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Bank of England may alter reserve targets flexibility

January 08, 2008 | "The Financial Times"

Banks may lose some of the flexibility they have acquired in recent months to miss their own reserve targets at the Bank of England amid signs that severe dislocation in money markets may be easing.

The move is seen as a sign that the Bank of England believes its co-ordinated injections of liquidity unveiled in December are bringing more normal conditions back to sterling money markets.

Overnight Libor was set at 5.595 per cent on Monday, just 9.5 basis points above the base rate, against a peak in August of 125bp. The lower spread suggests that, at least for short-term money, supplies are sufficient to drive rates below the current Bank lending rate.

In a statement posted on the Bank of England’s website on Monday, it said that although it would maintain the ranges around reserve targets that can earn or pay interest at attractive rates at the current level, it would “consider ahead of the February maintenance period in the light of money market conditions at that time, whether some reduction in the target ranges is warranted”.

The move has its roots in the complex system the Bank adopted in 2006 to conduct open market operations to maintain money market rates in line with its own targets. Its policy is to penalise banks that deviate from their own monthly reserve targets by one percentage point. It does this to encourage banks to use the money markets to cover deficits or shed surpluses.

It charges banks an above-market rate when their borrowings from the Bank of England for one month are more than one percentage point above their average target or by paying interest below market rates when their monthly average is more than one percentage point higher than that actually needed to meet targets.

In August, as the credit squeeze hit, banks became unwilling to lend to each other at almost any price. That made it much harder for them to plan how much money to keep at the Bank of England on a day-to-day basis. The Bank then offered preferential rates for loans and deposits that were as wide as 60 per cent higher or lower than reserve targets.

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