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Julian D. A. Wiseman
Abstract: the credit crisis of autumn 2007 has revealed yet another problem with the Bank of England’s needlessly complicated implementation of monetary policy; and the BoE’s rules on collateral have become more confused.
Contents: False signals, Collateral.
Publication history: only here. Usual disclaimer and copyright terms apply.
The Bank of England has been criticised for its autumn 2007 liquidity support to Northern Rock plc, and its subsequent changes to the collateral against which it will lend £. Criticised by some for assisting too late, by others for assisting at all. But the BoE went wrong long before that decision, in the means by which it implements monetary policy. The events of autumn 2007 revealed an undesirable and previously unanticipated consequence of the BoE’s needlessly complicated modus operandi.
Like many other central banks, the Bank of England has a committee that decides on monetary policy. Such decisions need to be implemented: the central bank must lend or borrow, or do something in financial markets to make that interest rate happen. As described in The pretend market for money (first published in the August 2007 edition of Central Banking), the BoE’s system is needlessly complicated. Usually this complication is of modest consequence: those close to the money markets can see that it is more expensive to do than necessary, slightly less robust and slightly less effective than it could be. Those not close to the money markets assume that it is somehow being done satisfactorily.
But recently this complexity has contributed to financial instability. One of the little used features of the system, the ±100bp corridor, was tapped by Barclays. This was caused by a minor error, essentially an administrative error, just before the payment system closed. But on 31 August 2007 it was reported by the Daily Mail thus:
The financial health of Barclays was being questioned after it was forced to ask for huge loans to bail it out.
The lender has tapped an emergency credit facility with the Bank of England twice in ten days.
The loans for almost £2billion are fuelling fears that it has become too deeply involved in high-risk debt investments.
The worries centre on Barclays Capital investment banking division, which has experienced huge growth in recent years. BarCap has been heavily involved in highly speculative deals linked to America's mortgage market.
Other newspapers also interpreted it badly, The Guardian reporting that:
An emergency loan of £1.6bn and speculation about the sub-prime fallout have rocked the bank - just as its battle with RBS to take over ABN Amro reaches a critical point.
The Independent grumbled about the BoE’s secrecy, though acknowledged the possibility of stigma:
Oh dear, it's Barclays again. There was a good explanation last night for why Barclays needed, for a second time in just over a week, to borrow heavily from the Bank of England's standing facility.
…
The secrecy that surrounds use of the Bank's standing facility has turned out to be a quite damaging characteristic of an otherwise vital part of the interbank payments system. The refusal to name Barclays and the technical reasons why it was forced to borrow unnecessarily unsettled currency markets yesterday as well as causing speculation to run riot over who the guilty party might be.
The last time it happened, rival bankers freely named Barclays as the miscreant. This time they were under strict instructions from the Bank of England not to comment, but when did that ever stop the free flow of gossip in the City? By tea-time everyone knew. The Bank insists it cannot name the parties involved because that would stigmatise them.
Furthermore, if they thought they were going to be stigmatised in this way, they wouldn't use the facility and the payments system would break down. Yet in the end the truth will always out. Part of the problem in the crisis is a lack of transparency. A little glasnost from the Bank would provide some welcome relief.
The BoE has been very keen to signal to a wide range of economic agents that future inflation will be close to its target. Given this care in monetary signalling, why does it allow this careless signal about financial instability? It is impossible to know whether this smoke helped give the impression of fire in the banking system, and hence the run on Northern Rock, but why create a system that needlessly gives this false signal?
The problem is that if a feature is little-used, and is then used during any sort of market turbulence, some will believe that usage of that feature contains significant information. The problem can be fixed by having a simpler system, such that all the features are used almost every day. See The pretend market for money for a description of a system that would be simpler, cheaper, more effective and more robust.
The previously esoteric subject of collateral has recently reached the news, and, again, the central bank’s critics have not acknowledged longer-standing issues.
Why are a central bank’s monetary policy loans collateralised? There are two obvious possibilities:
So that a central bank would not lose if there were a default by a counterparty;
Because a counterparty having collateral so demonstrates that it is solvent.
It is easy to show that it isn’t the first, by considering the default of a particular bank. (When the author worked at the Bank of England, staff seemed willing to consider the general idea of a bank default, but were extremely unwilling to consider the idea of a particular bank defaulting. This paragraph will therefore go against the grain.) The particular bank is Deutsche Bank: not because the author knows anything bad about its creditworthiness, but because it is a large euro-based bank very active in sterling. The Bank of England has since 1999 accepted €-denominated government bonds: imagine that the Bank of England had lent Deutsche some £20bn, against a similar value of € bonds issued by Germany. Then, for some reason, Deutsche goes bust. In theory the Bank of England would sell the German Bunds for euro cash, and then sell the € for £ in the foreign exchange market. In theory. But in practice, central bank politesse would ensure that the BoE would not be willing to be seen to be selling the government bonds and the currency of a country whose largest bank had just defaulted. (Consider the reverse: Barclays goes under, and the following day the Bundesbank is seen selling gilts and selling £—a lesson in how not to make friends.) So the Bank of England would have to wait for at least several weeks, and more likely several months, before converting the collateral into the currency of the loan. And, in the three months following Deutsche’s default, how far might the euro fall? It might lose 5% to 10%; and it might tumble more than 15%. Certainly very plausible is a –10% move in the euro, which would cost the Bank of England some £2bn (more than the BoE’s £1.86bn equity reported in the 2007 accounts). Hence the collateral would not protect the central bank against default by a counterparty. And if that were the purpose of collateral, the BoE would not accept euro-denominated paper from a €-based bank, nor dollar-denominated from a $-based bank. Further, it would be easier and fairer to restrict all banks to using £-denominated collateral rather than have the BoE try to anticipate what bank defaults would be correlated with what currency moves. Banks with paper in other currencies could use those currencies’ central banks to convert the securities into a secured loan, and the FX market to convert that non-£ loan into £.
So, assuming the Bank of England’s top management thought through such an eventuality when allowing €-denominated collateral, that leaves the second possibility: a bank having gilts or Bunds thereby demonstrates that it is solvent. This hypothesis fits what the BoE had been doing until the run on Northern Rock. But the new policy necessitates taking yet more credit risk. Consider mortgages provided as collateral by the Northern Rock. If the mortgages don’t default, Northern Rock is (probably) solvent and so the collateral would not be needed. And if the mortgages do default, Northern Rock is bust and the collateral it provided isn’t worth much. The collateral would have least value exactly when it was needed. That’s what happens when counterparties are allowed to manufacture their own collateral—it ceases to have useful value.
So whatever the motivation behind the Bank of England’s collateral rules, they are—at best—lacking clarity of purpose, and—more probably—just plain confused. (To be fair, other central banks accept dodgy collateral, though few non-European CBs accept securities in a different currency.)
Please could the BoE provide some clarity of purpose, and some matching of the rules to that purpose?
Julian D. A. Wiseman, New York, September 2007
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