Liquidity Facilities: How a Central Bank Adds or Drains Cash

A liquidity facility is an arrangement under which a central bank lends settlement balances to a bank against pledged securities for a stated period, or takes balances back in. Facilities exist because no bank paying another can change the total of settlement balances in the system. The central bank keeps the accounts, and only the central bank can change that total.

A bank's two sides are familiar enough. Deposits and other funding on one, advances and investments on the other, and the difference between them belonging to the owners. Far less often said is where the cash itself lives, and the answer to that decides everything about how a bank meets a payment.

Where does the cash a banking system settles in actually sit?

Every bank keeps one account at the central bank, and the balance in that account is called a settlement balance. The settlement balance, and not the notes stacked in a branch till, is what one bank hands another when a payment is made. The notes matter to the person at the counter. Notes do very little for the payment running between two institutions at nine in the morning.

The cash a banking system runs on is a column of entries on one institution's books. The institution keeping those books is the central bank. Read that twice. Almost every surprising thing about liquidity comes straight out of it. If the cash is entries on a ledger, then somebody keeps that ledger, and whoever keeps it is in a position no participant can occupy.

Here is the everyday picture to hold beside it. Ten shops sit in one shopping centre, each banking somewhere different. The first shop pays the tenth for a delivery. No notes cross the corridor, no cash box is opened, and nobody walks anywhere. Two lines change on a ledger that neither shopkeeper has ever seen and neither of them keeps. The shops experience a payment. The event itself was a pair of entries somewhere else entirely.

What happens to that cash when one bank pays another?

Somebody banking at one bank sends money to somebody banking at another. Follow the cash rather than describing the transfer. The paying bank's settlement balance goes down. The receiving bank's settlement balance goes up, by exactly the same amount, at exactly the same moment. Two entries, one event, and nothing in between.

The cash does not vanish, it moves, and the useful question is always where it went. The rule looks almost too simple to be worth stating, and everything else in the subject rests on it. A bank that is short of settlement balances at the end of the day has not lost anything to the void. The bank has paid it to somebody, and that somebody banks somewhere, and that somewhere now has more than it started with.

Which gives the second half, the half that surprises people: somebody's shortfall is somebody's surplus, and the two are one event described from two sides. The household living on one salary is the everyday version. On the day the salary lands, the household's bank has more and the employer's bank has less, by the identical amount at the identical moment. Nobody anywhere has made a rupee appear.

So who can change the total, and why can no bank do it?

Add up every settlement balance in the system before that payment. Add them up after. The two totals are identical. The equality holds for one payment. The same equality holds for a million of them running through a Tuesday. And it holds when every bank in the system decides on the same morning that it would like to end the day holding more than it started with.

Every bank's transaction has another bank sitting on the other side of it, so no bank can change the total. Each rupee one bank gains is a rupee another bank gives up. Effort does not help. Skill does not help. Ten banks all trying at once produce a lot of movement inside the column and not one extra rupee in it.

Which leaves exactly one party in a different position. The only participant whose own transaction does not have a bank on the other side is the one that keeps the accounts. When the central bank lends a bank cash, the entry paying for it is made on the central bank's own books, and the total in the column goes up. The extra rupee is not a trick and not a privilege anybody granted for cleverness. The position follows from keeping the ledger, and nothing else.

What is a liquidity facility, and what are its moving parts?

Now the instrument itself, and it is much less mysterious than the name suggests. A facility has exactly four moving parts. A DIRECTION, being cash out to banks or cash in from them. A PRICE, being the rate charged or paid. A PERIOD, being how long the cash stays. And a SECURITY, being what the bank hands over while it holds the cash.

