Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Bank of England U-Turn

Last week, I blogged
admiringly about the Bank of England paper on inter bank liquidity and
moral hazard and it was embarassing to find the Bank do a U-turn
within days of that paper. Mervyn King faced a hostile Treasury
Committee and the transcripts
of this oral testimony are quite disturbing.

King stated that he wants to carry out lender of last resort
operations covertly and wants disclosure laws to be changed to make
this possible. To my mind, this is totally unacceptable. The
disclosure requirements of modern securities market are sacrosanct and
central banks must simply learn to live with them.

The transcripts also show that King had difficulty providing a
convincing explanation for his U-turn on moral hazard:

Q2 Chairman: … In that letter of 12 September you told us that
providing extra liquidity at longer maturities – in your words –
undermines the efficient pricing of risk by providing ex post
insurance for risky behaviour and that you would conduct such
operations only if there were 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. However,
yesterday you conducted such operations. What has changed in the past
seven days?

Mr King: … the balance of judgment between how far you extend
liquidity against a wider range of collateral on the one hand and
being concerned to limit the moral hazard on the other, to limit the
ex post insurance, is a judgment that we are making almost daily in
the febrile circumstances of the time. The operation yesterday was
carefully designed and judged. It does not give ex post insurance, it
is limited in size, it is limited in amount to each individual bank,
and that provides a strict limit on the extent to which there is some
ex post insurance, so we have balanced the concerns about moral hazard
against the concerns that arose at the beginning of this week about
the strains on the banking system more generally.

Q18 Chairman: When you talk about everybody knows their own job,
Governor, I have to ask you this question because it has been in the
public press: are you your own man? Were you lent on in this
situation? Is that why you did the U-turn in the past seven days?

Mr King: No, I can assure you that the operation we carried out was
designed in the Bank. Of course in these circumstances I want to
discuss it with Callum McCarthy and the Chancellor. It would be very
odd if they were to have woken up and found we had done this and they
did not know anything about it, so of course we discussed it, but I
give you my personal assurance that I would never do anything unless I
thought it was the right thing to do. The independence of a central
bank is not just about legislation; it is about having people in the
central bank who will do what is right for the country in their job
and not do what people ask them to do, whether it is the banks or
whether it is politicians.

Q46 Mr Fallon: Governor, you have spoken on moral hazard and you
have written us an eloquent essay on moral hazard, but is not the
criticism that you have passed the theory but when it came to dealing
with Northern Rock and when it came to dealing with three-month
funding actually you failed the practical?

Mr King: No, I do not think that is true at all. I am happy to
explain a bit later if you like why I think moral hazard is such an
important issue. Can I just answer this point. I have tried to set out
a sequence of events in which Northern Rock required ultimately a
lender of last resort, the way in which we would have preferred to do
it was not open to us, and at that point we did it in an overt way. I
do not think it was at all obvious what impact that would have. It
might or might not have led to people wanting to take their money
out. In the event it did and once that run had started people were not
behaving illogically by joining it and at that point the only solution
was the Government guarantee. I think this is a very clear chain of

Q86 Peter Viggers: How severely do you think the principle of moral
hazard has been compromised since you wrote us your rigorous and lucid

Mr King: I hope that it has not and I do not believe that it has but,
as I said, this is a balancing judgment. When I listened to the banks
I do not believe that they felt that offering them an ability to bid
for liquidity at a 100 basis point premium over bank rate was
something that they regarded as entirely generous, so I think there is
still a fair chunk of restriction against moral hazard in what we have


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