If we were to believe what the Central Bank has to say about the average trader in the dealing rooms of banks, you would tend to think of them as despicable creatures that are up to no good.
They cause volatility in the market and if left unchecked to their own devices they would stymie growth and cause a major fall in the value of our beloved currency and provide us with expensive funds for our businesses.
WANTING GOOD NOT TRANSLATED INTO DOING GOOD: Contrary to popular belief held in the corridors of the interest rate setting institution, there is more to controlling interest rates than by merely selecting the level of the cut-off at the periodic auctions or the Open Market Operations (OMO) conducted.
The end objective of either providing monetary stimulus to the economy or restraint depends more on what the borrowers pay for increasing their purchase of real and financial assets.
And this will in turn depend on their conviction as to their ability to make a profit from acquisition of these assets today against borrowed capital.
It's interesting to note that, on the final analysis, banks, due to their customers' demands, are constantly adjusting their liquidity and interest rate exposures on a daily basis. And not, as the regulator believes, once every auction or OMO.
In addition, the traders are required to constantly adjust their prices, given market volatility, to react to market demand and supply condition.
The largest and most powerful of all the market participants in the financial world is the Central Bank.
Despite their ability to influence their thought on the market by words and action, Central Banks are hardly ever successful, when they use undue oral influence to limit market movement, ignoring market fundamentals, fears, momentum and perceptions.
BRINGING TOGETHERNESS OF MINDS: While most regulators are regular invitees to seminars for bankers, businessmen or other such forums, the reverse is a rare occasion.
Hence, I felt it my obligation to pen my thoughts that would invite a healthy discussion between those who regulate and those who are regulated.
At the outset, though, it should be said that there are no touchstones of managing the ethereal activity relegated to the regulator of managing the emotional responses of the economic participants to economic events.
But one thing is certain, there are fundamental principles used by the economic participants as they respond to adverse market information by taking a course of action for self-preservation.
The key is not that to have a response that limits such responses but to channelise these creative forces for more productive activity.
FRAMEWORK FOR ECONOMIC MANAGEMENT: Returning to the individual under focus - the traders, let us evaluate their role as individuals that regulate the flow of liquidity and value from the participants in the financial world to the real world.
The first thing in this context is that the financial intermediation is undertaken for profit.
Any effort on the part of the regulator to curtail or enhance the profit objective is and should not be the guiding principle of the regulator, as it will at best hamper the transmission of its monetary policy to the economy.
Secondly, the financial institutions undertake financial intermediation by exposing themselves to liquidity and interest rate risk.
The quantum of which is governed by banks' perception of the level of such a risk acceptable to them given the quantum of capital available to them.
While there is tremendous incentive for these traders to follow the path of least resistance and look for information in the less costly medium, they are more than apt to search for information from less friendly medium if provided with the right incentives and direction.
In this context, it is more important to understand that financial institutions expect to receive constant barrage of information reflecting changing conditions.
And they are more agitated when instead of the information coming continuously comes sporadically, especially in light of significant movement in prices or economic fundamentals.
Based on this need, when the regulator changes the quantum of reserves held by the banks once a week, fortnight or month, it gives rise to interest rate volatility.
It is interesting that while the world understands the long term interest rates (anything greater than overnight) to be nothing more than constantly compounded overnight rates, the underdeveloped countries tend to set the 3 months or the 6 months rate or even longer.
And they expect the shorter-term interest rates to track this rate, without attempting to correct the shorter-term liquidity imbalances.
Of all the market participants, the monetary authority should understand that the reserves that bank hold change constantly as the government collects taxes, pays its bills, borrows or repays debt.
And the only way to correct the temporary imbalances is to take appropriate action on a daily basis.
BANKING - IT'S NOT MONOPOLY: It's important to understand that unlike utility distribution companies in the developing world, financial institutions are not monopolies.
Furthermore, their activity is beyond simply collecting deposits from unsophisticated customers and passing them to hapless borrowers.
On the contrary, banks have to continuously strive to find a fine balance between product pricing and promotion to attract deposits and at the same time try to deploy those funds with qualified borrowers at competitively favourable rates.
Neither the depositor nor the borrower places his trust in just any financial institution, either by falling for some marketing glitz nor by opinions expressed by the man on the street.
The reputation of a bank is built through sheer conviction of providing secure and value proposition to the customers, both the depositor and the borrower.
BANKS AND REGULATORS - MAXIMISING EFFECTIVENESS: While formal and informal meetings between banks and regulators form an important element of communication between the two, but the most important element usually overlooked by the regulator is the price. Let's see what are the prices prevailing in the market place and to whom do they affect.
TREASURY BONDS (PIB), BILLS AND REPO MARKET: The most liquid market that the banks operate in is the repo market.
While in the developed countries the repo market is generally used to cover the short position in the outright bills and bonds market, in the underdeveloped countries, it is used to collateralize borrowing and lending to weaker credit counter parties.
Even though the liquidity by weaker banks might also be generated through the sale of treasury bills, given the different tax timing treatment on the income of repo and the outright treasury bills, they make the use of Repo more preferable than secondary market treasury bills trading.
The banks prefer to manage their liquidity and interest rate views in the Repo market.
While we are talking about the tax timing difference, let's dwell on what are those timing differences and how do they affect the yields in the market.
The government's fiscal agent, the State Bank of Pakistan, pays the treasury papers' interest.
However, it deducts advance income tax on such payments. It should be understood at this point in time, that irrespective of whether banks pays advance income tax on treasury bills earnings or not, it does pay advance income tax four times a year on previous year's income.
