Discounting Rate – Control Of Bank Liquidity

Discounting Rate – Control Of Bank Liquidity

The discount rate is the price paid by the owner of securities to the central bank of Nigeria for converting the securities into cash. As a technique of monetary control, it is designed to influence the cost of credit (in essence the cost at which banks can borrow from the central bank of Nigeria) hence, variations in the rate reflect an increase (in the case of a fall in the rate) or decrease (in the case of rise in the rate) in central banks credit to commercial banks.

The objective of discount rate policy is to influence the availability of credit and hence the money supply; and the ability of the central bank to use this policy derive from its role as the ultimate source of cash in other words, as the lender of last resort. Thus, whenever commercial banks are short of reserves, they have two choices, either to obtain them from the central bank discount window, or to liquidate some of their loans and advances.

An increase in the discount rate involves an increase in the cost of the loans, which can be discounted at the central bank. Since the discount rate is usually set higher than the prevailing market rate interest, it is policy for commercial banks (in the face of rising discount rate) to raise the rate of interest on their loans.

Consequently, the cost of credit rises all round, and credit creation (and hence money supply) is reduced. It is in this sense that the discount rate is usually viewed as a penalty rate. The effectiveness of discount rate policy depends on many factors.

1. The discount rate must be closely tied to the structure of short term rates of interest prevailing in the economy.
2. Commercial banks must not have access to liquid assets and/or must keep excess reserves.

In fact, the effectiveness of the discounting rate policy has been weakened in developing countries whose commercial banks (as mere branches of international corporations) have access to liquid assets. What in fact makes the discount rate effective is the realization that it can render the commercial banks illiquid in two ways;

1. The rise in the discount rate, accompanied by a rise in the structure of short term rates, can dry up the supply of liquid assets.
2. Rise in the discount rate can be followed by central bank of Nigeria open market operations that are aimed at mopping up excess liquidity. these two possibilities may be rendered ineffective however, if the commercial banks have access to funds from abroad or if they keep excess reserves.

Reserve Requirement On Discounting Rate

Designed originally to protect customers deposits (by ensuring some minimum level of bank liquidity), a reserve requirement has become a popular weapon of monetary controls. A reserve requirement is usually expressed as a percentage of customer deposits, and it predetermines the maximum amount of credit that can be created by the banking system.

Law or custom usually fixes it, and it can be held in form of cash and non interest earning balance with the central bank. How does the reserve requirement work? If the reserve requirement (in essence ratio) is increased, the commercial banks compelled to liquidate some part of their investments and loans in order to acquire the assets that qualify as reserves. On the other hand, a decrease in the ratio means that the banking system can increase its loans and investments and possibly hold excess reserves. There is thus an inverse relationship between the reserve ratio and money supply. But the change in money supply manifests itself through changes in the money multiplier rather than through the monetary base.

An increase in the ratio decreases the money multiplier and hence the money supply. On the other hand, a fall in ratio leads to a rise the money multiplier and permits an increase in the money supply.

Reserve requirement policy has been several criticized on many grounds;

1. First, it has been argued that it is too general in its effects. Since it is imposed on the banks without references to their liquidity thus tend to suffer more than those holding excess reserves.
2. Secondly, it has been argued that the policy discriminates against commercial banks and in favor of non bank financial institutions to the extent that the latter are not subjected to it.
3. Thirdly, if commercial bank business are required to hold government securities to satisfy the reserve requirement, the policy discriminates in favor of the government as a borrower and against private borrowers.