The Official Cash Rate in action

Since March 1999, the Reserve Bank has used the Official Cash Rate (OCR) as its tool for controlling inflation. By setting the OCR, the Reserve Bank is able to substantially influence short-term interest rates such as the 90-day bank bill rate, as well as long-term interest rates and the foreign exchange rate. All of these end up influencing the economy in various ways. Here, we take a closer look at how the OCR system works - who pays this interest rate, and why do they pay it?

The banking system: settlement accounts and the Reserve Bank

Most transactions involve transferring money from one person's bank account to another, whether it be paying a $100 power bill, borrowing $100,000 to buy a house, or investing $100 million in the government bond market. If the people involved in a transaction hold their accounts at different banks, it essentially means that one bank owes money to another bank, on behalf of its customer. As well as transactions between commercial banks, there are also transactions with the Reserve Bank, and with various government departments.

In order to make these day-to-day payments (that is, to "settle" them), banks hold settlement accounts at the Reserve Bank. For this reason, the Reserve Bank is sometimes called "the banks' bank". This centralised system means that cash can be transferred from one bank to another with ease. The government also holds an account at the Reserve Bank, which is called the Crown Settlement Account (CSA).¹

Settlement accounts are administered through the Exchange Settlement Account System (ESAS). On an average day, ESAS processes about 4000 transactions, worth about $35 billion in total. Large wholesale transactions are settled individually and in real-time, that is, as soon as possible after transaction occurs. In contrast, retail transactions such as EFTPOS and cheques are settled by totalling all of the transactions between each pair of banks, and then making one bulk payment between each pair at the end of the day.

A diagram of the New Zealand settlement system

The diagram above is a simple representation of the New Zealand settlement system. In this example, there are two commercial banks - Kea Bank and Global Bank - the Reserve Bank, and the government. When Kea Bank's customers make payments to Global Bank's customers, Kea Bank will transfer cash from its settlement account to Global Bank's settlement account (and vice versa). Transactions by government departments will create cash flows between the CSA and the other settlement accounts. The Reserve Bank supervises the CSA, and it is also able to transfer money between the CSA and any other settlement account.

Settling transactions with settlement cash

In order to settle a trade, the parties involved must exchange something of value that they can both agree on. For example, if you buy a car, you have to pay for it with something that the seller is happy to accept. It is the same for banks - they can borrow and lend various assets between themselves, but at the end of the day they also want to settle their debts with something safe and certain. Reserve Bank settlement account deposits, or settlement cash, is the safest option, because the probability that the Reserve Bank will default on its obligations is essentially zero.

In fact, banks have to hold accounts at the Reserve Bank, for two important reasons. First, banks need to supply notes and coins to their customers, which they can only get from the Reserve Bank. If a bank needs more notes and coins to circulate to its customers, it will "buy" them from the Reserve Bank using settlement cash. Similarly, if a bank sends notes and coins back to the Reserve Bank, they will be added to the bank's settlement account. Of course, banks don't use notes and coins to settle inter-bank transactions; the size of their transactions, and geographical distance, mean that an electronic book entry is much more convenient.

The second reason is that the government's transactions have a significant impact on the availability of cash. When the government receives more cash than it pays, it withdraws cash from the banking system. Similarly, if the government pays more than it receives, the banks will be left holding surplus cash. This creates cash flows that banks can't cover by borrowing and lending among themselves. Therefore, they have to turn to the Reserve Bank in order to top up their settlement accounts, or to deposit their surplus cash.

If banks are forced to use settlement accounts - and at present they are - the Reserve Bank can set the cost of holding settlement account balances, that is, the overnight cash rate.² This is a cost that banks cannot avoid, and they pass it on through the interest rates that they offer to their customers.

How do banks get settlement cash?

Banks typically start the day with a small amount of cash in their settlement accounts, but as transactions build up over the day, they may end up paying more than they receive. Banks try to manage their cash flows in order to minimise the chances of running out of cash, but if they do (and they are not allowed to let the balance of their settlement accounts go below zero), they can borrow cash for a short time to cover their customers' payments.

Intra-day borrowing

There are two main types of borrowing in the cash market: intra-day and overnight. Banks can borrow intra-day from the Reserve Bank, as long as they can supply some security as collateral to back up the loan. This collateral can be any government debt security, or short-term securities from banks and other firms with a very low chance of default. The Bank does not charge interest on intra-day borrowing, but the loan must be repaid by the end of the banking day.

This type of loan is called an intra-day repurchase agreement, or a repo for short. It is so called because one party - the bank that needs to borrow cash - sells the security to the other party - the Reserve Bank - and agrees to repurchase it before the end of the day. It is essentially a secured loan; if the borrower defaults, the lender still holds an asset of equal value, which they can sell in order to recoup the lost cash.