A facility is a transaction and not a rule: two willing sides, a price, a term and collateralAn asset a borrower hands over so that the lender still gets its money back if the loan is not repaid. Handing it over does not make it the lender's property; it makes it available if things go wrong., exactly like any other secured loan, and the only unusual thing about it is who sits on the other side. Strip the vocabulary away and a bank pledging securities to a central bank for cash is doing what a household does when it pledges jewellery at a lender's counter, with better paperwork and a different counterpartyThe other side of a transaction: the party being dealt with, and therefore the party that has to perform if the promise is to be met..

Then the hard part. The Reserve Bank of India sets the price, the period, which securities qualify and what is deducted from a pledged security's value, and it revises all four. A direction carries no number, so the direction is the one part that can be written out in full and stay true.

Why are adding cash and draining it the same lever?

Run the mechanism forwards. Cash out to banks: the central bank lends, a bank pledges securities, settlement balances go up, and the column holds more than it held. Now run it backwards. Cash in from banks: the central bank borrows or sells, a bank hands over balances, and the column holds less.

The second direction is not a punishment and the first is not a rescue. Both are one lever moved in opposite directions. A reader who is told that a central bank drained liquidity, and pictures a stern parent taking something away, has read a mood into a ledger entry. A reader told that it injected liquidity, who pictures generosity, has done the very same thing with the sign reversed.

Think of a tap and a drain on one tank. The same hand works both, and works them for one reason, to keep the level where it is meant to be. Nobody calls the drain cruel. The drain is the other half of the same job, and the level is what matters rather than either fitting.

What does a drawing do to a balance sheet, line by line?

Work it on a real set of figures. Suvarna Commercial Bank Limited, an invented bank, reports total assets of Rs 2,40,000 crore, of which advances are Rs 1,44,000 crore and investments are Rs 60,000 crore. Deposits are Rs 1,92,000 crore. Net worthWhat is left for the owners once everything the institution owes has been met from everything it has. Net worth is the difference between the two sides, never a pot of cash sitting somewhere. is Rs 24,000 crore, so total assets are 10.00 times net worth.

Suvarna Commercial Bank draws Rs 9,600 crore. On the asset side, its balance at the central bank rises by Rs 9,600 crore. On the funding side, what it owes the central bank rises by Rs 9,600 crore. Total assets go from Rs 2,40,000 crore to Rs 2,49,600 crore.

And here is the line that does not move: net worth is Rs 24,000 crore before the drawing and Rs 24,000 crore after it. Nothing the bank has became worth more. Nothing it owes was forgiven. The bank has more cash and more debt, in equal measure, and the difference between the two sides is exactly where it was.

One more reading. The size of the drawing is where a base error waits. Rs 9,600 crore is 5.00 per cent of deposits of Rs 1,92,000 crore and 4.00 per cent of total assets of Rs 2,40,000 crore. One amount, two perfectly correct percentages, differing only because the number underneath the division changed. Every one of these figures needs its base named beside it. A percentage given without its base is not yet information.

An absence worth naming rather than filling. The statement gives advances of Rs 1,44,000 crore and investments of Rs 60,000 crore and then stops, so the remaining Rs 36,000 crore of total assets, which is Rs 15.00/- of every Rs 100.00/- of assets, is not split anywhere. How much of that block is already a balance at the central bank is not stated. Anybody working out where a bank's cash sits would want that split more than any other figure, and no statement carries it. Knowing which figure to go and ask for is worth more than a plausible guess.

Why is a pledge not a sale?

A pledge is the part readers skim and then get wrong. The securities Suvarna Commercial Bank pledges stay on its own balance sheet. The bank has not sold them. It has booked no gain and no loss on them. The securities come back when the bank repays. The investment line reads Rs 60,000 crore before the drawing and Rs 60,000 crore after it.

The bank has swapped the usefulness of an asset without swapping the ownership of it. A security is something it has; it is not something a depositor can be paid with at four o'clock on a Friday. A settlement balance is. For as long as the arrangement runs, the bank holds the form of the asset it needs, and the security sits encumberedStill the owner's, but promised to somebody else first, so it cannot be sold or pledged again until that promise is discharged. against the cash.

