Return to positive interest rates: Why reserve tiering?

Speech

Embargo

17 November 2022, 6.30 pm

Return to positive interest rates: Why reserve tiering?

Money Market Event

Andréa M. Maechler and Thomas Moser∗

Member of the Governing Board / Alternate Member of the Governing Board Swiss National Bank

Geneva, 17 November 2022 © Swiss National Bank

• The speakers thank Florian Böser, Lucas Fuhrer and Mico Loretan for their support in drafting this speech. They also thank Dirk Faltin, Cyrille Planner, Michael Schäfer, Jacqueline Thomet and Tanja Zehnder for valuable comments as well as the SNB Language Services for the translations of the text.

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Ladies and gentlemen

It is with great pleasure that my colleague Thomas Moser and I welcome you to this year's Swiss National Bank (SNB) Money Market Event in Geneva. We are very glad that so many of you have joined us this evening, be it on site or remotely.

Since we last met in this setting a year ago, fighting inflation has become the most important task for central banks worldwide. Many countries have experienced a surge in inflation, the scale and pace of which very few anticipated. A large part of this surge was due to ongoing disruptions to global supply chains caused by the coronavirus pandemic. Russia's war against Ukraine - in addition to causing immense human misery - has further contributed to inflationary pressures through its impact on energy and food prices. Over recent months, inflation has proved more persistent and become more broad-based than had initially been expected. Consequently, we have witnessed a turnaround in monetary policy at a global level as central banks have begun to tighten their policies.

The SNB, too, has tightened its monetary policy and has lifted its policy rate back into positive territory. With the transition to a positive rate environment, the SNB has had to adopt a new approach to implementing its monetary policy in the money market. Our new approach features two elements: reserve tiering, also referred to as tiered remuneration of reserves, and reserve absorption by way of open market operations.1 This new approach takes into account the structural changes that have occurred in the money market since we were last in a positive rate environment. In particular, under these changed conditions, the new approach allows us to pursue our objective of keeping secured short-term Swiss franc money market rates close to the SNB policy rate.

Tonight's event offers an excellent and timely opportunity to discuss our new approach in detail. After reviewing the rationale for adopting the new implementation approach, we will give you an overview of how the new approach has played out so far.

Why did the SNB return to a positive policy rate?

Let me start by giving you an overview of why the SNB has tightened its monetary policy.

Until recently, consumer price inflation had been both low and relatively stable for roughly three decades. Slide 2 shows consumer price index (CPI) inflation rates in the US, the euro area and Switzerland since 1980. In the 30 years from 1990 to 2020, the Swiss inflation rate, shown in red, averaged a mere 1.0% per annum. Since the end of 2020, however, the tide has turned markedly, and inflation has surged globally. Inflation has risen in Switzerland as well, albeit somewhat later and not as sharply as in other economies. Swiss annual consumer price inflation has been above 3% since the middle of this year and has reached its highest level since the early 1990s. The latest CPI data put Swiss inflation at 3.0%. This rate is above the

1 In the context of the SNB, 'reserves' are often referred to as 'sight deposits'. In this speech, we use the term 'reserves'.

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range the SNB equates with price stability, namely a rise in the CPI of less than 2% per annum.

As inflationary pressures emanating from abroad intensified in the second half of last year, the SNB decided at its monetary policy assessment in December 2021 to allow the Swiss franc to appreciate a certain amount in nominal terms. Additionally, starting in June of this year, we tightened our monetary policy by raising the SNB policy rate.2 On 16 June, we raised the SNB policy rate - the blue line in Slide 3 - by 50 basis points, to −0.25%. As this was our first rate increase in 15 years, it was a truly historic moment for us. On 22 September, we raised the policy rate further, this time by 75 basis points. With this second increase, the policy rate moved back into positive territory to its current level of 0.5%. This was another historic moment for us, as it ended the phase of negative policy rates in Switzerland, which had prevailed since January 2015.

Why does the implementation of monetary policy matter?

Our rate hike in September (the red arrow in Slide 4) signalled that we would like to see secured short-term Swiss franc money market rates - particularly the most representative money market rate, SARON - settle close to the now-positive level of the SNB policy rate. The announcement of a policy rate change does not, in and of itself, always cause money market rates to rise, especially in an environment of abundant reserves. For money market rates to rise as envisaged, monetary policy must be implemented in a manner that ensures Swiss franc money market rates move close to the SNB policy rate. What does it take to achieve this? In terms of our chart on Slide 4, what does it take for the blue arrow to materialise?

The transition to a positive rate environment did not change the objective we pursue when implementing our monetary policy. Our objective, stated on the left-hand side of Slide 5, remains to keep secured short-term Swiss franc money market rates close to the SNB policy rate. However, for reasons we will explain shortly, the SNB had to adjust the approach it uses to implementing its monetary policy. Specifically, as shown on the right-hand side of Slide 5, two new elements were needed: reserve tiering and reserve absorption.

Before we dive into the details of what reserve tiering and reserve absorption accomplish, you may be wondering why we did not revert to the implementation approach we used to employ before the global financial crisis, or GFC. Back then, we controlled money market rates in positive territory by keeping the supply of reserves limited and close to the banks' structural demand for reserves.3 In the aftermath of the GFC, conditions in the money market changed

1. Since June 2019, the SNB has communicated its interest rate decision using the SNB policy rate. In setting the SNB policy rate, the SNB signals the desired level of interest rates in the secured money market. For the approximately 20-year period prior to June 2019, the SNB set a target range for the three-month Libor in its monetary policy assessment, and it then usually sought to keep this interest rate in the middle of the target range through money market operations.
2. At that time, the structural demand was mainly driven by the minimum reserve requirement that banks have to fulfil as well as by banks' desire to hold sufficient reserves to be able to make all required payments.

