Lesson 29 Monetary Policy Continued.

Lesson 29
Monetary Policy Continued.

Open Market operation and
its practice in Pakistan
Lecture No. 126
Open Market Operation
The most important conventional monetary policy tool

Primary determinants of changes in interest rates, monetary base, and
the money supply.
Open market purchases causes increase in reserves, monetary base,
and the money supply and decrease in short-term interest rates.
Open market sale has opposite effects
The most frequently used instrument for implementing monetary
policy in Pakistan.
Two types of OMO
Dynamic open market operations: intend to

change the level of reserves in the market and the
monetary base
Defensive open market operations: used to offset

effects of other factors that affect reserves and the
monetary base
Objectives of OMO (SBP)
To manage liquidity in the interbank money market
To ensure availability of sufficient funds/reserves for smooth

settlement of interbank transactions
To keep the overnight interbank repo rate near the Policy (target) Rate
OMO as repo transactions
OMOs are usually conducted as repo transactions to address banks’

temporary liquidity needs
OMO purchase as reverse repo transaction: central bank purchase of
government securities to inject liquidity in the interbank market with
an agreement to sale the underlying security at a specified price at a
designated future date
OMO sale as repo transaction:

Outright OMO
When market liquidity is anticipated to remain short or in surplus

over a longer period of time.
Purchase or sale of government securities on permanent basis

(outright OMO), i.e. until the maturity of the underlying security.
In outright OMOs ownership of underlying security changes

between the financial institution and the SBP.
How are OMOs conducted?
Through ‘variable rate tenders’; banks disclose both the

amount of money and the rate for transaction.
The tenor of OMOs, set and announced by SBP, ranges

between overnight to two weeks, but are mostly of one
week.
Standing facility and its
practice in Pakistan
Lecture No. 127

Standing Facilities
Borrowing and lending facilities for financial institutions
To reduce the volatility in short term interest rates
To bring more transparency in the implementation of monetary policy
Standing overnight repo / reverse-repo facilities (i.e. floor & ceiling)
Two end-of-day Standing facilities offered by the State Bank of Pakistan

SBP Reverse Repo Facility
The eligible financial institutions can use SBP reverse repo facility
Rupee funds can be obtained for one day against approved securities
Approved securities are lent to the SBP with the agreement to

repurchase that security on next day.
The interest rate charged against such lending, the SBP reverse repo
rate or discount rate, is set above the money market overnight repo
rate and serve as ceiling
SBP Repo Facility
The eligible financial institutions can place their excess funds with SBP
for overnight
They take Treasury Bills against such excess funds.
The interest rate paid to the banks under this facility is called SBP repo
rate.
It is set below money market overnight repo rate and serves as a floor
Restricts downward movement of money market overnight repo rate.

Lender of last resort function
Discount loans to cope with financial panics and bank runs
Cost and benefits of this function

Coping with financial panics is beneficial as these result in large scale
disruption of economic activity owing to disturbance in financial
intermediation
Carries cost due to moral hazard problem; banks take risky position in
anticipation to be rescued by central bank in case of any trouble
Reserve requirement and its
practice in Pakistan
Lecture No. 128
Reserve Requirements
To hold Liquid assets in the form of cash and approved securities (t-
bills, PIBs, Ijara Sukuk etc.)
SBP requires scheduled banks in Pakistan to maintain two types of
reserve
Cash reserve requirement (CRR)
Statutory liquidity requirement (SLR)

Cash reserve requirement
Proportion of banks’ applicable time and demand liabilities

(TDLs), they are required to hold in the form of cash with the SBP
Cash in vault of banks is not accounted for meeting the CRR

requirement
SBP does not remunerate deposits that banks keep with it for
meeting the cash reserve requirement.
Cash reserves are maintained on fortnightly

average basis
A (lower) minimum reserve level is maintained

with the central bank on daily basis.
Required level of reserves for a bank in a reserve

maintenance period are worked out on the basis of
applicable TDLs of that bank at the end of the first day (i.e.
Friday) of the maintenance period.
Banks are not allowed to carry their excess of reserve

position over the next maintenance period.
Summary CRR
Type of CRR Definition Applicable Maintenance
Deposit liabilities period
Domestic Commercial banks are required Demand and time Daily and
currency to keep a portion of their rupee liabilities of less fortnightly
deposits deposits with SBP as cash than 1-year tenor average
Foreign Commercial banks are required All foreign Daily

Currency to keep a portion of their currency deposits
Deposits foreign currency deposits with
SBP as cash reserves (non-
remunerated) and special cash
reserves (remunerated).
Effects of CRR
Increase in CRR ratio reduces the funds available with the banks for
lending to both the public and the private sector
Banks have to hold additional cash in the form of reserves with the
SBP for the same amount of their liabilities.
Assuming all else equal, the increase in CRR reduces the money
multiplier and money supply in the economy, and tends to increase
the interest rates
Statutory liquidity requirement
The proportion of bank’s liabilities that they are required to invest in

approved securities
And/or hold in the form of cash;
Balances with SBP, balances with NBP, balances left in the vault of
banks, banks’ investment in capital of Micro-Finance Banks (MFBs)
and foreign banks’ deposits with SBP under section 13(3) of the
Banking Companies Ordinance 1962.
Maintaining period for SLR is also fortnightly that starts from

