Corridor and floor systems

A corridor-type (with its floor-type variant) system is an approach to the setting of inter- est rates that an increasing number of central banks have adopted since the mid 1990s. The system has now become the operational framework that most central banks utilize for implementing their strategies on interest rates.

The interest rate policy of central banks consists of a strategy and an operational framework. Strategically, central banks set their desired level for one or more interest rates, based on what they consider adequate in terms of their public policy objectives. Operationally, they use a set of instruments and procedures to effectively steer the chosen interest rates toward the target policy rate. Since the 1990s, the prevailing operational framework for monetary policy implementation is a corridor system. In the 2000s, the central banks of Japan and New Zealand, as well as a number of other central banks in the aftermath of the global financial crisis, have further modified their framework and embraced a floor system.

Historically, the interest rate policy of central banks was simply the setting of the interest rate at which the central bank was willing to lend funds. This could be a discount rate - that is, the rate on discount window loans - or a Lombard rate, to wit, the rate on a collateralized loan of a standard maturity, usually overnight. This liquidity-providing standing facility would put a cap on banks' funding costs. When the interbank market for reserves began to develop, an increasing number of central banks began conducting monetary policy by choosing a target for the market-determined interest rate at which licensed institutions lend funds to each other on an overnight basis.

In order to target the interbank market rate, a central bank must engage in liquidity management to ensure that there is appropriate bank liquidity for the interbank market rate to be at target. First, it needs to estimate banks' demand for reserves; that is, the amount of overnight reserves necessary to meet reserve requirements (if any) and the amount banks are willing to hold as precautionary reserves. Second, it needs to estimate how the supply of reserves is influenced by "autonomous factors", including banks' net demand for cash and the government's net payments out of its account at the central bank (if any). Finally, the central bank uses open market operations to calibrate the amount of settlement balances in such a way that, given the demand for reserves, the interbank overnight market interest rate will settle close to the target, neither too high nor too low.

This market rate will fluctuate in response to factors affecting reserve supply and demand that are outside the central bank's direct control (Ennis and Keister, 2008). Small unanticipated changes in supply can lead to substantial interest-rate volatility above or below target if banks' demand for reserves is steep. Volatility is further amplified by unanticipated shifts in the demand for reserves. Volatility is capped, however, by the inter- est rate set on the liquidity-providing standing facility. This rate sets an upper bound, or ceiling, for the market interest rate by giving banks the option to borrow funds outside the market, namely at the central bank. On the other hand, the lower bound, or floor, to the interbank market rate is the interest rate that a bank would receive by not lending its reserve balances on the interbank market. As this rate was traditionally set at zero, the lower bound was zero.

Since the 1990s, central banks have raised the lower bound by setting a positive remu- neration on banks' excess reserves. This was typically implemented by creating a deposit standing facility at the central bank where banks earn interest on their overnight, or term, balances. This removes any incentive for banks to lend funds on the interbank market at a lower rate of interest and thus establishes a floor to the market rate. With the introduction of a floor above zero, central banks have the option of setting a symmetric channel, or corridor, directed at containing the volatility of market rates within symmet- ric bounds. This corridor system was particularly useful at a time when reserve require- ments were on the wane worldwide, which made it more difficult to calibrate the supply of reserves. With the corridor system, the overnight interest rate on the interbank market can only oscillate within a channel, or band, between the lower and upper bounds set by the central bank. The narrower the corridor is, the lower the interest rate volatility, the higher the average recourse to standing facilities, and the smaller the interbank turnover (Bindseil and Jabłecki, 2011).

In the 2000s, several central banks (either formally or de facto) have moved from a corridor system towards a floor system. While some central banks modified their frame- work for monetary policy implementation by setting their target rate of interest as the floor and providing banks with excess reserves, others responded to liquidity shocks by expanding excess reserves well beyond the target supply needed to achieve the target rate of interest. Unsurprisingly, the market interest rate fell to the floor of the corridor.

With the floor system, the market rate of interest is more stable, and the central bank can disentangle its interest-rate strategy from decisions concerning the scale of liquidity operations in response to liquidity shocks (Keister et al., 2008). The floor system has the advantage of simplifying liquidity management, making reserve requirements obsolete, and allowing the central bank to change its target rate of interest without necessarily changing the stock of reserves. The concern that, by downsizing the market for reserves, the floor system means losing market signals is hardly justified, considering that the price to be discovered is the price pre-set by the central bank by virtue of its monopoly on reserves.

See also:

Bank of Canada; Cash; Collateral; Effective lower bound; Interest rates setting; Monetary policy instruments; Monetary policy objectives; Open-market operations; Policy rates of interest; Reserve requirements; Settlement balances.