After the latest decisions of the Central Bank of Turkey (CBT) mixed fund costs were calculated several times. These are not meaningful in regular countries.'

Imagine a bank that has a total 100 TL of funds (liabilities) all of which is in form of deposits and has one year maturity. If required reserve ratio of 5 percent and the bank uses the deposits only in form of extending credits, it has to deposit 5 percent to the CBT an extend credits with the remaining 95 TL.

Assume that the central bank of the country in question has raised required reserve ratio to 10%. In that case the bank can extend only 90 liras of credits. If the bank seeks to protect the old credit volume, it should push of the deposit interest rate so as to collect more deposits. This will increase the cost of the funds as a result of which the credit interest rate will automatically increase. So, on the one hand the volume of funds that can be extended as credits will decrease and on the other hand demand for credits will decrease due to the rising costs. This way, the central bank's actions will result on monetary contraction.

The second example: the bank has a 100 TL of one-year maturity funds and 20 TL one-week maturity fund borrowed from the central bank. The bank extends a one-year maturity loan but does not use the funds borrowed from the central bank. So under these circumstances, if the required reserve ratio has been increased, the exact outcome in the first example will be observed no matter how low the interest the central bank charges for the one-week loan is: interest on credits will increase and the credit limit will fall.

The third option
Take the bank in the first example and change the maturity of deposits to one week. Should the central bank increase the required reserve ratio the bank will have a third option: to borrow from the central bank with one-week maturity. The central bank sets the level of weekly deposit interest rate and aims to secure that the market interest rate does not diverge from the policy rate. If the commercial bank cannot borrow at that rate from other financial institutions, the central bank has to lend the amount so that interest rate does not increase.

In that case the credit line does not decrease despite the rise in the required reserve ratio. If the central bank reduces the interest on one-week maturity loans to banks simultaneously when raising the required reserve ratio, total cost of funds for banks either elevate less than the increase in required reserve ratio r remain constant or fall.

What is the problem?
As a fourth example, assume that out of the bank's funds 50 percent is deposits and 50 percent is borrowed from the central bank and that the maturities are the same. A one-point increase in required reserve ratio accompanied with a one-point cut in the lending interest rate will not change the cost of funds. Neither this will affect the credit line. Therefore, the central bank policy will not imply any monetary contraction.

However if the maturity of deposits was one year in the fourth example, the central bank's policy would imply monetary contraction since in that case the commercial bank would not extend one-year maturity loans with one-week maturity central bank loans that incur lower interests.

This is where the problem in Turkey lies. The maturity of deposits is extremely low. After the latest CBT decisions, mixed fund costs were calculated several times. These are not meaningful in regular countries due to the above mentioned reasons. But such calculations make sense in Turkey. The underlying distorted maturity structure demonstrates why the BRSA and the political authority must step in with the perspective I mentioned on Tuesday in order for the new CBT policy to serve the purpose.

This commentary was published in Radikal daily on 05.02.2011