Friday and ends at Thursday of the subsequent week.
Applicable Time and demand liabilities at the end of the Friday (i.e.
the first day of the maintaining period) are taken into account for the
determination of SLR to be maintained during the maintaining period
(if Friday is a holiday then time and demand liabilities as of close of
the preceding working day is taken into account for calculating the
SLR.)
Increase in SLR ratio implies that banks are required to hold a larger
share of their funds into liquid assets approved/notified by the Federal
Government for this purpose.
Changes in SLR may change the composition of banks’ assets.
Both CRR and SLR are the least frequently used monetary policy tools
by SBP
Summary SLR
Type of SLR Definition Applicable Maintenance
Deposit liabilities period
Domestic Commercial banks are required Demand and time Daily

currency to keep a portion of their liquid liabilities of less
deposits assets in the form of cash, gold than 1-year tenor
or approved government
securities
Relative advantages of
different tools of monetary
policy
Lecture No. 129
Relative Advantages of OMO
OMO is the most important

conventional monetary policy tool
Four basic advantages

1. Complete control
Open market operations are initiated by the central bank, which

has complete control over their volume.
In other tools, like discount operations, the central bank can

encourage or discourage banks’ borrowing of reserves by
changing the discount rate but cannot make banks borrow;
hence, it cannot control the volume of borrowed reserves
2. Flexibility and precision
OMOs are flexible and precise
Can be used for any amount
Very small and large changes required in reserves or monetary base

can be handled by corresponding sale and purchase of securities
Other tools are not precise

3. Reversibility
OMOs can be easily reversed
Mistakes in OMOs can be immediately reversed
If OM purchases result in money market rate being too

low, then CB can immediately conduct OM sale
4. Quick
OMOs can be implemented quickly when required
No administrative delays
Changes in reserve requirements takes time as banks are

given advance warnings, so that they can calculate their new
reserve requirements
Advantages of Interest rate on reserves
Accumulation of large excess reserves
Money market rate tends to decrease
Central banks can increase money market rate by increasing

interest rate on excess reserves
No need to conduct OMO to reduce reserves

Advantages of Discount Loans
In case of extreme situations,

discount loans are very helpful
Lender of last resort role

Lesson 29 Monetary Policy Continued.

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Lesson 29

Monetary Policy Continued.

The most important conventional monetary policy tool

Dynamic open market operations: intend to

Defensive open market operations: used to offset

To manage liquidity in the interbank money market

To ensure availability of sufficient funds/reserves for smooth

OMOs are usually conducted as repo transactions to address banks’

OMO sale as repo transaction:

When market liquidity is anticipated to remain short or in surplus

Purchase or sale of government securities on permanent basis

In outright OMOs ownership of underlying security changes

Through ‘variable rate tenders’; banks disclose both the

The tenor of OMOs, set and announced by SBP, ranges

Lecture No. 127

Borrowing and lending facilities for financial institutions

To reduce the volatility in short term interest rates

To bring more transparency in the implementation of monetary policy

Standing overnight repo / reverse-repo facilities (i.e. floor & ceiling)

Two end-of-day Standing facilities offered by the State Bank of Pakistan

Approved securities are lent to the SBP with the agreement to

Restricts downward movement of money market overnight repo rate.

Discount loans to cope with financial panics and bank runs

Cost and benefits of this function

Cash reserve requirement (CRR)

Statutory liquidity requirement (SLR)

Proportion of banks’ applicable time and demand liabilities

Cash in vault of banks is not accounted for meeting the CRR

Cash reserves are maintained on fortnightly

A (lower) minimum reserve level is maintained

Required level of reserves for a bank in a reserve

Banks are not allowed to carry their excess of reserve

Foreign Commercial banks are required All foreign Daily

The proportion of bank’s liabilities that they are required to invest in

And/or hold in the form of cash;

Maintaining period for SLR is also fortnightly that starts from

Changes in SLR may change the composition of banks’ assets.

Domestic Commercial banks are required Demand and time Daily

OMO is the most important

Four basic advantages

Open market operations are initiated by the central bank, which

In other tools, like discount operations, the central bank can

OMOs are flexible and precise

Can be used for any amount

Very small and large changes required in reserves or monetary base

Other tools are not precise

OMOs can be easily reversed

Mistakes in OMOs can be immediately reversed

If OM purchases result in money market rate being too

OMOs can be implemented quickly when required

Changes in reserve requirements takes time as banks are

Accumulation of large excess reserves

Money market rate tends to decrease

Central banks can increase money market rate by increasing

No need to conduct OMO to reduce reserves

In case of extreme situations,

Lender of last resort role

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