Collateral lets a central bank add cash without taking on the risk of the borrowing bank. Adding cash to a bank is a very different thing from adding capital to it. The distinction between cash and capital decides what a facility can and cannot fix. Which securities qualify, and what is deducted from a pledged security's value before cash is advanced against it, are set by the Reserve Bank of India.

Which line does a facility never move?

A facility raises an asset and a liability by the same amount. A facility therefore changes what a bank has and changes what it owes, and it leaves the difference between them precisely where it was.

A facility does not touch the number that measures capital, so it can fix a bank that is short of cash and can never fix a bank that is short of capital. Cash and capital are not two words for the same worry. A bank can hold every rupee it needs to settle and still have lost more on its loans than the owners put in. The same bank can be worth a great deal and have nothing to pay Friday's clearing with. A facility addresses the second condition and is blind to the first.

Which gives the reading rule worth keeping for good with bank balance sheets. When a bank borrows from a central bank, the line to look at is net worth. The answer is always nothing, and once that has been checked once, a bigger balance sheet stops reading as news about strength.

What are the three shapes a facility takes?

Facilities come in three shapes, and the difference between them is not the price. The difference is who starts the transaction and who decides how big it is.

First, a standing arrangement. A standing arrangement is always available, and the bank comes to it on its own initiative for as long as it qualifies. Second, an operation. The central bank starts it, sizes it and times it, and banks bid into it. Third, a band, formed by the rate at which cash can always be borrowed and the rate at which it can always be placed, with the price of cash between banks sitting inside it.

The band exists so that a bank which cannot find a lender still knows what cash costs. That is worth stating plainly because the third shape is the one people find slippery. A band is not a transaction at all. A band is a pair of known worst prices on either side of the market, and knowing them changes what every participant will accept long before anybody actually uses either one. Every rate, every period and the width of that band are set by the Reserve Bank of India, including where the policy rateThe rate a central bank announces as the price it wants cash to trade at between banks. A change in it goes on to affect borrowing, spending and prices, and that chain is worked through separately. sits inside it.

How Central-Bank Liquidity Reaches Banks and Markets: which banks feel it?

Cash added by a facility travels along two routes at once, and mistaking one for the other is the commonest confusion in this whole subject.

THE DIRECT ROUTE is narrow and easy to see. Balances land on the account of the bank that took the cash. Only that bank's line in the column changes. If Suvarna Commercial Bank draws Rs 9,600 crore, Suvarna Commercial Bank has Rs 9,600 crore more, and no other bank's line has moved by a rupee.

THE INDIRECT ROUTE is wide and invisible. Every other bank now faces a money marketThe market in which banks and other large participants lend cash to one another for short periods, often just overnight. The way that market works and clears is worked through separately. with more balances in it available to lend. The price at which banks lend to one another moves, and it moves for banks that never spoke to the central bank, never pledged anything and never filled in a form.

The first route reaches one named bank and the second reaches every participant in the market at once. That asymmetry is why a facility used by a single institution is never only about that institution. Nobody counts the rupees travelling the second route, so the two routes cannot be ranked by size. Breadth is a different question, and there the first route reaches one bank while the second reaches every bank that lends or borrows overnight.

Where the price of cash between banks goes next, what it does to anybody borrowing outside the banking system, and what any of it does to spending or prices are each worked through separately. The account here stops at the market between banks.

How does somebody outside a central bank actually use this?

Who sets the rate, the period and the terms of every facility?

Six parameters govern every facility, and not one of them is settled by the bank that uses it. Each value belongs to the authority, and each changes whenever the authority changes it.

Each of these is set by the authority named inside its row, each of them is revised from time to time, and an account that wrote one out would be false, rather than merely dated, from the day it changed. An address that can be checked beats a number that cannot be dated. Take the sheet below to the site printed inside it and fill the middle column in there. A sheet used that way stays useful for as long as somebody does it, and a printed number would not.