Norway: New Liquidity Management System in operation on 3 October 2011

• Norges Bank announced that the new liquidity system is planned to come into operation on 3 October 2011.
• As proposed by Norges Bank on 6 October this year, in the new system, only a certain portion of a bank’s deposits in the central bank (a quota) will bear interest at the key rate. Deposits in excess of the quota will bear interest at a rate of 100 basis points below the key rate – the reserve rate. 
• The main changes from the original proposals are: 1) Settlement banks will have somewhat higher quotas than other banks in the same group; 2) More importance will be given to transparency and communication on Norges Bank’s part in the management of liquidity. 
• Market reaction: FRA June 11 contract increased by 2-3 basis points, as planned implementation was postponed from mid-2011 to October.

New system for management of banks' reserves

On 6 October 2010, Norges Bank distributed a consultative document concerning a new system for the management of banks’ reserves. In the new system, only a certain portion of a bank’s deposits in the central bank (a quota) will bear interest at the key rate. Deposits in excess of the quota will bear interest at a rate 100 basis points below the key rate – the reserve rate.

The new system for the management of banks’ reserves will apply to all banks in Norges Bank’s settlement system (NBO). The banks in NBO are divided into three groups. In principle, the same groups will apply when quotas are set.

The new system for liquidity management is planned to come into operation on 3 October 2011. When Norges Bank first proposed these changes on 6 October, it indicated that the new system would be implemented from mid-2011.

The aim of the change is to correct weaknesses in the current system. At present, banks have substantial deposits in Norges Bank, which bear interest at the key rate. In the opinion of Norges Bank, banks have little incentive to redistribute reserves in the interbank market and total reserves in the banking system have trended up over time. In the new system, banks will have a greater financial incentive to redistribute reserves between themselves, which will lead to more activity in the overnight interbank market, according to Norges Bank.

Furthermore, in the opinion of the central bank there is no well-developed market for overnight interbank loans in Norwegian krone. The most liquid short-term interest rate is the NIBOR tomorrow-next rate, which is the rate on loans from tomorrow until the next business day. This is a swap rate derived from the interest rate on US dollars and the forward premium in the foreign exchange market (determined by the differential between dollar forward and spot rates). In time, the new system could pave the way for the overnight rate in Norwegian krone to be used more widely as a benchmark rate in the market for financial products, Norges Bank states.
The new system for the management of banks’ reserves will be largely as presented in the consultative document of 6 October 2010, but with some changes.

First, settlement banks will have a somewhat higher quota than other banks in the same group. Settlement banks face uncertainty about payments to and from level 2 banks (i.e. banks that have a bank other than Norges Bank as their settlement bank) as well as uncertainty about their own transactions. After due consideration, Norges Bank has decided to assign settlement banks an additional quota determined by the size of the settlement bank in relation to the size of the level 2 banks. Second, more importance will be given to transparency and communication on Norges
Bank’s part in the management of liquidity. With Norges Bank ensuring that there is always a substantial surplus of reserves in the banking system, banks will always know that there will be sufficient reserves to cover payments into the government’s account.

Norges Bank will fine-tune banks’ reserves at short notice (daily) as necessary to ensure this. If required, Norges Bank will offer F-loans with longer maturities than normally offered in the current system. Norges Bank will also publish forecasts of movements in banks’ reserves and, as far as possible, give advance notice of planned liquidity operations (F-loans, F-deposits). In the opinion of Norges Bank, these measures will make banks’ liquidity management easier. They will also bring greater predictability, which will probably help reduce volatility in short-term money market rates.

Current system for managing bank reserves

In the current system, the sight deposit rate normally forms a floor for very short-term money market rates, as banks will not normally want to lend money at a rate of interest that is lower than the rate they receive from the central bank. Similarly, Norges Bank’s overnight lending rate (for D-loans) forms a ceiling for very short-term money market rates.

Norges Bank must ensure that there is a surplus of reserves in the banking system. In other words, banks must always have deposits of a certain size in the central bank. When these deposits are sufficiently large, very short-term money market rates will be pushed down toward the deposit rate.

Market reaction

The FRA June 11 contract increased by 2-3 basis points, as planned implementation was postponed from mid-2011 until 3 October 2011.
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