April 25, 2008
Is the Bank of England subsidising the banks through the Special Liquidity Scheme?
On my way to Gatwick Airport to participate in a conference in Riga (Latvia) on economic challenges faced by the Baltic countries, I noticed a sign post for the village of Pratts Bottom. It reminded me of why I love living in this country. I am sure I really could find Little Whinging in Surrey if I looked long enough.
This naturally brings us to the question as to whether the Bank of England subsidises the banks through its newly created Special Liquidity Scheme (SLS). The scheme is a swap of one-year maturity Treasury Bills for illiquid mortgage-backed securities, covered bonds (Pfandbriefe), and asset-backed securities backed by credit card receivables. Let’s refer to this collection of bank assets as MBS (for mortgage-backed securities).
The securities offered by the banks in the swap are either valued at market prices (if there is a functioning market, which typically is not the case) or by the Bank of England. Haircuts (discounts) are applied to this valuation, ranging from 12 percent on floating rate and short maturity fixed-rate debt to 22 percent on long-term fixed rate debt.
Then there is the fee for this swap or, equivalently, for this collateralised (against MBS) borrowing of TBills by the banks. Here’s what the Bank of England says:
“The fee payable on borrowings of Bills will be the spread between 3-month LIBOR and 3-month General Collateral gilt repo rate, as observed by the Bank, subject to a floor of 20bps. The fee may vary at the Bank’s discretion.”
This is somewhat cooky, but certainly not cheap. You would have expected the fee for each pound’s worth of TBills borrowed (against the MBS collateral) to depend on the difference between the one-year collateralised borrowing rate for banks and the rate on one -year Treasuries. It’s not clear where the three month rates used by the Bank of England come from.
In any case, what this means is that even if we ignore the haircut, the banks borrow through the SLS from the Bank of England at an unsecured rate (LIBOR) although their borrowing is secured against MBS. That’s pretty tough. In addition, because of the haircut, the banks have to over-collateralise their borrowing. If the haircut, expressed as a fraction, is h - with a haircut of 22 percent, h = 0.22 - then for each £ worth of collateral offered, the banks can borrow only 1-h worth of TBills.
LIBOR has become the rate at which banks don’t lend to each other in the interbank market, so it is certainly possible, indeed highly likely, that the market rate for borrowing against the kind of MBS collateral the banks are offering to the Bank of England would have been higher than LIBOR.
The fact that the Bank of England makes secured loans to the banks at a rate below what these banks would have paid in the market does not, however, mean that the Bank of England is subsidising the banks. Instead what it is doing is correcting a form of market failure, illiquidity, without subsidising the banks.
The Bank of England’s loan of TBills is a subsidy only if these are provided at a price below the Bank of England’s risk-adjusted marginal cost of funds. That does not seem likely, given the fact that the BoE prices the MBS securities offered as collateral and applies serious haircuts to these valuations.
Once more (because I get more confused correspondence about the issue than about any other economic issue): the price charged can be less than what it would cost the banks to obtain the funds in the market without this being a subsidy, if the market price exceeds the marginal cost of funds to the Bank of England. That is the indeed the case. The welfare economics case for the Bank of England doing this is exactly that the funds it provides are priced both below the (distorted, illiquid) market price and above the Bank of England’s own marginal cost of funds (for those of you who cannot get enough of this, there is a paper on subsidies and related issues by Mark Schankerman and myself).
The spread of the Bank of England’s risk-adjusted marginal cost of funds over the risk-free rate is equal to p/(1-p) times the excess of the risk-free rate over the rate the Bank of England would receive in the event that both the bank offering the collateral and the issuer of the collateral default. The probability of a joint default of the borrower and the issuer of the collateral is p. If, for instance, the Bank of England were to receive nothing (neither interest nor principal) in the event of a joint default of borrower and collateral, the rate the bank would receive given joint default is -1 and the spread of the Bank of England’s marginal cost of funds over the risk-free rate is (approximately) equal to the joint default probability (the exact spread is p/(1-p) times (1 plus the safe rate)).
Ideally, the risk-free rate would be measured by the 1-year TBill rate, but it is instead approximated by the Bank of England with the 3-month General Collateral gilt repo rate.
Even over a one-year horizon, the likelihood that both the borrowing bank and the collateral will go belly-up must be very small indeed. The Bank of England’s risk-adjusted cost of capital is therefore only slightly higher than the risk-free rate. It is certainly lower than LIBOR. So there is no subsidy involved in the Bank’s SLS.
Of course, it is possible that the highly unlikely event of a simultaneous default by the borrowing bank and by the issuer of the MBS offered as collateral does materialise. In that case the state, that is, the tax payers or the other beneficiaries of public spending are out of luck and out of pocket. But that risk was properly priced ex ante, and while it would be appropriate to curse the Gods, it would not be appropriate to curse the Bank of England.
Unlike the Fed, the Bank of England does not appear to want to be in the business of subsidising the banking sector or of helping to recapitalise it through quasi-fiscal sleight of hand. Long may it remain that way.
As far as I can tell the whole process is designed to avoid true price discovery. Unless the BOE reveals the prices it is accepting/setting than this is just another way of forestalling the inevitable.
