A. Outright Operations

For many central banks, this would imply expanding the range of securities held outright on their balance sheets to include those issued by government agencies, other levels of government and their agencies, and private sector entities such as financial institutions and commercial enterprises.

Since government securities are typically the most actively traded fixed-income securities in any domestic financial market, this option implies that a central bank must be prepared to use less liquid instruments in its market operations. However, Gravelle (1999) notes that some countries are finding that trading in non-government securities generally increases, while that in government securities declines, as the stock of government securities declines in importance. That said, in times of market stress, non-government securities can become very illiquid as trading activity shifts in favor of government securities.

The proportion of a central bank’s securities portfolio that should be held in liquid form depends on the size of its market operations relative to its balance sheet and the volatility of demand for base money. In many countries—notably Canada, Japan, New Zealand, and the United States—most securities owned by central banks are held to maturity as a backstop to base money, and are not actually needed for monetary policy operations. As a result, they do not need to be very liquid because the demand for base money in the economy (and hence the securities backing it) usually grows over time.¹¹ Thus, central banks that have large holdings of government securities on their balance sheets may be able to shift some of their holdings into less-liquid securities without compromising their ability to conduct monetary policy and manage their balance sheets.

An expressed willingness of the central bank to trade in a broader range of securities might help foster trading activity in those markets. World Bank-IMF (2001) encourages central banks to use government securities in their market operations as a means of helping to spawn trading activity in those markets. A similar argument might hold true if central banks were willing to broaden the range of securities used in their activities. By trading a broader range of securities in the market, central banks would be providing additional liquidity to these markets, which in turn might increase investors’ willingness to trade in these markets.

An expanded range of domestic securities would involve a central bank more directly in the intermediation of funds in the economy. There is also a risk that central bank decisions regarding which securities to hold could result in those trading at a premium in the marketplace, and distort the allocation of credit in the economy between that issued in the form of securities and other forms. There are ways to mitigate this risk. For example, a central bank could indicate that it will entertain all securities that exceed a minimum credit rating threshold set with respect to ratings published by reputable external credit rating agencies (e.g. AAA, or AA or better if there are not enough AAA securities available), and a minimum amount outstanding threshold to help ensure that the security is sufficiently liquid. It could also precommit to hold a portfolio on its balance sheet whose composition reflects that of the market as a whole for securities that satisfy its thresholds.¹² While this may, at the margin, cause all securities within that class to command a premium price, it helps to minimize the central bank’s involvement in funds intermediation within that class. In addition, such an approach, by constraining the judgment exercised by the central bank in the execution of its monetary policy and balance sheet management operations, helps to reduce the risk that the market might, inappropriately, examine these operations for signals regarding the central bank’s opinion on the creditworthiness of the issuer of the security being transacted, or treat the issuers of the securities in question as being “too big to fail”.

There is also a risk that central bank independence could be undermined, but this should be manageable. As Broaddus and Goodfriend (2001) note, allowing a central bank to transact in a broader range of securities may give rise to external pressure on the central bank to give preference to securities of certain entities or industries. Some ways to forestall such pressure are: (1) to ensure that the central bank’s market operations are carried out in a transparent fashion so that any such pressure is subject to public scrutiny; and (2) to delegate the management of the central bank’s securities portfolio to external investment managers. The previous suggestion that central banks manage their holdings of domestic securities like an index fund helps to insulate them from undue external influence. In addition, a central bank’s portfolio managers could also be required to publicly account on a regular basis for the performance of its domestic securities portfolio in terms of how well the central bank’s securities portfolio tracked a properly defined index that is made public. Such a practice is becoming increasingly common in public debt and foreign exchange reserves management, and helps ensure these activities are insulated from undue interference and devoid of signaling content.¹³

Expanding the range of domestic securities exposes central banks to additional credit risk, which would have to be managed. Other securities—whether they be issued by government agencies, financial institutions, or private corporations—carry more credit risk than government securities, which are usually risk-free. Consequently, if central banks hold a broader range of securities, they would have to protect themselves against losses that might arise from default by the issuer. As noted previously, there are a number of procedures that can be used in this regard, such as: maintaining minimum credit rating thresholds; restricting outright transactions to securities guaranteed by financial institutions, such as bankers’ acceptances, that provide the central bank with a claim against the bank and the underlying corporate borrower; and possibly setting limits on the amount of securities of a single issuer that are held on the balance sheet. Central banks could also hold reserves on their balance sheets to cover any future losses.

An important issue to resolve is whether central banks should trade in securities of financial institutions for which they are the regulator or have close ties to the regulator. In such cases there is a risk that the market may perceive that the central bank is trading in these securities on the basis of privileged information obtained either through its regulatory role or ties to regulators, which could further undermine the stability of an institution suspected of being in difficulty. Some central banks, like the Bank of Japan, have addressed this issue by refusing to hold securities of financial institutions they supervise. Others, such as the Bank of Canada, address it by only dealing in short-term debt securities guaranteed by banks, and adhering to conservative pre-announced minimum external credit rating thresholds—that is, AA or better—where the probability of an unexpected default is highly remote. In such cases, the security is more likely to be downgraded below the threshold, and thus become ineligible, before a default takes place.

