If they hit their target on average (and subject to a small tolerance range around that), they earn Bank Rate on their reserves balance. By contrast, any excess or deficiency incurs a significant charge and banks are thus incentivised to meet their chosen targets. 4  The Bank’s other liabilities include various deposits (e.g. from other central banks) and debt instruments issued in the Bank’s own name (e.g. to finance the Bank’s foreign currency reserves). Various Governmentrelated balances can also appear on either side of the balance sheet from time-to-time. 5  http://www.bankofengland.co.uk/markets/money/publications/redbookdec10.pdf. 2  BIS central bankers’ speeches  In order that it is possible for every bank to hit its individual target – and hence for the system to hit the implied collective target – the Bank calculates the aggregate demand for reserves across the commercial banks and then ensures that the aggregate amount of sterling in the system is exactly consistent with that collective target. It does that by offering, via short-term Open Market Operations (OMOs), exactly the right amount of sterling lending (against high quality liquid collateral).6 Commercial banks can ensure they meet their individual reserves target by transacting with each other in the market. This should distribute the reserves around the system such that no bank falls short or exceeds its own target. Alternatively, in the event of an unexpected operational disruption or exceptional volatility in overnight market interest rates, SMF member banks can borrow from, or lend to the Bank of England via the Operational Standing Facilities (OSFs).
As we have already discussed, the first component of the insurance aspect of the framework is the reserves averaging mechanism itself, which permits banks, within reason and without penalty, to vary their reserves account balances day-to-day in the face of small and/or short-lived liquidity shocks – provided they hit their reserves target on average over the maintenance period. The second component is the OSFs which allow banks to cope with larger, expected (frictional) payments shocks day-by-day. A third component comes through longer-term OMOs to which we now turn. Longer-term Open Market Operations The most routine method for ensuring there is the correct amount of sterling in the system, consistent with reserves targets, is via short-term OMOs. Prior to the start of QE, the Bank carried out weekly short-term reverse repo operations (STRs) against a pool of “narrow” collateral comprising highly liquid sovereign or near-sovereign bonds from a small selection of countries. At that frequency, the scale of the operations could be judged fairly precisely so as to offset any autonomous factors which affected the net supply of sterling to the market. But relying solely on short term OMOs could have meant carrying out very large repo operations every week. To avoid that degree of churn, some longer term reverse repos (LTRs) were also used precrisis – at maturities from 3 to 12 months.