The cost of capital and whether or not it is too cheap seems somewhat irrelevant by comparison. The Bank would appear to have become engaged in the time honored naked option sellers tradition of picking up nickels in front of a steamroller.
Posted by: SS | April 25th, 2008 at 3:18 pm | Report this commentSS
Nope. Buiter is right. Think it through.
Posted by: David Heigham | April 25th, 2008 at 10:17 pm | Report this commentDavid,
First I am not an expert in this area and would be happy to take some comfort from more knowledgeable participants. Please feel free to flesh out what you believe I am missing. It may be that my knowledge of finance is insufficient to this task.
The nub of the matter for me is that a maximum markdown of 22% does not seem adequate for much of the ostensibly “AAA” securities out there. Consider the recent marks from RBS for example or consider that the AAA rating may be based on an insurance wrapper issued by a likely insolvent company. Consider also, the precipitous decline in the “market” value of these “AAA” securities, since Professor Buiter recommended this very same action last year – and the bailout of BS. Consider also, that the BOE does not have the expertise to accurately value the underlying components of each of the “illiquid” securities.
What makes values now any better if there is no price transparency on the deals being done by the BOE and the private sector can’t/won’t step up to offer a similar type of transaction? Notice that the LBO debt is finally clearing. However, it has taken some heady discounts and innovative financing terms — as well as a few deals cratering — to reduce those outstanding balances.
I still believe that the issue is solvency — especially given the massive capital raising efforts of just about every major bank. I can’t help but wonder if the probability of default is virtually 1 — i.e. issuer default due to non/payment and foreclosures will necessarily lead to bank default given the size of the problem. I view it as incredibly unlikely — i.e. political suicide for the Government — that the BOE will exercise it’s recourse to make itself whole by destroying banks wholesale in an effort to reclaim its collateral.
For these reasons, I argued that any fee charged for the swap to almost be incidental and the effort to be a bailout by any other name – although not for reasons of interest pricing.
SS
Posted by: SS | April 25th, 2008 at 11:22 pm | Report this commentI am not convinced that the SLS does not represent a subsidy to the banks:
As your paper with Schankerman says, the price of a service is subsidy-free if it is greater than or equal to the incremental cost of providing that service, and the relevant cost is the opportunity cost. In other words, it is not only the BoE’s cost of funding that is relevant; it is whatever else the BoE might have done with the available resources, including the staff involved. It is practically impossible to know what this opportunity cost is, but since central banks have rarely provided such a liquidity service, it seems that the marginal cost to them is reckoned to be clearly higher than for the private sector. The difference between the SLS and private sector prices for liquidity is therefore not an unreasonable estimate of the value of the subsidy.
Note that the credit risk of the SLS is not as low as you suggest, because, as I explain in a comment on your previous post, even if the issuer of the securities pledged as collateral does not default, if the value of these securities is less than the value of the t-bill loan when the borrower defaults, the public sector is left with a shortfall.
The justification for public sector intervention in the market for mortgage bonds is that it is abnormally illiquid at the moment. I wonder if, on the contrary, it is the present degree of liquidity which is normal. It seems to me that liquidity derives from the existence of a wide range of buyers for such securities. However, we are led to believe that before the crisis, many of the buyers of mortgage-backed securities did not properly understand them. That cannot be normal. Perhaps this is not so much a liquidity crisis as a liquidity-at-unreal prices crisis.
Posted by: Tim Young | April 26th, 2008 at 8:16 pm | Report this commentWhether the scheme is inappropriately beneficial to participating banks or not (which I don’t actually think it is), I can’t agree with Professor Buiter’s assessment of whether or not this is a subsidy. Whilst it is certain that the effective funding is being provided at more than the marginal rate at which it can be sourced by the Bank, they are doing so in exchange for taking exposure to potentially £50bn of highly correlated securitised debt. Would any bank on earth do this if it didn’t stand to make a significant profit on the venture? Whilst the effective rate is certainly more than the Bank’s CoC, it is highly debatable whether it is above the risk-adjusted market rate at which it should be doing this business.
The only argument that springs to mind to contradict this is that the Bank would never let the participating institutions go under anyway, thereby exposing it. If this is the case, then the scheme is more than a subsidy: it’s potentially quite effective insurance.
Posted by: Richard | April 28th, 2008 at 2:01 pm | Report this commentMr Buiter claims that “The Bank of England?s loan of TBills is a subsidy only if these are provided at a price below the Bank of England?s risk-adjusted marginal cost of funds.” Thats pretty academic.
Posted by: Jacob Peter | April 28th, 2008 at 10:18 pm | Report this commentOk so we are in a desert, my bank friend and I and we come to this oasis. As a banker my fiend gets fresh water for the cost of fund + 2pence = 2pence I guess. I on the other hand gets nothing. Post mortem I would claim that he was subsidised and I was left to die
Oh forgot to mention. I actually had 3 pence in my pocket.
Posted by: Jacob Peter | April 28th, 2008 at 10:23 pm | Report this comment[…] Tim Young makes three interesting comments on my blog on the Bank of England’s Special Liquidity Scheme: […]
Posted by: FT.com | Willem Buiter’s Maverecon | Some further thoughts on the Bank of England’s Special Liquidity Scheme | April 29th, 2008 at 7:32 pm | Report this comment