The Bank of England loses a game of chicken
Monday, 24 September 2007
Martin Wolf
I regard Mervyn King, governor of the Bank of England, as a friend. I also admire him as an economist, as a man of principle and as a public servant. Over the last one-and-a-half decades he has played a central role in the emergence in the UK of a modern monetary framework under the control of an independent central bank of the highest quality.
More recently, I agreed with the tough line Mr King has taken on the provision of liquidity to the markets during the current turmoil. But I recognise that he has been gravely damaged by the recent events. This is not so much over the handling of the crisis at Northern Rock, for which blame is shared, as it is over the volte-face on the terms on which the Bank lends to the markets. Mr King is playing a game of chicken with the world's most irresponsible industry. Sadly, he is losing.
The recent chaos over Northern Rock raises questions about the workability of the "tripartite system", created by Gordon Brown in 1997, under which the Financial Services Authority supervises individual banks, the Bank deals with systemic crises and the Treasury provides public money. As the governor noted in his testimony before the House of Commons Treasury committee last Thursday (September 20), the Northern Rock debacle also demonstrated the difficulties created by today's company law and system of deposit insurance: the former precluded covert assistance, while the inadequacies of the latter almost ensured a run on the bank. The only point to add on Northern Rock is that the government should have added nationalisation to its decision to provide a deposit guarantee. Taxpayers should not bail out shareholders. Equity is risk capital. In banking, risks must include the drying up of liquidity.
For decisions on how to intervene in markets, however, Mr King bears responsibility. In the paper on the crisis submitted recently to the Treasury committee, he defended a line markedly different from that taken by the Federal Reserve and the European Central Bank. "On the one hand, the provision of greater short-term liquidity against illiquid collateral might . . . reduce term market interest rates. But, on the other hand, the provision of such liquidity support . . . encourages excessive risk-taking, and sows the seeds of a future financial crisis."
The only reason for intervening, then, would be "strong grounds for believing that the absence of ex post insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in future." Since then Mr King must have decided that the threat to the financial system posed by the unwillingness of banks to lend had become too dangerous. By advancing three-month money against mortgage collateral, the Bank has, as a result, abandoned two of its principles for acting as lender of last resort.
Albeit welcoming what it called "the more flexible approach" - that is, the defeat - of the Bank, the British Bankers' Association demanded unconditional surrender, noting "concerns about the 100 basis point penalty paid by users of the standing facility". In short, it wants the Bank to provide limitless liquidity against questionable security, without penalty. Will the Bank resist this pressure? I hope so, but doubt it.
In a game of chicken, the loser is the player who swerves first out of the way of the other driver's car. Since the Bank is concerned about the health of the economy, while the banks are concerned only about their survival, the former is at a huge disadvantage. Apparently, the banks told the authorities they would not lend to their weaker brethren until the Bank opened its wallet. The threat was credible and the Bank swerved.
Am I unfair, then, in blaming these events on the irresponsibility of the banks? Consider that, even though the world economy has enjoyed years of good growth and the US housing market, epicentre of the crisis, has weakened but a little, credit markets are frozen. Consider, too, that the banks both created the radioactive securitised obligations and set up the special investment vehicles (off-balance-sheet banks) that they must now rescue at the expense of lending to everybody else. Consider, not least, that banks exposed themselves to the risk of illiquidity from which they expect a public rescue, at no charge.
Yet the banks are winning, not only because they are a formidable lobby, but because they can inflict such damage. Today, as a result, the government has guaranteed deposit liabilities and the Bank has taken a big step towards rescuing them from self-inflicted illiquidity. So Mr King is losing his gamble on toughness. Let us at least understand why. Our sophisticated financial system suffered a typical collapse in self-discipline. Now the authorities are under huge pressure to rescue it from its folly. Mr King's "mistake" - what critics call his "inflexibility" - was the view that banks should no more enjoy a rescue than other businesses. Fortunately, the Bank's provision of liquidity is not yet free. Let Mr King stick to his guns on the penalty. If not, still more dangerous crises will come.
