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 15,000 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 bulk payments between each pair.

A diagram of the New Zealand settlement system

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.

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. A Reserve Bank settlement account deposit, 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. One reason is that 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.

How do banks get settlement cash?

Banks typically start the day with a sufficient amount of cash in their settlement accounts, but as transactions build up over the day, they may end up paying out 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.

Overnight and term borrowing

There are two main types of borrowing in the cash market: overnight and term. Banks can borrow overnight 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.[2]

This type of loan is called a repurchase agreement, or a reverse repo. 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 on the agreed date. 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. A repo, as the name suggests is the opposite of a reverse repo. In this case, the Reserve Bank will sell a security now, and agree to buy it back again in the future.

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, they are able to hold these balances in their settlement account (receiving the OCR in interest on their balances) and/or lend these surplus balances in the inter-bank market. To prevent banks from hoarding cash and holding more cash in their ESAS accounts than needed for settlement purposes, the Reserve Bank operates a tiering system. Each bank is assigned a tier, an amount of cash that has been determined is the level each particular bank needs for settlement purposes. Any excess cash held above this level will receive an interest rate of 1.00 per cent below the OCR. This should incentivise banks to borrow cash from one another and use the Reserve Bank as a last resort.

For the banks that are short of cash, the Bank offers to lend to them overnight at an interest rate 0.50 per cent higher than the OCR. This is called the Overnight Reverse Repo Facility (ORRF).

For example, if Global Bank is short of cash by $50 million, and the OCR is set at 1.75 per cent (per annum), the Reserve Bank offers to lend cash overnight to Global Bank at 2.25 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 1.75 per cent (or at 0.75per cent on the bank’s ESAS balance is over its tier).

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, 1.75 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 (had it been over it’s tier). 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

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 0.75 per cent and 2.25 per cent. But in practice, banks usually trade at (or around) the Official Cash Rate, 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 (via the ORRF), it is able to limit the overnight borrowing rate to within a 1.50 per cent range, under normal conditions.

Incidentally, the banking ‘day' runs from 9:00am to 8:30am the next day. Therefore, an ‘overnight' loan tends to be for only a very short period. Banks typically 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. The Bank receives estimates of the government's cash flows on a daily, weekly and monthly basis, 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. At present, the Reserve Bank maintains a ‘fully cashed up” system. With this system there is essentially enough cash to enable banks to efficiently settle day-to-day settlement obligations. The Settlement Cash Level can be anywhere in the range of $6.5 to 9 bln NZD.

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.

When it is determined an OMO is needed, 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, approved counterparties 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).

Since only a few institutions regularly 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 rate is estimated from market rates, and is designed to ensure that the Reserve Bank transacts at ‘fair' market rates.

Further reading and resources

Video – The OCR and how it works.

What is the Official Cash Rate? (PDF 113KB)

Sandeep Parekh, ‘How the Reserve Bank of New Zealand manages liquidity for monetary policy implementation’, Reserve Bank Bulletin, May 2016. 

Reform of the Reserve Bank of New Zealand's Liquidity Management Operations', Consultation Paper, June 2006

Jan Frazer, ‘Liquidity Management in the New Zealand banking system', Reserve Bank Bulletin, December 2004.

Andy Brookes and Tim Hampton, ‘The Official Cash Rate one year on', Reserve Bank Bulletin, June 2000.

Tim Hampton, ‘Intra-day liquidity and real-time gross settlement – 18 months on', Reserve Bank Bulletin, December 2000.

Bruce White, ‘Central banking: back to the future', Discussion Paper DP2001/5, September 2001.

ESAS overview

[1] Although the government ultimately does all of its banking with the Reserve Bank, it uses an account held at Westpac for its transactions with the public. That's why payments from the government, such as unemployment benefits, are paid using Westpac cheques. The transactions in this account are totalled up and the balance is transferred to the CSA at the end of the banking day.

[2] A list of eligible securities is available.