repo facilities to securities houses which have assumed the role of market-makers in government bonds, in which case such bonds serve as the underlying securities and the maturity is 30 days. The central bank provides no privileged credit for private or public borrowers. Until 1985, however, the Bank applied preferential rates when rediscounting loans which the banks had granted to certain business sectors.

Interest rates

78. Financial institutions can freely set all their interest rates. However, the central bank determines the so-called penalty interest rates on overdue payments according to a formula specified by law. There are no indications that interest rates are set by an agreement among financial institutions; such collusion is strictly forbidden by law. The large market share of a small number of banks may nevertheless have led to oligopolistic behaviour in the setting of bank rates.

Foreign exchange operations

79. The central bank may intervene in the foreign exchange market by buying or selling kronur so as to prevent the exchange rate from moving too far from the central rate. Since the fixed exchange rate policy was adopted, foreign exchange reserves have been adequate to maintain the exchange rate at the desired level. Government foreign borrowing has sometimes been helpful in supporting the reserve position, but is not used in any systematic way to regulate official reserves. The Central Bank follows a policy of maintaining reserves at three months’ value of merchandise imports, at a minimum. Iceland presently has a quota of SDR 85.3 million in the Fund. Since 1962, the Central Bank has been a party to an agreement between the Nordic central banks which consists of an exchange of credit lines, allowing each of the banks to draw on the others on a short-term basis in times of temporary foreign reserve shortage. According to the current agreement the Central Bank of Iceland can draw up to 200 million euro. In addition, the Central Bank has access to secured interbank lines for a total amount of US$275 million and unsecured interbank lines with a number of international banks. Existing credit facilities total $600–800 million.

Reserve requirements

80. Deposit money banks are subject to reserve requirements that can be fulfilled only via deposits in blocked accounts with the central bank. The base for the reserve requirement includes not only deposits but also DMBs’ bond issuance and other domestic liabilities. Since November 1993 the required reserve ratio has been lower for time deposits and outstanding bonds than for other liabilities. Prior to that no differentiation was made with regard to the type of liabilities. Marginal reserve ratios were applied in the 1960s and 1970s, but they have no relevance except when the (average) reserve ratio is being raised. Reserve ratios have been reduced sharply over the last decade at the same time as access to central bank financing by banks and the Treasury has also been reduced. Deposits on the required reserve account with the central bank have always been remunerated. There had also been a minimum liquidity ratio until March 1998, which was temporarily restored in February 1999. It is a secondary requirement that is fulfilled by holdings of cash, Treasury bills and free reserves as measured by an average during each month.

81. The development of monetary instruments has been gradual, but has moved toward arrangements that will improve financial markets. Credit ceilings were applied in the 1970s and early 1980s. Since the early 1980s, the Central Bank has not used direct or indirect quantitative controls on lending. The Bank’s instruments and facilities were mostly based on arrangements put in place in 1987 when the Bank began a gradual lowering of reserve requirements. However, a liquidity ratio was introduced and then raised to offset the declining reserve requirements. The liquidity ratio also served to induce the deposit money banks to hold treasury bills and other government paper as these assets could be used to satisfy the liquidity requirement. At the same time, the Central Bank began engaging in repurchase transactions in treasury bills with deposit banks as well as transacting in treasury bills on the Stock Exchange. These measures resulted from the Bank’s desire to support the development of the securities market and establish repo transactions in Iceland. Nonetheless, the arrangements were unnecessarily complicated in that they provided many routes for deposit money banks to secure liquidity from the Central Bank. This liberal access hampered the development of the interbank market for kronur as commercial and savings banks took advantage of the repo facility rather than approach each other for liquidity. Furthermore, the liquidity ratio gradually became ineffective as an instrument as deposit bank holdings of marketable securities rose. Many of the recent changes to monetary instruments, especially those in 1998, were intended to address these shortcomings.