.........................................
— FT Syndication Service
I regard Mervyn King, governor of the Bank of England, as a friend. I also admire him as an economist, as a man of principle and as a public servant. Over the last one-and-a-half decades he has played a central role in the emergence in the UK of a modern monetary framework under the control of an independent central bank of the highest quality.
More recently, I agreed with the tough line Mr King has taken on the provision of liquidity to the markets during the current turmoil. But I recognise that he has been gravely damaged by the recent events. This is not so much over the handling of the crisis at Northern Rock, for which blame is shared, as it is over the volte-face on the terms on which the Bank lends to the markets. Mr King is playing a game of chicken with the world's most irresponsible industry. Sadly, he is losing.
The recent chaos over Northern Rock raises questions about the workability of the "tripartite system", created by Gordon Brown in 1997, under which the Financial Services Authority supervises individual banks, the Bank deals with systemic crises and the Treasury provides public money. As the governor noted in his testimony before the House of Commons Treasury committee last Thursday (September 20), the Northern Rock debacle also demonstrated the difficulties created by today's company law and system of deposit insurance: the former precluded covert assistance, while the inadequacies of the latter almost ensured a run on the bank. The only point to add on Northern Rock is that the government should have added nationalisation to its decision to provide a deposit guarantee. Taxpayers should not bail out shareholders. Equity is risk capital. In banking, risks must include the drying up of liquidity.
For decisions on how to intervene in markets, however, Mr King bears responsibility. In the paper on the crisis submitted recently to the Treasury committee, he defended a line markedly different from that taken by the Federal Reserve and the European Central Bank. "On the one hand, the provision of greater short-term liquidity against illiquid collateral might . . . reduce term market interest rates. But, on the other hand, the provision of such liquidity support . . . encourages excessive risk-taking, and sows the seeds of a future financial crisis."
The only reason for intervening, then, would be "strong grounds for believing that the absence of ex post insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in future." Since then Mr King must have decided that the threat to the financial system posed by the unwillingness of banks to lend had become too dangerous. By advancing three-month money against mortgage collateral, the Bank has, as a result, abandoned two of its principles for acting as lender of last resort.
Albeit welcoming what it called "the more flexible approach" - that is, the defeat - of the Bank, the British Bankers' Association demanded unconditional surrender, noting "concerns about the 100 basis point penalty paid by users of the standing facility". In short, it wants the Bank to provide limitless liquidity against questionable security, without penalty. Will the Bank resist this pressure? I hope so, but doubt it.
In a game of chicken, the loser is the player who swerves first out of the way of the other driver's car. Since the Bank is concerned about the health of the economy, while the banks are concerned only about their survival, the former is at a huge disadvantage. Apparently, the banks told the authorities they would not lend to their weaker brethren until the Bank opened its wallet. The threat was credible and the Bank swerved.
Am I unfair, then, in blaming these events on the irresponsibility of the banks? Consider that, even though the world economy has enjoyed years of good growth and the US housing market, epicentre of the crisis, has weakened but a little, credit markets are frozen. Consider, too, that the banks both created the radioactive securitised obligations and set up the special investment vehicles (off-balance-sheet banks) that they must now rescue at the expense of lending to everybody else. Consider, not least, that banks exposed themselves to the risk of illiquidity from which they expect a public rescue, at no charge.
Yet the banks are winning, not only because they are a formidable lobby, but because they can inflict such damage. Today, as a result, the government has guaranteed deposit liabilities and the Bank has taken a big step towards rescuing them from self-inflicted illiquidity. So Mr King is losing his gamble on toughness. Let us at least understand why. Our sophisticated financial system suffered a typical collapse in self-discipline. Now the authorities are under huge pressure to rescue it from its folly. Mr King's "mistake" - what critics call his "inflexibility" - was the view that banks should no more enjoy a rescue than other businesses. Fortunately, the Bank's provision of liquidity is not yet free. Let Mr King stick to his guns on the penalty. If not, still more dangerous crises will come.
.........................................
— FT Syndication Service