That means that the Bank has to supply excess reserves to the system in aggregate, such that no firm has any incentive to pay more than  7  4  And the OSF Deposit Facility rate was set to zero. BIS central bankers’ speeches  Bank Rate for the marginal unit of reserves. In that world, banks’ incentives to trade with one another in the overnight markets are largely diminished. A third model for implementing monetary policy is the “zero corridor” system. In this case there would be no reserves targets and banks could both lend to and borrow from the Bank in unlimited amounts at Bank Rate every day. Although short term market interest rates should always equal Bank Rate precisely, this system has several drawbacks. First, banks would never need to transact with each other; they simply transact with the central bank via the OSFs: there would be little or no commercial overnight interbank money market. That would be unwelcome. For example, the information the Bank deduces from movements in overnight market interest rates would be lost. It might also disrupt functioning of longer-term money markets, given implicit links to the overnight market. Second, if the Bank can always be relied upon to meet daily liquidity needs, then commercial banks have less incentive to actively manage their liquidity. And the Bank would be unable to distinguish between banks using the OSFs to manage their day-to-day liquidity buffers, and those facing more fundamental shocks.
As a consequence, the stock of reserves increased and exceeded the level the banks would have needed to hit the targets they would have chosen voluntarily. Because banks then had no control over the rate of expansion of reserves, the system of reserves averaging was suspended. Banks were instead remunerated at Bank Rate on any level of reserves.7 That means that there is no incentive for any commercial bank to lend in the market at less than Bank Rate. As a result, the current system should set a “floor” on money market rates, at Bank Rate (Chart 4). Similar mechanisms are currently employed by the Federal Reserve in the US, and the Swedish Riksbank. In principle, banks could have continued to set monthly targets and – to the extent that the MPC’s asset purchases supplied reserves in excess of these targets – the Bank could have borrowed them back through OMOs. But the Bank judged it better not to borrow reserves in increasingly large quantities at the same time as the purchase programme grew. While this is an easy and effective way of implementing monetary policy at the moment, there are drawbacks to this “floor” system. For example, in order to ensure overnight rates settle at Bank Rate, the Bank’s supply curve needs to intersect the commercial banks’ demand curve where it is infinitely elastic.