82. Changes in the relationship between the Central Bank and the Treasury have also helped develop financial markets. Before 1992, the Treasury only sold bills on tap at a price decided by the Ministry of Finance. The Treasury started auctioning T-bills in 1992, and now regularly sells Treasury bills, Treasury notes and Government savings bonds at auctions. In the past, the Treasury also had unlimited access to a short-term overdraft facility with the Central Bank. Consequently, the Central Bank had a rather limited ability to influence short-term interest rates of commercial banks and savings banks. Following the 1992 agreement on Central Bank credit accommodation between the Government and the Central Bank, the Treasury meets all its borrowing needs in the financial market. As a result of this agreement, a significant money market has developed in only few years, the largest financial market in Iceland in terms of turnover. Interest rates on government securities are fully set by the market, and they now play a bigger role in the determination of general domestic interest rates. Through market operations, the ability of the central bank to influence short-term interest rates has been strengthened.

Overview of the recent changes:

84. On March 1, 1998, the following changes to monetary instruments took effect;

• The secondary liquidity requirement (liquidity ratio) was replaced with weekly auctions of such agreements.

• The maturity of repurchase agreements was extended from 10 to 14 days and weekly auctions replaced tap-availability. The number of securities eligible as collateral in repos was expanded to include all government guaranteed securities registered on the Stock Exchange. Central Bank CDS will continue to qualify as well.

• The tap-sale of 45 day Central Bank CDS was abolished but the Central Bank reserved the option to auction 14 days CDS on the weekly auction when it wishes to reduce liquidity. CDS of 90-day maturity will continue to be available on tap.

• An overnight facility was established in the Central Bank for credit institutions subject to reserve requirements. The same securities can serve as collateral for overnight loans as in repurchase agreements.

85. The second phase of the changes became effective on May 21, 1998 when the following changes were implemented;

• The reserve base was expanded, both in terms of coverage of institutions and types of liabilities.

• The discount quota of deposit money banks was abolished.

• The foreign currency accounts of deposit banks at the Central Bank were closed.

86. The two most significant changes were the abolition of the liquidity requirement and the revision of regulations governing reserve requirements. The liquidity requirement had been introduced to offset declining reserve requirements and induce banks to hold government paper (Table 13). However, only deposit money banks were subject to the liquidity requirement and it was difficult to see how it could be applied to other credit institutions. In addition, the liquidity requirement had a distortionary impact on price formation for government paper as short-term and long-term government paper was not treated in the same manner.

Table 13:

Required Reserve and Liquidity Ratios

Source: Central Bank of Iceland

^1/Abolished on March 1, 1998. Reinstated on March 21, 1999.

^2/The second ratio is for bonds and time deposits with maturities of at least one year.

Table 13:

Required Reserve and Liquidity Ratios

Effective	Date	Reserve Ratio	Liquity Ratio 1/
May 1,	1990	10.0	11.0
June 1,	1990	7.0	12.0
Nov. 1,	1991	6.0	12.0
Jan. 1,	1992	7.0	12.0
Nov. 1,	1992	6.0	12.0
Dec. 1,	1992	5.0	12.0
Nov. 1,	1993	4.0 2.5 2/	10.0
Oct. 1,	1996	4.0 2.5 2/	12.0
March 1,	1998	4.0 2.5 2/	0.0
April 1,	1998	4.0 1.5 2/	0.0
March 21,	1999	4.0 1.5 2/	1.5

Source: Central Bank of Iceland

^1/Abolished on March 1, 1998. Reinstated on March 21, 1999.

^2/The second ratio is for bonds and time deposits with maturities of at least one year.

View Table

Table 13:

Required Reserve and Liquidity Ratios

Effective	Date	Reserve Ratio	Liquity Ratio 1/
May 1,	1990	10.0	11.0
June 1,	1990	7.0	12.0
Nov. 1,	1991	6.0	12.0
Jan. 1,	1992	7.0	12.0
Nov. 1,	1992	6.0	12.0
Dec. 1,	1992	5.0	12.0
Nov. 1,	1993	4.0 2.5 2/	10.0
Oct. 1,	1996	4.0 2.5 2/	12.0
March 1,	1998	4.0 2.5 2/	0.0
April 1,	1998	4.0 1.5 2/	0.0
March 21,	1999	4.0 1.5 2/	1.5

Source: Central Bank of Iceland

^1/Abolished on March 1, 1998. Reinstated on March 21, 1999.

^2/The second ratio is for bonds and time deposits with maturities of at least one year.