B. Expanded Collateralized Lending Operations

This option implies that central banks would be willing to accept a broader range of securities issued by domestic entities, supranational agencies, and foreign entities as collateral when they extend credit to the financial sector.¹⁴ The credit extended could be granted using repo, a lombard facility, or rediscount vehicles depending on individual country circumstances. It reflects the practice of the Euro System and some other European central banks, where the credit granted is underpinned by a wide range of securities and also some non-marketable assets that meet certain prescribed criteria with respect to their risk characteristics. As noted previously, it is an option that is already being pursued by many central banks.

This option should not pose any significant problems for monetary policy implementation or the liquidity of central bank assets. Expanding the range of assets used as collateral in central bank credit-granting operations would not have any significant implications for the conduct of monetary policy. Similarly, increased reliance on these operations at the expense of outright operations should not have any material effects on the liquidity of central bank assets. Although there is no secondary market for previously-negotiated central bank credit (it is not tradable in the conventional sense), central banks can offset the economic effects of a credit-extension before it matures by borrowing funds from the financial sector.

For longer-term or permanent liquidity adjustments, central banks would need to roll over central bank credit on a regular basis. These agreements tend to have tenors that are less than 12 months, and often 3 months or less. Thus, for these type of liquidity adjustments central banks should consider executing longer-term credit operations, such as 3-month loans, in order to avoid having to roll over the entire portfolio on a frequent basis. To provide added flexibility, it might be useful to stagger the maturity dates of credit granted to avoid a bunching of maturities and minimize rollover risk.

Central bank credit can be extended effectively in the absence of an active secondary market for the underlying securities. One of the advantages of repo operations is that they can take place in the absence of an active secondary market for the security provided as collateral, since the purchase and repurchase conditions are known in advance and can be made transparent to market participants. Conducting central bank credit operations with a broader range of securities might help to stimulate additional trading activity in the underlying securities because market participants might be more willing to trade these securities knowing that they can be used to obtain central bank credit.

The implications for funds intermediation and central bank independence should be minor. In contrast to the previous option where central banks choose which securities to transact in their market operations and hold on their balance sheets, this option helps to minimize a central bank’s involvement in the intermediation of funds in the economy. When a central bank is supplying liquidity, the financial institutions receiving the central bank credit select the collateral to be used in the operation, subject to the parameters set by the central bank regarding which assets are deemed to be acceptable collateral, and possibly limits on the amount of securities of a single issuer that can be pledged by a borrower.

A central bank may have indirect effects on funds intermediation, inasmuch as it sets the parameters that determine which assets can be used by financial institutions to obtain central bank credit. The Committee on the Global Financial System (2001) suggests that these effects might be modest. Even so, there are ways to contain these effects. A central bank could indicate that it would entertain all assets as collateral that meet certain prespecified and easily monitored criteria in terms of risk and liquidity. For example, it could announce ahead of time that it would accept those that have a prespecified minimum credit rating from a reputable external credit rating agency, a predetermined minimum amount outstanding, and that are lodged in a domestic electronic securities settlement system (to facilitate transfers between the central bank and its counterparties). While these criteria may, at the margin, cause all assets satisfying the criteria to command a premium price, it helps to minimize the central bank’s involvement in allocating credit within that class.¹⁵

Limiting the amount of judgment exercised by the central bank in selecting the assets that can be used as collateral also helps to reduce the risk that the market might, inappropriately, examine central bank lending operations for signals regarding the central bank’s opinion on the credit-worthiness of the issuer of the security. Such an approach would also contribute to the transparency of the central bank’s market operations, thereby helping to ensure that any external pressure on the central bank to give preference to certain entities or industries is subject to public scrutiny.

Accepting securities issued by foreign entities as collateral in lending operations might expose a central bank to public scrutiny regarding which countries’ securities to favor. While this might be a legitimate concern, it should not be overstated. Central banks already face this issue on an ongoing basis in their role as manager of the foreign assets held on their balance sheets or in government accounts. As indicated previously, clear investment guidelines combined with properly defined performance benchmarks and public reporting obligations should help to contain any unwarranted external interference in the management of these assets. And proper safeguards and procedures need to be in place to ensure that these assets can be transferred between the central bank and the borrowing financial institution efficiently, and that the central bank has ready access to these assets in the event of a default by its counterparty.

Lending operations involving a broad range of assets pose less credit risk for a central bank than outright operations involving the same assets. Assuming proper procedures are in place to ensure that a central bank has clear access to the assets in the event of default by the borrowing financial institution, these operations should enjoy lower credit risk than holding the assets on an outright basis.¹⁶ Collateralized loans essentially constitute a double-claim against both the borrowing financial institution and against the underlying asset. For a central bank to suffer a loss, both the financial institution that provided the asset as collateral and the underlying borrower would have to default simultaneously—an extremely rare event.¹⁷ Moreover, collateralized loans, unlike outright transactions benefit from the haircuts/margins discussed previously, although these may be less effective in times of extreme market stress. These two factors make it easier for central banks to entertain a broader range of securities in their monetary policy operations without jeopardizing their financial condition.

