The UK Treasury is considering the creation of something I shall refer to as an FSC (for Financial Stability Committee/Council) to advise/assist/overrule the Governor of the Bank of England and the other four executive members of the Bank of England’s Monetary Policy Committee (MPC) who currently deal with and decide on financial stability matters.

This could be a good idea or a bad idea, depending on how it is implemented.

It is certainly desirable to clarify the role of the MPC in the design and implementation of financial stability measures and policies. The Bank of England Act 1998 is hopelessly vague about what the instruments available to and set by the MPC actually are. It should be made clear that the MPC sets a short, risk-free nominal interest rate, currently Bank Rate. That’s what it has done since its inception and there is no reason to change that.

The other instruments the MPC could set or at least have a say in setting are public debt management, foreign exchange market intervention and liquidity management. As regards public debt management, the government took the operational responsibility for this out of the Bank of England when the Bank was granted operational independence for monetary policy in 1997 and relocated the Debt Management Office in the Treasury. I don’t expect the Bank to get it back.

The Bank only has puny foreign exchange reserves of its own. It acts as the government’s agent (and on the instructions of the Treasury) for interventions including the larger foreign exchange reserves of the Treasury. During the first three years of the MPC, when I was an external member, foreign exchange market intervention was discussed on a few occasions as if it were a potential policy instrument of the MPC. No interventions were undertaken during that period. Following the terrorist attacks on the USA on 11 September 2001, the Federal Reserve established thirty-day reciprocal swap arrangements with the European Central Bank (ECB) and the Bank of England and temporarily augmented its existing swap facility with the Bank of Canada. The ECB drew on the swap facility on three occasions, but the Bank of England did not. The responsibilities of the MPC in the area of (sterilised) foreign exchange market intervention should be clarified.

Liquidity management is a multidimensional set of activities. It includes the following:

(1) Discount window operations (collateralised loans from the Bank of England’s standing lending facility).

o Determination of the eligible collateral at the discount window (the standing lending facility)

o Determination of the maturity of the discount window loans

o Determination of the eligible counterparties for discount window loans

o Determination of the penalty interest rates on discount window loans of different maturities

o The pricing of any illiquid collateral accepted at the discount window (who will do it, and using what methodology)

o The haircuts (discounts) applied to the valuation of the collateral

o The other terms (fees etc.) charged for discount window access

(2) The implementation of the Bank Rate decision of the MPC.

Currently this is a mess, despite the reforms of May 2006. If the MPC sets the overnight (default-risk free) nominal interest rate, it should be willing to lend or borrow at that rate any amount of risk-free sterling overnight liquidity at any time during the maintenance period. This means (1) the Bank of England sets the rate at which eligible counterparties can make deposits with the Bank of England at Bank Rate, for any amount of deposits. This would mean doing away with the standard deposit facility which pays 100 basis points below Bank Rate. It also means that (2) the Bank of England sets the rate at which eligible counterparties can borrow any amount of overnight reserves from the Bank of England, against a narrow range of high-grade collateral (after all the MPC fixes a default risk-free overnight rate!). Effectively, as regards borrowing overnight reserves from the Bank of England, the central bank holds a continuous fixed rate auction for overnight liquidity during each working day in the maintenance period. The collateral accepted for the purpose of implementing the MPC’s interest rate target can be highly restrictive, rather like the mainly sovereign debt instruments accepted by the Bank as collateral in all repo operations, before it saw the light. Compounding interest continuously on such overnight transactions would further help smooth out variations in the overnight secured interbank lending rate.

To the objection that doing this would kill the overnight interbank market, with all transactions occurring through the intermediary of the Bank of England, the best answer is: so what? The financial markets in general, and the overnight interbank market in particular, are not an employment programme for budding bankers. In any case, interbank lending, secured and unsecured, at maturities longer than overnight could still thrive. Also, what the Bank of England would set through these continuous fixed-rate repos would be the secured overnight right. Unsecured lending and borrowing in the interbank market , the current overnight Libor rate, would still be set by private banks.

If, for whatever reason, the Bank of England values the existence of a (redundant) thriving interbank market for secured overnight lending, it could set the rate at which it would accept (any amount of) deposits at Bank Rate minus 0.5 x and its secured lending rate at Bank rate plus 0.5 x, where x is just a bit bigger than the private bid-ask spread in the overnight interbank market under orderly market conditions.

