"The recent turmoil in financial markets has increased uncertainty in the world economy. All those involved … need to analyse carefully the causes of the recent turmoil and think through the long-term consequences of any actions."
So opens Mervyn King’s paper, submitted to the Treasury Committee in advance of the September 20th meeting to discuss the recent economic crisis.
The Bank of England, of which Mr King is Governor, has come under heavy criticism for its lack of action during the last few weeks.
The European Central Bank has plunged an extra EUR 75 bn into the financial system for a three-month period to minimise the interest rate gap between overnight funding and lending over longer maturities.
The Federal Reserve has made less extreme moves to help but has made money, at the borrower’s request, available through its discount window.
In his report of September 12th Mr King defended the Bank of England’s decision not to simply inject money into the market and thereby “encourage reckless risk-taking and sow the seeds of a future financial crisis.”
The report focuses on the two central issues that concern everyone involved – why has this happened and what now needs to be done?
What caused the recent economic turmoil?
The trigger for the crisis has been rising default rates on sub-prime mortgages in the US. These were sold to conduits and specialist investment vehicles (SIVs) often set up by the Banks themselves as ‘off-balance-sheet’ vehicles for investment. Most of these vehicles financed their deals by issuing short-term commercial paper (the financial world’s IOU).
This ‘off-balance-sheet’ investing was a new business idea designed to give investors higher return and capital safety. Investors could withdraw their money at any time with one month’s notice.
Banks are forced to conform to government regulations to maintain a large amount of capital as a guarantee and to balance their books precisely at the end of each day. Hedge Funds and SIVs are not regulated in the same way. By dealing in high-quality assets that have almost no likelihood of suffering losses these vehicles could almost ensure that all their promises could be kept within the one month notice period. The only risk was that there would be no way of meeting a sudden demand for liquidity from a large number of investors.
Guess what happened in Mid-August of this year?
As investors lost confidence USD 100 bn came up for refinancing. A further USD 113 bn will be added this week prompting leading Bankers to name this the worst crisis for 20 years.
As a result Banks are hoarding assets which can be quickly turned into cash and LIBOR (the rate at which Banks lend to each other) has climbed to a 9 year high.
The most serious casualty of this halt on lending is mortgage provider Northern Rock who this morning received money fom the Bank of England to keep them afloat during the crisis. While Northern Rock has not been involved in any of these failed investments it relies on liquidity provided by Banks to fund its lending.
What action needs to be taken?
King states that the primary concern of monetary policy is to “protect the public from the consequences of the recent turmoil by continuing to maintain economic stability.” To do this the policy to be decided at the meeting of September 20 must focus on three issues: interest rates; the monetary market and liquidity support.
Interest rates are flexible and can be altered as changes in the market necessitate. The Monetary Policy Committee is watching credit conditions closely to ensure household and corporate borrowing is not adversely affected.
The rate at which Banks lend to each other needs to be lowered. Banks settle payments with each other using Central Bank money and they hold reserves at the Bank of England to manage their daily needs. Under normal conditions Banks are asked to estimate how much they require and any extra is charged at a penalty rate. The crisis has meant that Banks have exceeded their reserves and have called on Central Banks to release more liquidity. In response to this the Bank of England has pledged to make 25% extra of the original target available.
King argues that following the example of the European Central Bank would only be necessary if the crisis reaches such a scale that the moral implications of such a decision could be ignored. Such action would provide insurance to “institutions that have engaged in risky and reckless lending…and penalise those that sat out the dance, encourage herd behaviour and increase the intensity of future crises.” He believes that the Banking system as a whole is strong enough to take the assets of conduits and other vehicles onto their balance sheets.
Money markets have received a GBP 4.4 bn injection of liquidity but those institutions that require more will have to take it at a penalty rate to discourage future risk taking.
King’s report ends with two key objectives: to monitor the inflation target and thereby maintain economic stability and to ensure that they financial system continues to function effectively.
The outcome of next week’s meeting and the future of the financial system are still uncertain but we can be sure that the actions of the next few weeks will have long-term consequences for the economy. Whether those consequences are beneficial or not remains to be seen.
Just to clarify, I’m not asking if you’ve ever had success whilst wandering the wards of your local hospital making amorous advances toward the frail and ill. Or even if you’ve ever swapped bodily fluids with someone you’ve just met who turns out to have a really nasty cold.