One question that may arise is whether a central bank should delegate some of the functions related to the management of the collateral to an external institution, for example through a tri-partite repo structure. This is particularly useful when borrowers are allowed to substitute replacement assets for the collateral during the life of the loan. Such innovations require more sophisticated tools and expertise to value the collateral and manage the risks associated with the collateral, which may not be readily available in central banks. However, two issues arise in this respect: (1) proper safeguards need to be in place to protect the central bank against the risk of loss in the event of operational problems at, or even outright failure of, the entity that is managing the collateral on behalf of the central bank; and (2) a central bank should take care to avoid conveying an impression that the institution managing its collateral is “too big to fail.”

Since collateralized loans are short-term agreements, they help to limit a central bank’s exposure to interest rate risk. Central banks seeking to minimize their exposure to interest rate risk would typically prefer to hold assets that are either short-term or have interest rates that are frequently reset because their liabilities are either non-interest-bearing, or have interest rates that are frequently adjusted. As noted previously, collateralized loans typically mature within a few months at most.

C. Foreign Exchange Swaps

The option of foreign exchange swaps involves operations in the foreign exchange market and does not involve the transfer of securities in the first instance. These transactions do not have any direct effects on the exchange rate because the purchase (sale) of foreign currency in the first leg of the transaction is offset by a simultaneous forward resale (repurchase) of the foreign exchange.¹⁸ They have been particularly useful in the past for countries like Norway and Switzerland, which had large stocks of foreign assets, active foreign exchange markets, but a domestic fixed-income market that was at an early stage of development.

The attractiveness of foreign exchange swaps as a primary instrument of liquidity management might be limited because, for some central banks, settlement arrangements are complicated by the lack of delivery-versus payment, especially when there is a need to conduct transactions across time zones.¹⁹ Also, at the margin, foreign exchange swaps may not be well-suited for liquidity-withdrawing operations, since they represent a temporary contingent claim against a central bank’s foreign assets during the life of the swap. This could limit the availability of these assets for use in foreign exchange market intervention. However, this need not be a major concern, inasmuch as industrial country central banks are not normally active interveners in the foreign exchange market, and intervention could be funded, if necessary, through offsetting foreign exchange swap transactions.²⁰

This option should not pose any concerns regarding the liquidity of central banks assets. Foreign exchange swap markets in most industrialized countries are very deep and liquid, and usually more active than domestic fixed-income markets. Indeed, BIS (2001) notes that these markets are the most active segments of the foreign exchange market, eclipsing underlying spot markets for foreign exchange. Consequently, central banks should not normally experience any difficulty in executing the transactions volumes needed to manage the amount of monetary liquidity in the domestic financial system without having to be concerned about material effects on quoted swap prices. In addition, while there is no secondary market for previously negotiated swaps (they are not securities in the conventional sense), central banks can offset a swap before it matures by executing a swap in the opposite direction.

Inasmuch as these swaps do not involve domestic securities, there are no direct implications for the functioning of the domestic fixed-income market. And there should not be any implications for domestic funds intermediation or central bank independence. Using these swaps enables central banks to sidestep the need to take decisions regarding which assets to hold on their balance sheets.

Foreign exchange swaps are not collateralized in the same way as collateralized loans. As a result, a central bank takes on the credit risk of the commercial bank counterparty with which it executes the swap without the security of any underlying collateral to claim in the event of default. Although a central bank receives substantial protection from the fact that the proceeds received at the beginning of the swap can be invested in low-risk assets, it might still experience a loss if the exchange rate moved sharply against it over the life of the swap, and the counterparty to the swap failed to honor its side of the transaction. In this case, the loss would arise if central bank had to enter the market to replace the contract.

In order to manage the credit risk associated with these swaps, central banks could adopt many of the risk management practices used by commercial banks active in this market. These include: (1) setting caps on exposures to individual counterparties, marking-to-market exposures on a daily basis to take account of exchange rate movements, and ensuring that any unrealized losses are charged against these caps; and (2) working with market participants to introduce netting arrangements that limit the credit risk of counterparties to the net, rather than gross exposure when there are multiple transactions with the same counterparty. They could also consider adopting a practice that is common in futures markets, and introduce an agreement with their counterparties that these transactions will be marked-to-market on a daily basis, with a cash settlement between parties to eliminate the resulting credit exposure.

Looking to the future, the settlement risk associated with foreign exchange swaps may decline following the introduction of continuous-linked settlement (CLS) services. A special-purpose bank will, in effect, hold a settlement account at each of the central banks for the currencies participating in the system so that it can process both legs of a foreign exchange transaction virtually simultaneously, thereby reducing the amount of settlement risk that currently exists in the foreign exchange market. Thus, central banks wishing to implement monetary policy using foreign exchange swaps may be able to minimize settlement risk through this system provided it offers same-day functionality.²¹