436 PA R T V The Bank of Canada s Standing Facilities Central Banking and the Conduct of Monetary Policy At the end of each banking day, each LVTS participant must bring its settlement balance with the Bank of Canada close to zero Of course, it can scarcely be expected that LVTS participants will always be successful in ending up with nearzero settlement balances The Bank of Canada therefore stands ready (with what we call standing liquidity facilities) to lend to or borrow from a participant to bring their settlement balances to zero at the end of the banking day As already noted, participants also know with certainty the rates applicable to positive and negative settlement balances with the Bank of Canada (see the FYI box, Monetary Policy Implementation in the LVTS Environment, and Figure 17-1) To permit participating financial institutions to adjust positions with each other (i.e., reduce the costs of either positive or negative positions), the LVTS has a pre-settlement trading period of half an hour, at the end of the banking day (6 6:30 p.m.) The purpose of the pre-settlement trading period is to allow LVTS participants to reduce their LVTS positions (which resulted during the day from their own transactions and those of their clients) at interest rates better than those at the Bank of Canada s standing liquidity facilities That is, to provide a window for those participants with excess positions to trade with those in deficit, at a better return than can be achieved at the Bank s facilities, to the advantage of both In fact, the typical bid ask spread on overnight funds in the interbank market has been less than 1/8% This is significantly less than the spread of 50 basis points between the rate charged on overdrafts and that paid on deposits by the Bank of Canada after settlement of LVTS multilateral positions In general, pre-settlement trading among participants will achieve a zero settlement balance for each participant on wholesale transactions However, if at the end of the settlement day a participant has a negative balance on the books of the Bank The Worldwide Decline in Reserve Requirements and the Channel/Corridor System for Setting Interest Rates FYI As already noted, central banks in many countries have been reducing or eliminating their reserve requirements For example, there are no reserve requirements in Australia, Canada, New Zealand, Switzerland, and the U.K., while in the euro area the reserve ratio is 2% and in the U.S 3%, rising to 10% for large deposit holdings The fall in reserve requirements has elicited the concern that if the demand for reserves falls to zero, then a central bank may not be able to exercise control over interest rates However, the so-called channel or corridor system for conducting monetary policy which has been adopted by Canada, Australia, and New Zealand shows that central banks can continue to effectively set overnight, interbank interest rates like the overnight interest rate in Canada How the channel/corridor system works is discussed in detail in this chapter.5 The important point of this analysis is that the channel/corridor approach enables the central bank to set the overnight policy rate whatever the demand for reserves, including zero demand Thus in the future, continuing declines in the demand for reserves may eventually lead central banks to follow in the footsteps of the central banks of Canada, Australia, and New Zealand and to adopt the channel /corridor system for conducting monetary policy See also Michael Woodford, Monetary Policy in the Information Economy, in Symposium on Economic Policy for the Information Economy (Federal Reserve Bank of Kansas City: 2001)