But the liquidity of other assets is less assured, and banks can suffer problems if the liquidity of their assets dries up. That could cause financial instability. The Bank of England can provide liquidity insurance to individual, creditworthy institutions and to the banking system as a whole, by accepting those less liquid assets as collateral, for a fee, in exchange for more liquid assets, including reserves.9 But such liquidity insurance must be provided in a way that takes account of the potential for “moral hazard” – the incentive for individual banks to undertake riskier activities because of the presence of a central bank backstop. The Bank’s operations must not undermine the incentives of private sector firms to manage their liquidity needs safely in the market, rather than turn to the Bank routinely. Moreover, although the Bank’s operations are collateralised, the value of the securities delivered to the Bank is always uncertain. We would never be able to protect ourselves perfectly against credit risk. 8  “The Bank’s money market framework”, Bank of England Quarterly Bulletin, 2010 Q4. 9  The Bank also stands ready to provide gilts via its permanent Discount Window Facility, introduced in October 2008. This facility is available to provide bilateral liquidity support to solvent and viable institutions, against a wide pool of collateral. BIS central bankers’ speeches  5  As well as implementing the policy rate, the SMF is also used to provide that liquidity insurance.
Within the tolerance range around its reserves target, a bank has no incentive to pay more than Bank Rate for an additional unit of reserves, or to charge less than Bank Rate for lending an additional unit of reserves, and the demand curve is relatively flat. The length of the flat portion of the curve depends on the size of the tolerance range set by the Bank. If the tolerance range is very small, market interest rates will be relatively sensitive to variations in  6  If the system as a whole already has excess reserves (relative to the commercial banks’ collective target), the Bank can drain reserves by issuing short-term Bank of England bills. BIS central bankers’ speeches  3  the supply of reserves. That is because small variations in supply could potentially move banks into using the deposit or lending facility. If the tolerance range is very wide then banks have little or no incentive to distribute reserves around the market to meet their targets precisely. Alternative frameworks for setting interest rates This system of reserves targets is just one of a number of systems that would be used to implement the policy rate. Indeed, as a system for influencing market rates, these arrangements could be seen as overly complicated. Since March 2009, when the Bank embarked on its asset purchase program known as QE, we have been implementing Bank Rate in a rather simpler fashion. The Bank’s asset purchases were financed by creating additional central bank reserves.