Note that the resulting demand curve will be downwards sloping (strictly, in steps), as the share of funds allocated against wider collateral rises, the stop out spread falls. If market conditions deteriorate such that the value attached to borrowing against wider collateral relative to borrowing against narrow rises, this demand curve will shift higher. Because bids in the auctions should provide accurate information on individual banks’ demand for liquidity and the prices they are willing to pay for it, the Bank can use the pattern of bids in each auction to assess the extent of stress either in the market as a whole, or at individual institutions. In turn, it can use that information to inform its decisions on the size and maturity of future operations, or to engage individual institutions in a dialogue to understand their funding needs and plans. For example, consider two variants on our example laid out in Table 1. In the first, an exogenous shock hits the market, reducing interbank lending volumes and impairing the mechanism by which banks transfer liquidity amongst themselves. The result is that banks, individually, bid more aggressively for funds (Table 2 and Chart 6 show an illustrative example). That pattern results in an upwards shift in the aggregate demand curve, leading to a rise in the share of funds allocated against wider collateral, and hence providing liquidity insurance to the banking system. BIS central bankers’ speeches  9  In an alternative example, assume that an individual counterparty suffers a liquidity shock.
Paul Fisher: Recent developments in the sterling monetary framework Speech given by Mr Paul Fisher, Executive Director, Markets, and Member of the Monetary Policy Committee of the Bank of England, at the Manchester Economics Seminar, Manchester, 30 March 2011. All speeches are available online at www.bankofengland.co.uk/publications/speeches. *  *  *  I would like to thank Sarah Ashley, Roger Clews, Ronnie Driver, Tarkus Frost, Chris Salmon, Olaf Weeken, Iain de Weymarn and Richard Whisker for their help in preparing this paper. Introduction During the recent financial crisis and ensuing recession, the implementation of monetary policy has been the subject of intense debate. Most visibly, that debate focused on the Bank’s use of large-scale asset purchases – otherwise known as “quantitative easing” (QE) – as a monetary policy tool. But other aspects of the mechanics of setting policy have also been of great interest. In this paper, I want to focus on two issues which go to the heart of central banking: (i)  The first concerns how the Bank should seek to implement the Monetary Policy Committee’s (MPC) decisions on the official interest rate (known as Bank Rate), so as to best deliver a flat money market yield curve between one MPC decision and the next. (ii)  The second is about how best to provide liquidity insurance to the banking system as a whole, while also encouraging banks to manage their day-to-day liquidity needs, and subject to minimising the credit risk taken on the Bank’s balance sheet.