NORGES BANK'S LIQUIDITY INSTRUMENTS NORGES BANK INTRODUCES A COLLATERAL REQUIREMENT FOR FIXED-RATE LOANS.

• Author: Kilen, John E.

With effect from 1 September 1999, Norges Bank introduced a collateral requirement for fixed-rate loans. This is in line with Norges Bank's policy of securing its loans to the banking sector. This article starts with an introduction presenting the background for the collateral requirement. The central bank repo facility was designed to provide such security, but the mixed experience with this arrangement prompted a change in the lending regulation and the collateral requirement applying to fixed-rate loans.

1. Introduction

   Money market liquidity is defined as the banks' sight deposits with Norges Bank from one business day to the next. This balance is influenced by transactions on Norges Bank's balance sheet that are generally undertaken for purposes other than to steer money market liquidity. The central government's accounts in Norges Bank are used for loan transactions and fiscal policy purposes. These liquidity flows are substantial in periods, but follow a set pattern. Norges Bank's transactions in the foreign exchange market and changes in the circulation of notes and coin also influence money market liquidity.

   Furthermore, Norges Bank can supply or withdraw liquidity in order to neutralise fluctuations in liquidity. The fluctuations are primarily caused by central government ingoing and outgoing payments. Norges Bank will to ensure that there is always sufficient liquidity for the banks to effect their payments. Norges Bank can use several instruments to smooth fluctuations in money market liquidity. The most common instruments used are repos and fixed-rate loans, which are used to supply liquidity, and fixed-rate deposits, which are used to mop up liquidity.

   Pursuant to [subsections] 19 and 20, c.f. [sections] 22, of the Norges Bank Act, the central bank shall normally only grant liquidity loans to and receive deposits from banks. Banks' access to the Bank's lending and deposit facility is subject to Regulation no. 586 of 3 June 1997 on banks' access to loans and deposits in Norges Bank etc. with subsequent changes. The repo facility is described in a circular.

   Norges Bank attaches importance to securing the liquidity it supplies to the money market. Norges Bank required collateral for its loans to banks until the end of the 1960s. The collateral requirement was gradually relaxed as Norges Bank extended loans without requiring that securities be deposited, but that the counterparty (the banks) include securities in its portfolios as a basis for access to the central bank lending facility. With the sharp growth in banks' borrowings from Norges Bank, the requirement of underlying collateral was deemed to be of little significance in 1986 and was thus removed from the regulation. In the period 1986 to 1990, Norges Bank's loans to banks amounted to about NOK 60-70bn, while their holdings of government bonds came to around NOK 20bn.

   Since the beginning of the 1990s, Norges Bank has gradually re-introduced the principle of full collateral for loans from Norges Bank. Norges Bank first introduced limitations on access to its fixed-rate lending facility and subsequently required collateral for overnight loans. Norges Bank's exposure to the banking sector was reduced as a result of a substantial net supply of liquidity from the state in connection with an expansionary fiscal stance early in the 1990s. The banks' need for borrowing was gradually reduced towards the mid-1990s.

   In November 1993, Norges Bank introduced a collateral requirement for banks' overnight loans from the central bank, and since September 1995 the requirement for such loans has been 100%. With the start-up of Norges Bank's settlement system (NBO) on 24 November 1997, the provisions on intraday loans came into force. Such loans through the day are granted against collateral. Individual banks could initially borrow up to twice the value of that collateralised. The collateral requirement was revised on 8 June 1998, allowing banks to borrow up to 1.5 times the collateralised value, and with effect from 8 December 1998 Norges Bank required full collateral for D-loans.

   The purpose of the collateral requirement was to eliminate Norges Bank's credit risk exposure to individual institutions. Systemic risk in the financial system will have to be handled by instruments other than liquidity policy instruments. There is little to suggest that the central banks shall assume risk when supplying unsecured liquidity given the objective of liquidity policy. Developments in the 1980s showed that out of concern for financial stability it may be appropriate...