ESAS has an automated system that allows banks to quickly borrow cash from the Bank at any time during the day. This system is called the autorepo system, and the secured loans or repos transacted are often known as autorepos.

Intra-day borrowing deals mostly with the cash flows between banks. For example, if Kea Bank pays $100 million to Global Bank at 10:00am, then Global Bank pays $100 million to Kea Bank at 11:00am, the transactions offset each other, and will not affect the cash position of the banks at the end of the day. But settlement happens in real time, so Kea Bank has to come up with the original $100 million from somewhere; the Reserve Bank's autorepo facility is the most convenient source.

Overnight borrowing

The second type of borrowing is overnight borrowing, and this is where the OCR comes into play. At the end of the banking day, some banks may still have debts owing, while others may have surplus cash in their settlement accounts. At this time, the Reserve Bank offers to restore the bank's settlement accounts to a desired level. For banks that hold surplus cash in their settlement accounts, the Bank offers a deposit facility that pays them interest at a rate 0.25 per cent below the OCR. For the banks that are short of cash, the Bank offers to lend to them overnight at an interest rate 0.25 per cent higher than the OCR. This is called the Overnight Repo Facility (ORF).

For example, if Global Bank is short of cash by $50 million, and the OCR is set at 5.00 per cent (per annum), the Reserve Bank offers to lend cash overnight to Global Bank at 5.25 per cent. If Kea Bank has $50 million in its settlement account, the Reserve Bank offers to hold the cash overnight and pay interest at 4.75 per cent.

However, the banks have a second option: they can borrow from, and lend to, each other in the inter-bank cash market. Kea Bank could agree to lend its cash to Global Bank instead and charge, say, 5.00 per cent. Global Bank will pay less interest than it would by borrowing from the Reserve Bank, and Kea Bank will earn more than it would by leaving its cash with the Reserve Bank. Therefore, both sides have an incentive to bypass the Reserve Bank, and deal directly with each other. Most (but not all) of the trade in the overnight cash market is done this way.

An example of a transaction in the inter-bank cash market

In this example, the banks have an incentive to trade at any rate between 4.75 per cent and 5.25 per cent. But in practice, banks usually trade at the mid-point of this range (that is, at the OCR), because in most cases no single bank is in a position to negotiate a better rate for themselves. This means that, even though the Reserve Bank only occasionally deals in the overnight cash market, it is able to limit the overnight borrowing rate to within a 0.50 per cent range, under normal conditions.³

Incidentally, the banking `day' runs from 9:00am to 8:40am the next day. Therefore, an `overnight' loan tends to be for only a very short period. Banks borrow or lend overnight cash near the end of the banking day, when they are better able to calculate their cash positions, and overnight loan repayments are usually among the first transactions of the new banking day.

Government cash flows and open market operations

Although the government's transactions can be quite significant from day to day, most of these cash flows can be forecast several days ahead. For example, benefit payments are scheduled each fortnight, and GST is collected once every month. Every day, the Bank receives estimates of the government's cash flows for the next two weeks, and aims to smooth out some of these flows, so that the need to use the overnight cash market from day to day is reduced.

To do this, the Reserve Bank also offers to borrow or lend cash through open market operations (often referred to as OMOs), to offset the government's day-to-day transactions. As before, the Bank uses repos to withdraw cash, and reverse repos to supply cash. (A reverse repo, as the name suggests, is the opposite of a repo. In this case, the Reserve Bank will purchase a security now, and the other party agrees to buy it back again in the future.) At present, the Reserve Bank aims to leave about $20 million in the banking system every day.

OMOs aren't limited to overnight borrowing or lending. For example, the Bank can create a repo agreement where it will borrow cash on a day when it needs to withdraw cash from the banking system, and repay it at a future date when it expects that banks will need additional cash.

Every banking day at 9:30am, the Reserve Bank announces the details of the OMO. This includes the repurchase date for each of the repos (for example, three days and ten days ahead) and how much it is willing to borrow or lend for each date. From then until 9:45am, settlement account holders can submit bids, expressed as interest rates (that is, the party that borrows the cash in a repo agreement must pay interest at the end). Because these repos are usually for only a few days, the interest rate in a repo tends to be close to the OCR.

Since only a few institutions participate in OMOs, the Reserve Bank announces a minimum rate at which it will lend, or alternatively, a maximum at which it will borrow, depending on whether it is injecting or withdrawing cash on the day. The minimum/maximum is estimated from market rates, and is designed to ensure that the Reserve Bank transacts at `fair' market rates. Sometimes the OMOs "fail", meaning that there aren't enough acceptable bids to fully offset the government's cash flows. If this happens, the institutions will need to use the Overnight Repo Facility to make up the shortfall.