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fundamentally and permanently. The following two structural changes, in particular, drove our decision to adopt the new approach to implementing monetary policy.4

First, since the GFC the stock of reserves has grown tremendously.5 As a result, the money market is today characterised by a structural reserve surplus instead of a structural reserve deficit. A return to the status quo before the GFC would have required us to reduce the stock of reserves on a very large scale.6 Given the substantial quantities involved and the long time it would have taken to complete this task, we doubt that we would have been able to steer money market rates in the short term.

Second, the landscape of Swiss franc reference rates has changed significantly. In particular, Libor was replaced by SARON as the new reference rate in Swiss francs.7 SARON - an acronym for Swiss Average Rate Overnight - is calculated based on actual transactions by the private sector in the overnight segment of the Swiss franc repo market. A sufficient volume of interbank money market activity is therefore required to ensure a robust basis for calculating

SARON.

Why does the SNB apply reserve tiering?

Let me now explain in more detail how our approach works and, in particular, why both elements of the approach are required in order to implement our monetary policy in a positive rate environment. We begin with the first new element in our implementation approach, which is reserve tiering.

As I will show, remunerating reserves lets us steer money market rates in an environment with a positive policy rate and a large stock of reserves.8 However importantly, and in contrast to many other central banks that also pay interest on reserves, the SNB does not apply the same interest rate to all reserves. Instead, we employ reserve tiering. To illustrate how reserve tiering works, let us consider a highly stylised banking system, depicted on Slide 6.

The SNB grants each bank that holds reserves a so-called 'threshold'. This is marked on the slide by a red vertical bar. Each bank's individual threshold is a function of its minimum

1. Berentsen et al. (2018) examine various approaches to implementing monetary policy based on the assumption of a large stock of reserves.
2. Uncertainty about both the level and variability of the structural demand for reserves has also increased during this period. This uncertainty is partly due to new liquidity regulations that came into effect in the wake of the GFC.
3. The stock of reserves could be reduced by selling some of the foreign currency acquired in previous years and by absorbing reserves via open market operations. In both cases, negative effects, such as a substantial appreciation of the Swiss franc, could not be ruled out.
4. Libor, which had been the key reference rate for several decades, ceased to exist in many currencies at the end of 2021. SARON has fully replaced Swiss franc Libor. Maechler and Moser (2022) discuss the transition from Libor to SARON.
5. We also remunerated reserves from January 2015 to September 2022. During this period, we paid negative interest on banks' reserve holdings at the SNB. To reduce the burden for banks, we exempted reserves up to a bank-specific threshold from negative interest. Maechler and Moser (2020) discuss the SNB's monetary policy implementation in the negative rate environment.

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reserve requirement, so that the threshold generally does not match its reserve holdings.9 As a result, there are two types of banks: those whose reserves exceed their thresholds, shown in the upper half, and those whose reserves are below their thresholds, shown in the lower half. The SNB now remunerates reserves up to the threshold, shown in dark blue, at the SNB policy rate, which is currently 0.5%. In contrast, the SNB remunerates reserve holdings that exceed the threshold, shown in light blue, at the SNB policy rate minus a discount. Currently, the interest rate on reserves above the threshold is 0%. For the remainder of this speech, we will refer to reserves above the threshold as 'excess reserves'.

Let us examine the banks with excess reserves more closely. As we just noted, part of their total reserves would be remunerated at 0%. These banks therefore have a strong incentive to lend some of their excess reserves to other banks, at an interest rate above 0%. Conversely, banks whose reserves fall short of their thresholds have an incentive to borrow reserves up to their thresholds at an interest rate below 0.5%, and to deposit these reserves at 0.5% at the SNB. Such a trade, depicted on Slide 7, is beneficial for both types of banks - the bank lending the reserves earns the positive interbank interest rate on its excess reserves, while the bank borrowing the reserves earns the difference between the SNB policy rate and the interbank interest rate. Reserve tiering thus creates an incentive for interbank trading, and thereby supports activity in the interbank money market; this, in turn, ensures a robust basis for the calculation of SARON.10

To frame this slightly differently: If we did not apply reserve tiering and, instead, remunerated all reserves at the same interest rate, market participants would have little incentive to trade with each other and activity in the Swiss franc money market would decrease drastically as a result. There are two reasons for this. First, most market participants are still flush with reserves. Second, all institutions that have access to the repo market can hold reserves at the SNB. Taken together, there would be little incentive for market participants to attract reserves by engaging in repo transactions, and hence interbank activity would be low.

Why does the SNB use reserve absorption?

Let us now take a closer look at the second new element of our implementation approach - reserve absorption. Why do we absorb reserves and how do we perform this task?

As we just noted, in our reserve tiering system, banks with excess reserves have an incentive to lend those reserves to banks whose reserves fall short of their thresholds. Unless the borrowing capacity of these banks is substantial, there may still be excess reserves in the system even after all interbank trading is accounted for. This is precisely what we see in the

1. For each bank that is subject to the minimum reserve requirement, the individual threshold corresponds to the moving average of the minimum reserve requirements over the preceding 36 reference periods, multiplied by the applicable threshold factor. Theinstruction sheet governing interest on sight depositsprovides further information.
2. We gained the insight that reserve tiering promotes interbank trading during the time when our policy rate was negative. As we applied a negative interest rate to reserves that exceeded bank-specific exemption thresholds, we were essentially making use of reserve tiering during this period. Fuhrer et al. (2021) investigate monetary policy implementation via reserve tiering both theoretically and empirically.

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