Alternative monetary policy tools and bank balance sheets

This page contains information on Alternative Monetary Policy tools and bank balance sheets from the November 2020 Financial Stability Report

In the November 2020 Monetary Policy Statement the Reserve Bank’s Monetary Policy Committee announced the establishment of a Funding for Lending Programme (FLP). FLP will work in tandem with the Reserve Bank’s Large Scale Asset Purchase programme (LSAP) to lower lending rates and enhance the transmission of monetary policy.

How does LSAP affect bank balance sheets?

The aim of LSAP is to lower interest rates across the yield curve, through transactions in the New Zealand Government Bond market. The Reserve Bank achieves this by purchasing bonds at a range of maturities in the secondary market. In LSAP operations, commercial banks act as intermediaries between the Reserve Bank and existing holders of New Zealand Government Bonds – which may include banks themselves, but also asset managers, pension funds and other types of investor.

When the Reserve Bank purchases bonds from a bank participating in LSAP, it does so by crediting that bank’s Exchange Settlement Account System (ESAS) balance. The bank will similarly credit the deposit account of its customer that is selling the bonds. In this way, LSAP increases the amount of deposits in the banking system. All else being equal, the Reserve Bank’s purchases raise the price of Government Bonds, thereby lowering their yields, which has flow-on effects to a broad range of market interest rates.

ESAS balances are deposits that banks have with the Reserve Bank that are used to settle transactions between banks, the Reserve Bank, and the Crown. ESAS balances qualify as liquid assets for the purposes of banks’ regulatory liquidity requirements. An impact of LSAP is therefore to contribute to an increase in banks’ liquid assets, in the form of ESAS balances. Since the beginning of 2020, banks’ ESAS balances have increased by around $14 billion, which has driven an increase in total liquid assets in the banking system (figure A.1).

Figure A.1
Primary liquid assets of locally incorporated banks 

Primary liquid assets of locally incorporated banks

Source: Reserve Bank Liquidity Survey

Note: Daily data from 18 March 2020

How does FLP affect bank balance sheets?

The purpose of FLP is to lower customer lending rates by providing a low-cost marginal source of long-term funding. Banks need to have a sufficient quantity of long-term and stable funding, to match the maturity profile of their assets, and to meet regulatory requirements. The Reserve Bank’s Core Funding Ratio requires banks to fund a certain proportion of their lending with long term and stable funding, to reduce their exposure to short-term disruptions to funding markets and other liquidity stresses. Credit rating agencies also take into account the duration and stability of banks’ funding when assessing their risk profiles.

Under FLP, banks are able to borrow from the Reserve Bank for a term of three years, receiving ESAS balances in exchange for pledging eligible collateral. FLP provides banks with a cheaper source of stable funding than current alternatives such as term deposits and long-term wholesale funding. For a given loan book, banks can meet the corresponding stable funding required by substituting FLP funding for these more expensive alternatives (figure A.2). Banks’ average funding cost would fall as FLP gives them the option to allow these more expensive sources of stable funding to roll off. By reducing banks’ demand for term deposits, FLP would see interest rates on these fall. This has already been observed as banks have lowered the interest rates they offer on term deposits, partly in anticipation of FLP (figure A.3).

Price competition in loan markets leads banks to pass through their lower average funding costs to their lending rates for businesses and households, enhancing monetary policy transmission. Funding banks receive under FLP would not directly translate into new lending to businesses and households, as loan growth is determined by a range of factors including customer demand, banks’ available capital, and general competitive pressures. However, by lowering the overall cost of credit, FLP lowers borrowing costs for businesses and households, which serves to boost demand in the economy, helping the Reserve Bank to meet its monetary policy objectives for inflation and employment.

Figure A.2
Stylised bank balance sheet before and after recieving FLP funding 

Stylised bank balance sheet before and after recieving FLP funding

Source: Reserve Bank

Figure A.3
Deposit rates for the five largest banks

Deposit rates for the five largest banks

Source: interest.co.nz, Reserve Bank Income Statement Survey