Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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