Bank of England analysis of turbulence in inter bank liquidity

The paper that the Bank of England submitted yesterday to the Treasury Committee of parliament is an unusually lucid analysis of the recent turbulence in inter bank liquidity; surprisingly, it reads more like a thoughtful blog than a ponderous official pronouncement. This certainly cements Mervyn King’s reputation as the foremost academic among central bankers. Ben Bernanke is of course not far behind – his speech day before yesterday on global imbalances was also very insightful.

King’s paper contains a careful analysis of what has happened since the beginning of August:

In summary, the turmoil in financial markets since the beginning of August stems from a reluctance by investors to purchase financial instruments backed by loans. Liquidity in asset­backed markets has dried up and a process of re­intermediation has begun, in which banks move some way back towards their traditional role taking deposits and lending them. That process is likely to be temporary but it may not be smooth. During that process, demand for liquidity by the banking system has increased, leading to a substantial rise in inter­bank rates.

King then argues (a) that monetary policy should continue to be fixated on inflation targeting and (b) the provision of liquidity in the automatic window at penal rates against high quality collateral is sufficient for the smooth functioning of the payment system.

The concluding part of the paper is sharp and brutal:

So, third, is there a case for the provision of additional central bank liquidity against a wider range of collateral and over longer periods in order to reduce market interest rates at longer maturities? This is the most difficult issue facing central banks at present and requires a balancing act between two different considerations. On the one hand, the provision of greater short­term liquidity against illiquid collateral might ease the process of taking the assets of vehicles back onto bank balance sheets and so reduce term market interest rates. But, on the other hand, the provision of such liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behaviour. That encourages excessive risk­taking, and sows the seeds of a future financial crisis. So central banks cannot sensibly entertain such operations merely to restore the status quo ante. Rather, there must 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 the future. In this event, such operations would seek to ensure that the financial system continues to function effectively.

As we move along a difficult adjustment path there are three reasons for being careful about where to tread. First, the hoarding of liquidity is a finite process ... [T]he banking system as a whole is strong enough to withstand the impact of taking onto the balance sheet the assets of conduits and other vehicles.

Second, the private sector will gradually re­establish valuations of most asset backed securities, thus allowing liquidity in those markets to build up ...

Third, the moral hazard inherent in the provision of ex post insurance to institutions that have engaged in risky or reckless lending is no abstract concept. The risks of the potential maturity transformation undertaken by off­balance sheet vehicles were not fully priced. The increase in maturity transformation implied by a change in the effective liquidity in the markets for asset­backed securities was identified as a risk by a wide range of official publications, including the Bank of England’s Financial Stability Report, over several years. If central banks underwrite any maturity transformation that threatens to damage the economy as a whole, it encourages the view that as long as a bank takes the same sort of risks that other banks are taking then it is more likely that their liquidity problems will be insured ex post by the central bank. The provision of large liquidity facilities penalises those financial institutions that sat out the dance, encourages herd behaviour and increases the intensity of future crises.

In addition, central banks, in their traditional lender of last resort (LOLR) role, can lend “against good collateral at a penalty rate” to an individual bank facing temporary liquidity problems, but that is otherwise regarded as solvent ... LOLR operations remain in the armoury of all central banks ...

...Injections of liquidity in normal money market operations against high quality collateral are unlikely by themselves to bring down the LIBOR spreads that reflect a need for banks collectively to finance the expansion of their balance sheets. To do that, general injections of liquidity against a wider range of collateral would be necessary. But unless they were made available at an appropriate penalty rate, they would encourage in future the very risk­taking that has led us to where we are ...

The key objectives remain, first, the continuous pursuit of the inflation target to maintain economic stability and, second, ensuring that the financial system continues to function effectively, including the proper pricing of risk. If risk continues to be under­priced, the next period of turmoil will be on an even bigger scale. The current turmoil, which has at its heart the earlier under­pricing of risk, has disturbed the unusual serenity of recent years, but, managed properly, it should not threaten our long­run economic stability.

Posted at 1:35 pm IST on Thu, 13 Sep 2007         permanent link

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