However, the timing difference between the treasury bills advance income tax and what is payable on previous income causes timing mismatch which is reflected in the yield repo is transacted versus those of treasury bills.
That means that if advance income tax is deducted from treasury bills interest in January while the normal advance tax is not payable till March, the original investor is expected to pay the present value (for 2 months) of the tax paid early.
Needless to say that the repo trades at a lower yield than the corresponding tenure treasury bills and this difference is more pronounced as the Treasury Bill tenor gets shorter.
One would hope that the government does away with the distortion so that they are able to get better price information from inter bank trading.
Repo is more popular for another reason. In an economy where the banking sector of 40 odd banks, with the credit rating of banks spread over the entire spectrum of credit quality.
And as such banks have got limited appetite in lending money to each other.
Repo transactions enable them to bridge the credit limitation on each other is overcome with the use of the underlying collateral of the government paper.
Another interesting quirk in the treasury bills auction is the fact that instead of a market based system of price discovery it is more a system of price enforcement.
This means that in the event the bids do not match with the fiscal agent's benchmark the auction may be scrapped.
On the other hand, if the amount bid is more than initial target but the price is better than fiscal agent's benchmark there would be an automatic green shoe option exercised, irrespective of its impact on reserve balances of banks.
While price enforcement, per se, is not a bad thing, if it is really enforced. But, the bane of the whole process is that the price is selectively enforced only for one type of transaction.
The measurement of effectiveness of the rate selection is more on the amount of money that has been paid as interest and not really on what the key focus of the rate is for the economy.
This is evident immediately subsequent to the auction result when the entire curve moves to reflect the current condition of the liquidity in the market.
The resultant curve determines the rate at which prime companies would borrow funds from the bank (the KIBOR, Repo and T-Bills yield generally move in sync).
One other anomaly seen in this market is the fact that the overnight lending rate does not seem to have any significance with those of the cut off rate of treasury bills. Not only this, but the future movement overnight inter bank rate is independent of the cut off rates.
Whether the Regulator may not have an explicit overnight target rate, it does effectively convey it by its mere inaction on a daily basis, whereby the rates either drop close to zero or rises up to the discount rate.
The target rate would thus be derived from the average overnight rate during any reference period.
Hence, if the regulator feels that it would like to target rates for 3 months, then it should also strive to maintain the 3 months average overnight lending rates to that level, otherwise, the lending rates for the other borrowers in the economy would be "based" on a rate lower than the cut off rate of government paper.
Mind you, the word based implies that while the corporate rate might be higher, it would be determined on the basis of the risk free rate ("Repo rate") plus the credit spread.
Obviously, if we were to analyse history of the cut off rates and the average overnight lending rate, we do not see any correlation. Furthermore, the cut off rate has no significant correlation to either subsequent auction cut off or the discount rate.
It seems that the regulator is unable to discern the difference between the impact of price discovery versus price enforcement on the broader market of corporate and retail banking customers.
While the size of government paper is about PKR 800 billion, the customer lending for banks is PKR 1400 billion. The maximum size of an auction has not exceeded PKR 100 billion.
Furthermore, competitive bidding goes to the extreme, that means that any one bank can corner the market but putting an unrealistic bid so as to ensure that only it is allocated the paper which it may turn around and sell it at a much higher price. Such an act would not go condoned in any other market.
While both, Repo and Treasury paper market, enable participants to express their views on interest rate movement and bridge their reserve liquidity position, it does virtually nothing from making surplus lending capacity available between banks.
INTERBANK DEPOSIT MARKET: As mentioned above, good credit banks are handful and as such, lending capacity gets stuck in the lower credit banks as they maintain a higher level of safety to meet customers' needs, knowing fully well that their ability to raise inter bank deposits are at best limited.
As such, despite the growing spread ("security lending rate") of repo and "clean/call" lending rates, these banks stay on the side-lines.
The only way for them to participate in mitigating the runup in the security lending rate would be to invest their surplus liquidity in prime named banks negotiable/tradable certificates of deposits.
By having invested in such a paper they would be able to draw on the liquidity by selling off this paper to either the issuing bank or the other participants in the market.
The reason why this has not happened, yet again, is because of the taxes (stamp duty). While the provincial governments assure business that they would like to create a business-friendly environment, they have been unable to comprehend the value of allowing banks to trade CDs among themselves.
This would release surplus credit through money center banks and reduce the benchmark rates for borrowers making cheaper credit available for business activity.
It should be clear to the provincial government that they would not be giving up revenues as non-tradable lending between banks do not attract such tax.
The exemption for stamp duty would only be restricted to bank CDs that may be invested in by banks only (to qualify for zero CRR/SLR requirements also).
Why should KIBOR trade higher than repo? This primarily would be due to credit risk.
However, as we have seen in the past, KIBOR-Repo spread has seen 2% when the system wide acceptable securities over time and demand deposits shrunk close to 20% (the target SBP ratio for CRR and SLR).
This means that banks as a whole have extended to its customers as much as they could given the regulatory ratios they have to maintain.
It is interesting to note that the SBP has been able to coax the banks to set up a KIBOR page on the Reuters but getting them to trade daily is another thing.
The fact that the banks have agreed to quote for a token amount of PKR 50 million proves the point that their credit appetite is limited even for top names.
However, this credit limit may be made reusable if instead of lending for a tenor in untradable form the lending is done in a securtized form of a CD.
The monetary policy objective would be better suited if the transmission mechanism of those policies is more effective.
And the market perceptions are captured better by keeping a closer tab on the market pricing and realigning the short-term interest rate rather than trying to manipulate the entire curve.