Contradictions? Really? Mmh... Mervyn King, Governor of the Bank of England (BoE), was harshly criticised, last month. His decisions - argued the detractors - were at odds with his words. As a consequence, the Governor and BoE's credibility, was (further) damaged.
Strange... On September 12, speaking about a possible additional injection of liquidity, King said: "All Central banks are aware that there are circumstances in which [such] action might be necessary to prevent a major shock to the system as a whole". Central bankers usually don't like"" extraordinary money market operations, but sometimes they have to do such a thing to avoid the worst. After less than a week King did what he had said: to avoid a "major shock" after the bank run at Northern Rock, he decided to inject a lot of liquidity, namely 10 billions pound, on three-months terms.
OTHER WORDS
Where is the contradiction? It is difficult to see it; but on September 12 King said something else about money injections and, according to the critics, the contradiction sprang from here: "The provision of such liquidity support - stated the Governor - undermines the efficient pricing of risk by providing ex post insurance for risky behaviour. That encourages excessive risk-taking, and sows the seeds of a future financial crisis". A good piece of evidence, isn't it? No, it is not. Those words were not a clear-cut "no" to extraordinary injections of liquidity, nor a criticism to the Federal Reserve and the Ecb similar operations.
THE MISSING CONSIDERATION
Let's read carefully King's words. The provision of additional liquidity, argued the Governor, "is the most difficult issue facing Central banks at present and requires a balancing act between two different considerations". Nobody noticed the first consideration: extra liquidity could help the banking system to go back faster to normality. Unfortunately King said that in a very technical fashion: "The provision of greater short-term 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". Too difficult... So, everybody now remembers only the second consideration: a greater amount of money in the market "sows the seeds of a future financial crisis". Dramatic, indeed.
THE KEY WORD
Still, the key word in this discussion is "balance". King's actions sprang from a balancing act. Everything he has done so far, as he stressed last month before the Parliament's Treasury Committee, is in line with his stance on moral hazard. He is trying to avoid a great risk: to promote "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" through extraordinary actions.
A UNIQUE SYSTEM
The British system, which is unique in the world, is designed to avoid the risk of encouraging moral hazard: every extraordinary provision of liquidity is offered at a higher rate. "It is crucial that in making their lending and borrowing decisions - said King on 10th October - banks face the right incentives. That is why we did offer to lend in exchange for illiquid assets but only at a penalty rate of interest". The two 3-month auctions by the BoE were proposed at a minimum rate of 6,75%, a very high rate - and not one bank took up the offer. The Northern Rock rescue was granted at an undisclosed penalty rate: 7% according to some sources. Moreover, if any individual bank - as King has explained -"finds that on any day, due to unusually large payment flows, it needs additional liquidity, then that is supplied against eligible collateral at a penalty rate" of 1% above Bank Rate (currently at 5,75%).
THE PENALTY RATE
This "penalty" system works quite well: "Although the BoE has extended its money market operations - wrote in a report Michael Saunders, at Citigroup - it is keeping the principle (stressed by the BoE Governor) that emergency liquidity will only be available at a penalty rate of 100 basis points above Bank Rate. This makes it more likely that institutions learn the lesson and will be more cautious in the future".
A BIG MISTAKE
So, everything's OK? Unfortunately not. Everybody believes, now, that Mervyn King contradicted himself. His stance on moral hazard is not credible anymore, even if it is effective. King made a huge mistake. In the peak of the sub-prime crisis, the investors needed, first and foremost, information, more information, and clearer information. King didn't provide it. He didn't speak to the market: he wrote a long, formal paper and sent it to the Parliament's Treasury Committee; he released a very short and very formal communiqué about the "liquidity support facility" for Northern Rock, that triggered the bank run; and a shorter note - could you find it on the BoE web site? - about the three-months auction. Too bad, for a modern Central banker. |
