The Bank of England isproposing reform of the sterling money markets in a bid to reduce the volatility of short-term interest rates. In what the bank says are the “most far reaching reforms for a quarter of a century or more”, it will replace the present system, which involves frequent bank intervention to stabilise rates, with an arrangement modelled on best practice that should minimise interest rate swings.

“The new framework will, I believe, make our money market operations more open, accessible, transparent and effective, and bring the market itself more closely in line with best international standards,” said Mervyn King, governor of the Bank of England.

Under the new scheme, the bank will allow commercial banks to set their own balance levels – or positive reserves – that they will be required to hold with the bank on average over a “maintenance period” lasting from one Monetary Policy Committee (MPC) meeting to the next – typically one month – rather than adjusting them on a daily basis, as is now the case.

“Together with a narrow corridor on the final day of a monthly maintenance period, it will help to stabilise the overnight interest rate, and so promote healthy sterling money markets. The new framework will also give more banks access to the Bank of England, which will improve the banking system’s ability to cope in stressed conditions,” said Paul Tucker, executive director, markets, at the Bank of England.

The reforms rest on four main innovations: commercial banks will determine their average balances held in reserve over a one-month period, rather than balancing their books each day; the reserves will earn interest at the bank’s repurchase – or repo – rate, currently 4.5%. Presently, reserves do not earn interest and therefore there is little incentive to maintain a balance; commercial banks will also be encouraged to use the Bank of England’s balance sheet. Lending and deposit facilities will be available on demand, said the bank, with rates calculated at the MPC’s repo rate plus 25 basis points on the final day of the one-month maintenance period (and at a wider spread to the repo rate on all other days).

Finally, the bank will conduct weekly open market operations at a maturity of one week at the MPC’s repo rate and, as a matter of routine, there will be an “overnight fine-tuning” repo on the final day of the maintenance period.

The Bank of England said that it would issue a paper setting out the changes and the proposed timetable for implementation more fully in the early Autumn, and would consult the industry on the details.

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