The Central Bank of Iceland's Liquidity Management System: A search for an optimum

This paper aims to answer the question of what kind of liquidity management system would be optimal for Iceland with respect to two important considerations. One is the current environment of surplus reserves and the other is Iceland’s specific character of being a very small, significantly open economy, with its own currency. The paper takes note of the fact that implementation of monetary policy underwent significant changes at central banks in many countries following the Global Financial Crisis (GFC). In many cases, this went hand in hand with efforts to avert an even more severe recession through exceptional provision of liquidity, often leading to implementation of monetary policy under the conditions of a significant structural surplus of reserves. As in Iceland, the response was in a number of cases, a move to a de facto floor system. The crisis gave central banks in many countries a welcome opportunity to reflect on their operational frameworks, and this seems sensible for Iceland too, at the current juncture. To better understand the recent developments and consider the way forward as regards liquidity management, the paper looks at the theory behind monetary policy implementation. The various origins of surplus reserves, their characteristics and the implications for conduct of monetary policy are discussed in some detail. The reasons for the steep accumulation of surplus reserves in the Icelandic banking system are considered and fluctuations are found to be likely to persist in a small, open economy, not least one with a managed float. Four different types of liquidity management systems at central banks are considered in turn; a wide corridor with reserve averaging, a narrow corridor without reserve averaging, a floor system and a quota system. Through the comparison of these liquidity managements systems as well as operational realities in selected economies, notably the neighbouring countries of Sweden, Norway and Denmark, we reflect on whether other approaches might better serve a small, open economy such as Iceland. We set out to study in particular their advantages and disadvantages that are relevant to our discussion as well as circumstantial similarities and dissimilarities with the Icelandic context. The paper finds it doubtful that a corridor system would be optimal for Iceland under the current circumstances. Interbank activity is almost non-existent, yet measures to bring the system to a point of increased activity such as setting very high reserve requirements or drain liquidity to the point of effecting a deficit, are not feasible or realistic due to cost and incentive issues. A floor system does not seem to be a good option while interbank trade is still seen as necessary for the transmission of monetary policy. Even though interbank interest rates hover just above the floor and show very little volatility, there could be doubts about transmission along the yield curve with the almost complete lack of tension in the market. The paper posits that a small, open economy with its own currency and the potential for extreme swings in the structural liquidity position might benefit from a quota system with some of the characteristics of the systems currently in place at Norges Bank and Danmarks Nationalbank. The former relies on incentives to maintain the optimal liquidity position while the latter mixes incentives with automaticity, but both aim to maintain a frame around the daily liquidity management of banks and disincentivise holdings of liquidity beyond that amount. This can be done through incentives at the margin or by converting the surplus into longer-term instruments. The latter option is an even stronger tool to maintain the desired liquidity in the system and interest rate differentials can also be deployed if there is a need to target the exchange rate channel specifically. This paper has taken as a given certain priorities of the Central Bank of Iceland. This includes activating the interbank market for the successful transmission of monetary policy. It is also assumed that the Bank would prefer to define, or potentially minimize, the amount of domestic reserves in the form of current accounts at the central bank, not least with a view to the potential for free reserves to enter the market for foreign currency. However, it is very important to note that liquidity management systems, and the environments they operate in, are constantly evolving and that no system is perfect. It may be possible to arrive at an optimum, but this requires defining priorities and goals for the central bank as well as the whole economy. This paper suggests that such an exercise might be a feasible undertaking for the Central Bank of Iceland