87. Reserve requirements were expanded to include more institutions and additional forms of liabilities. To compensate for the expansion of the base, the reserve ratio for longer-term liabilities was lowered. This left the reserve requirement of the deposit taking institutions, already subject to reserve requirements, more or less unchanged. The remuneration of required reserves was also changed from indexed terms to nominal interest rates, leaving the expected nominal yield unchanged. This is in line with the official policy of reducing the scope of indexation in the financial system. Another important change is that institutions subject to reserve requirements will be able to meet their requirements on average during the reserve period instead of the reserves being held in frozen accounts at the Central Bank. This change makes it easier for credit institutions to manage their liquidity and should reduce the volatility of money market rates. The new regulations also allow one institution subject to reserve requirements to fulfil the reserve requirements on behalf of another or other institutions. This provision is intended for the savings banks which have long cooperated in the fulfilment of their liquidity ratio through Icebank Ltd.

88. The main changes to the repurchase facility are twofold. First the tap availability of repurchase contracts was discontinued, and second, the eligible collaterals were expanded to include all government registered securities on the Iceland Stock Exchange. This imposes a significant widening of the eligible collateral as only treasury bills had been eligible previously. In place of daily transactions, the Central Bank will hold weekly auctions of repurchase agreements, with advance notice of whether the auction will involve repurchase or resale agreements. The Bank can vary the auction form between a volume tender to fixed price auctions, the latter being the rule. This new agreement will enhance Central Bank discretion and stimulate interbank market activity. The older arrangement made the Central Bank the hub for intermediation of short-term funds between credit institutions. With the repo window open only once a week the credit institutions are encouraged to enter the interbank market to take-up or place short funds.

89. The establishment of the overnight credit facility at the Central Bank effectively creates a corridor for short-term interbank interest rates by setting an upper limit to their movements, while the interest rate paid on current accounts of credit institutions at the Bank provides the lower limit. These limits prevent large deviations of money market rates from the Central Bank’s instrument rates. Large fluctuations could cause uncertainty about the Bank’s interest rate policy and lead to turbulence in currency and money markets.

90. The discount quota was a limited overdraft facility for commercial and savings banks. The purpose of the discount quota was to smooth fluctuations in the money supply which were connected to uneven revenue collection by the Treasury. The change in reserve requirements, including averaging over the reserve period, obviated the need for the discount quota.

91. Foreign currency accounts at the Central Bank were established in 1979 when deposit money banks were allowed to offer domestic foreign currency accounts. Their main purpose was to make it easier for smaller deposit money banks, which did not have access to foreign accounts, to manage foreign currency deposits. Cooperation among the savings banks has reduced the need for this service. Moreover, the foreign currency accounts at the Central Bank had a detrimental effect on the development of the money and currency markets because the accounts channeled funds to the Central Bank that otherwise would have found their way onto the markets.

92. On February 23, 1999, the Central Bank temporarily introduced new liquidity restrictions on credit institutions. The rules were introduced partly as a prudential measure and partly as a short-term monetary policy instrument that will effectively restrain credit growth. The new liquidity rules differ from previous rules that were abolished in March 1998. Two specific measures were introduced: (i) liquidity should never be negative, and (ii) on a monthly average basis, the liquidity ratio should be 1.5 percent or greater. Liquid assets are defined as the sum of net deposits of credit institutions in the central bank, and domestic and foreign credit institutions with a maturity of 90 days or less, T-bills, and cash held in kronur or foreign currency. The base for the ratio is the same as the base for reserve requirements—total liabilities of credit institutions after deducting equity and interbank debt. Credit institutions will be allowed an adjustment period until these restrictions become fully effective in July 1999. The new rules are expected to increase the liquid position of credit institutions by 25–30 billion kronur. During the adjustment period, the new rules may also reduce trading volume in certain markets such as short-term foreign debt and the interbank market. The Central Bank intends to develop alternative provisions for prudential regulation of credit, in conjunction with the financial institutions and the Financial Supervisory Authority, under whose jurisdiction the rules fall. The alternative provisions will likely replace the liquidity restrictions, and be based on a maturity analysis of the balance sheet of banks in order to provide more flexibility. However, new legislation will be required for provisions related to maturity analysis and will not take effect until approved by Parliament, following its return in autumn 1999.