What Governor King should have told Mr. Fallon

At the House of Commons Treasury Committee hearing on Wednesday March 26, 2008, Mervyn King, Governor of the Bank of England, was asked by Michael Fallon MP why the Bank of England had been so much less aggressive in cutting rates and providing liquidity against a wider range of collateral than the Fed. The Governor proceeded not to answer the question, but answered a different question quite well – one comparing the ECB’s liquidity management with that of the Bank of England.

“In terms of the provision of liquidity, our system is much closer to that of the European Central Bank and in terms of the comparison between the ECB and ourselves the response has been virtually identical. The total lending by the Bank of England to the banking sector now constitutes about 1% of the assets of the banking sector. That is exactly the same level of support provided by the European Central Bank. In terms of the proportion of the total liquidity that is extended by central banks to the banking sector, that is provided at three months or longer, longer-term horizons, to the full-term funding. The proportion provided in that way by the ECB is between 50% and 60% of its total lending. The proportion at three months and longer provided by the Bank of England is also between 50% and 60%. … I do not think there is any significant difference at all. One of the reasons why this myth has grown up is because back in August and September a great deal of publicity was given to the very large injections made, particularly by the ECB, without anyone taking on board the fact that whatever money they put in with the one hand they have to take back with the other in order to maintain the total amount of money injected into the system to retain control of interest rates against inflation.”

Some of the assertions made by Governor King in the above quote don’t seem to be quite right.

First, I would suggest that putting an amount X of liquidity in at 3-month maturity, say, and taking the same amount X of liquidity out at 0 maturity (overnight) is not neutral as regards system-wide liquidity, if the scarcity of liquidity at 3-month maturity is greater than at 0 maturity. When there is imperfect arbitrage between different maturities, liquidity at different maturities is not a homogeneous substance, but something that can only be added together using the prices of liquidity at these different maturities. The Governor is adding together liquidity apples and bananas.

A good guide to the relative scarcity at the margin of liquidity in the interbank markets at different maturities is obtained by comparing the Libor-OIS spreads at these different maturities (and the overnight interbank rate and the official policy rate at the shortest maturity). I recognise that this spread is an imperfect measure of the price of liquidity, as reflects differences in bank default risk across maturities as well as differences in liquidity premia, but it is the best measure we have.

When markets are orderly, liquid and reasonably efficient, liquidity is arbitraged by the private sector among the different maturities. In that case it does not matter where (that is, at what maturity) the liquidity is injected. Nor does it matter which financial institutions are the counterparties of the central bank for the liquidity enhancing OMOs or discount window borrowing. If deposit-taking commercial banks are the main counterparties, they will smoothly trade the new liquidity to the other private institutions that want it but do not have direct access to the central bank through repos or the discount window.

This happy state of affairs does not exist when markets are disorderly and illiquid. Arbitrage requires the presence of liquidity. So when market liquidity is absent and many financial institutions are also constrained by funding liquidity, the central bank has to make sure itself that liquidity reaches the right maturities and the right institutions. This is done by chasing liquidity spreads aggressively through liquidity injections at any maturity that they are prominent. It is also done by extending the range of counterparties that the central bank deals with. The Fed has done this in the US by giving Primary Dealers (investment banks) access through central bank liquidity through sterilized repos (swaps of Treasury bonds for MBS at the Term Securities Lending Facility (TSLF) and overnight access to the discount window through the Primary Dealer Credit Facility (PCDF). The Fed and the ECB also accept a wider range of collateral at both the discount window and in repos than does the Bank of England.

Returning to a comparison of the performance of the Bank of England and the ECB, two things are clear from Figure 1 (showing the 3-month Libor-OIS spread and the spread between the effective overnight interbank rate (Sonia) and the official policy rate for sterling) and from Figure 2 (showing the 3-month Euribor-OIS spread and the spread between the effective overnight interbank rate (Eonia) and the official policy rate for the euro). The date are from August 28, 2007 till March 27, 2008.

(1) If anything, the ECB is even less competent than the Bank of England at keeping the overnight interbank rate in line with the official policy rate. There is no excuse for this. Haven’t these institutions heard of continuous fixed-rate tenders during the maintenance period?

(2) Although neither central bank produces a stellar performance at the 3-month maturity, the ECB does consistently less badly than the Bank of England.

Figure 1

Figure 2

Second, the average level of liquidity injected into the market (even if we add together blithely liquidity injected at different maturities) is not trivial to measure, as we have to average both within trading days and over the trading days in a maintenance period. For instance, injecting additional liquidity at the beginning of a maintenance period and taking it out again at the end of the maintenance period raises the average level of liquidity over the maintenance period. This is also true if the additional liquidity injected at the beginning of the period is withdrawn gradually over the maintenance period. It is not clear from the Governor’s reply to Mr. Fallon which measure of liquidity he is referring to.

Third, it is likely that British (parent) banks with subsidiaries in the Euro Area and in the USA have used these subsidiaries to access the liquidity facilities of the Eurosystem and of the Federal Reserve System to fund not only their local activities (i.e. those in the Euro Area and the US) but also those in the UK. While this is, in principle, a two-way street – US (parent) banks and Euro Area banks with subsidiaries in the UK could have used the UK liquidity facilities – the UK-based parents are likely to have used these foreign sources of liquidity to a greater extent. It would be nice to have information on the magnitude of this.

Close but no cigar for the Governor (not surprising, since with Eddie George’s departure, the Bank of England became a smoke-free zone). The Bank of England’s liquidity management has improved since August 2007, but it is still distinctly less competent than that of both the Fed and the ECB. As regards the range of eligible collateral, the maturities at which liquidity is offered, the amounts that are offered at the various maturities and the eligible counterparties, the Bank is still not up to par.

It is essential for the Bank of England to adopt ECB and Fed best practice in liquidity management, and for it to do so forthwith, lest a preventable disaster happens in the next few weeks or months. The Bank of England could steal a march on the Fed and the ECB by designing operational valuation techniques (e.g. reverse auctions of various kinds) for valuing and pricing illiquid collateral or illiquid private securities to be purchased outright by the central bank. Pricing such securities in ways that are punitive but do not threaten the survival of fundamentally solvent sellers would be a major contribution to the minimization of moral hazard and the prevention (or at least the postponement) of the next financial boom, bust and crisis, once the current financial crisis has become history.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website