Hitting the Mark: Design Choices in Targeted Refinancing

Central banks often work toward more than one objective. In most cases, monetary and financial stability are both at the core of their mandates. Many also have a remit to support the government’s economic policies and other goals.

To target their objectives, central banks have a broad toolbox. Each of their instruments has impacts on a range of their goals and must be calibrated accordingly. The critical role of design choices in targeted refinancing operations is a case in point.

Targeted Refinancing

Targeted refinancing refers to central banks offering liquidity to banks on preferential terms in support of financing to specific segments of the economy. It usually comes in form of a loan or a repurchase agreement between the central bank and a bank, and related loans from the bank to the targeted economic segment.

The Targeted Longer-Term Refinancing Operations (TLTROs) introduced by the European Central Bank in 2014 provide an illustration. They offered preferential refinancing for bank loans to the real economy, excluding loans for house purchases, and were a key pillar of monetary policy in the Eurozone until 2022. The Federal Reserve offers a seasonal lending program targeted at banks with seasonal liquidity pressures. The People’s Bank of China has a wide range of structural monetary policy tools, including targeted lending facilities, to support funding, inter alia, to small firms, rural areas and carbon emission reductions. The “Climate Response Financing Operations” by the Bank of Japan is a further example.

Setting preferential terms

The design of targeted refinancing operations is crucial to achieve their intended outcomes. Design choices cover various parameters through which central banks modify their routine lending rules, thereby supporting bank credit toward target areas. Getting these choices right is critical for a central bank to successfully expand funding to targeted segments and to align with its key objectives.

At the core of targeted refinancing are preferential terms for central bank liquidity, such as lower interest rates, longer maturities, eased collateral requirements and more flexible repayment modalities.

The European Central Bank, as an example, offered its third TLTRO program at rates as low as 50 basis points below its average deposit facility rate. It also made its TLTROs available with a 4-year maturity compared to 3-month for its standard longer-term refinancing operation and allowed for voluntary earlier repayments. The Federal Reserve’s Seasonal Lending Program offers loans for up to nine months compared to up to 90 days for primary credit through the Fed’s standard discount window. Under its Carbon Emission Reduction Facility (CERF), the People’s Bank of China provides commercial lenders with funds equivalent to 60 percent of eligible loans principal at a reduced interest rate of 1.75 percent. The State Bank of Pakistan accepts Demand Promissory Notes— an additional form of collateral compared to government securities and other instruments typically required under its routine Open Market Operations— as collateral under its Export Refinance Scheme.

Defining eligibility

Defining eligibility for targeted refinancing constitutes a second set of design parameters. Eligibility criteria are specified in terms of eligible counterparties and eligible bank loans that can be refinanced.

The seasonal lending program of the Federal Reserve, for example, is only available to banks who can demonstrate “a recurring seasonal need for funds that persists for at least one month”. It is usually also only available to banks with less than 500 million dollars in assets. The BoJ requires banks who seek liquidity under its Climate Response Financing Operations to adhere to the principles by the Taskforce on Climate-Related Financial Disclosures in their reporting.

In addition to such institutional parameters, the “targeting” of refinancing is centred on the loans that can be refinanced. The PBOC offers a “Central Bank Lending for Sci-Tech Innovation” program under which it provides refinancing for loans to eligible technology enterprises. The Monetary Authority of Singapore’s SGD Facility was available during the Covid‑19 pandemic for loans to meet the working capital needs of Singapore-based companies. The BoJ’s Climate Response Financing Operations are available to refinance bank loans and investments that contribute to addressing climate change.

In many cases, eligibility criteria also include specific provisions that banks need to reflect in the loans to their clients. The interest rate, for example, that banks may charge for loans under the High Tech and Green Facility of Bank Negara Malaysia (BNM) are capped. The State Bank of Pakistan offers a Refinance and Credit Guarantee Scheme for Women Entrepreneurs, under which banks are required to provide repayment flexibility to their clients in the form of a six-month period in which borrowers can, but do not have to, make repayments.

Further parameters

Key additional parameters to define include possible limits on the overall volume of a targeted refinancing operation, its duration, as well as reporting requirements.

The TLTROs introduced by the European Central Bank in 2014 did not come with an overall cap. In contrast, the “Bank Intermediated Lending Support Facility” offered by the Bank of Korea for preferential refinancing of loans to SMEs is linked to a ceiling for liquidity offered through this program.

The Climate Response Financing Operation by the Bank of Japan is available until 2030, whereas BNM’s High Tech and Green Facility is available until full utilization. As for reporting requirements, the BNM, as an example, requires banks participating in its Micro Enterprises Facility (MEF) to submit monthly and bi-annual reports, as well as additional information upon request.

Calibration

The calibration of each of these parameters is critical.

Preferential terms need to strike a balance between providing enough of an incentive for banks to respond, and the risk of adding too much liquidity, and thus creating bubbles and inflation pressures. Similarly, eligibility criteria need to be closely aligned with the targeted policy objective. If the target is broad, such as for the ECB TLTROs, a wider scope for eligibility is appropriate. If the target is narrow, eligibility criteria must be more tightly defined. Other parameters, such as reporting requirements, can help in making the program more effective, but at the same time, must not be so burdensome that they deter banks from participating in the program.

With the various design choices available, targeted refinancing is one of the most flexible and adaptable monetary instruments. Experience across the world has a lot to offer on how to calibrate them.

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