Banks are now allowed to keep a certain proportion of required reserves for lira deposits in FX.

Quite a while ago the Central Bank (CB) introduced a new monetary policy tool. The tool has two pillars: first, banks are now allowed to keep a certain proportion of required reserves in FX. This proportion was zero, but after the new policy it was raised to 10 percent as of 12 September 2011.

Within the process, the proportion of required reserves on lira deposits that can be kept in FX was raised gradually, lastly to 60 percent as of August. The second pillar of the new policy tool (called the reserve option coefficient), skipping the technical details, implies that if banks choose to raise the proportion of required reserved kept in FX, they can exercise this “right” at an exchange rate that is higher than the market rate. The regulation maintains that the applicant exchange rate shall be set by the CB.

To identify the initial implication of the policy for banks, let’s go back to the period where the proportion that can be kept in FX was first raised to 10 percent. Let’s say that Bank A holds a deposit of 100 liras and is obliged to keep 20 liras at the CB as reserve requirement. On 12 September 2011, banks were granted the “right” to keep 10 percent of this amount (2 liras) in FX. Bank A was therefore authorized to keep on its own will 18 liras plus the dollar value of 2 liras at the CB.

Let’s assume that the Bank A chose to keep the reserve requirement amount in FX. Please note that before the mentioned decision the entire amount (20 liras) was kept in lira terms but now Bank A chooses to keep 18 liras plus dollars corresponding to the value of 2 liras. In other words, the CB will return 2 liras and in exchange Bank A will deposit the dollar value back to the CB. This will increase the CB’s FX reserves and Bank A’s liquidity in lira terms.

When announcing this policy, the CB drew attention to the problems across Europe and said the new policy was introduced “so as to meet the Turkish lira liquidity requirement of the banking system through a longer lasting method and with a lower cost, as well as to use the foreign exchange reserves in a prompt, controlled and effective way…”

First, the CB stressed that the policy was aimed at meeting the liquidity requirement of the banking sector on a longer lasting method. In the boring example above, Bank A’s liquidity increased by 2 liras. Second, the CB argues with this policy the liquidity requirement will be met at a lower cost.

Here is why: Normally, if Bank A was willing to increase its funds by 2 liras, it would borrow on the current deposit rate applicable for the Turkish lira, which is quite high. Now, the Bank can borrow it from the CB under the new policy option.

Of course, this is not a zero-cost option: there is the cost of acquisition for the FX the bank will deposit to the CB in exchange for 2 liras. It either has to collect FX deposits or borrow from abroad. Yet, interest on FX funds is much lower compared to that on lira.

In this picture, the option the CB offers is profitable for the bank. At the same time, the CB says, it will be better off too. It basically says, “if banks choose this option, they will have to deposit cash, which will increase the CB’s FX reserves to be used when needed.”

These are the upsides of the policy tool. There also are significant downsides that I will handle next time...

This commentary was published in Radikal daily on 16.10.2012