(3). Liquidity oriented open market operations (OMOs), including repos and outright purchases of securities, other than those used to implement Bank Rate

This includes a range of activities, whose key decision parameters are the following:

• In the case of outright purchases of private securities:
  • the quantities purchased
  • the mechanism used for pricing these securities if they are illiquid
  • other fees for access to the OMO
  • the eligible counterparties
• In the case of term repos or collateralised term loans:
  • Determination of the eligible collateral in these ‘term’ open market operations (anything with a maturity longer than overnight and/or accepting collateral beyond what was acceptable in repos at the Bank of England prior to the August 2007 crisis).
  • Determination of the maturities at which these term repos will take place.
  • The size of the operation at each maturity.
  • The (auction) mechanism for pricing the liquidity provided at each maturity.
  • The other terms (fees etc.) charged for participation in the OMOs
  • Determination of the eligible counterparties these OMOs
  • The valuation/pricing of any illiquid collateral offered (when the OMO is not an outright purchase of private bank securities).
  • The haircuts (discounts) applied to the valuation of the collateral.

(4). Other liquidity facilities

Both the Bank of England and the Fed have created liquidity facilities that involve a swap not of central bank liquidity but instead of government securities (typically Treasury Bills) for private assets held by the banking sector (including such private asset-backed securities (ABS) as residential mortgage-backed securities (RMBS) and, in the case of the Bank of England, ABS backed by credit card receivables and also covered bonds). The Fed created the Term Securities Lending Facility to lend TBs against RMBS and other, often illiquid, collateral, to the primary dealers (large investment banks). The Bank of England created the Special Liquidity Scheme (SLS) to swap TBs for collateral banks could not sell to or repo with private counterparties at reasonable prices.

From an economic perspective, this is an unnecessarily complicated way of going about making central bank liquidity available to the private banking sector. The Treasury Bills are highly liquid. They can either be used by the banks acquiring them (or borrowing them) to obtain surplus pockets of liquidity held by other private financial institutions - liquidity that could not be winkled out any other way - or, more likely, be used as collateral with the Bank of England in repos to obtain central bank liquidity. It would be more straightforward to make central bank liquidity available directly, against the same collateral that is accepted for the Treasury Bills. No doubt there are legal and fiscal-financial window-dressing reasons to prefer the roundabout way to the direct route. Regular repos of central bank liquidity against illiquid collateral would put the illiquid collateral firmly on the central bank’s books. The SLS is off-balance sheet for the Bank of England. The credit and market risk exposure belongs to the Treasury. But because the Treasury Bills involved are of less than 1 year maturity, they don’t, for reasons not understood by any sane person, count as public debt in the UK, so for reporting purposes, including the Sustainable Investment Rule of the government, they don’t exist.

Determination of the eligible collateral for tripartite open market operations (repos).the maturity of discount window loans, the eligible counterparties at

(5). Any other lender of last resort (LLR) operation by the Bank of England to provide funding liquidity or market maker of last resort (MMLR) operations to provide market liquidity.

o Special or ad-hoc liquidity facilities like the Liquidity Support Facility created for Northern Rock in September 2007.

o Foreign currency swaps or contingent foreign currency credit lines arranged with foreign central banks, international institutions (e.g. the IMF) or private or state-owned counterparties, including Sovereign Wealth Funds.

It probably makes sense for the Monetary Policy Committee of the Bank of England not be involved with the design or implementation of policies under headings (1) to (5). The MPC will of course have to understand what they are and how they work, in order to allow for their impact on price stability and, subject to that, growth, employment and all things bright and beautiful, when setting the Official Policy Rate (Bank Rate). The important constitutional point is to have this division of labour spelled out precisely and explicitly. This is not the case now.

The FSC should determine the policies under headings (1) to (5), leaving the operational implementation to the Executive Members of the FSC (containing the Governor, the Deputy Governor responsible for Financial Stability, and the Bank’s Executive Director for Markets).

The composition of the FSC

I would propose that the FSC learn from the experience of the MPC, which is too large for optimal deliberation. I would propose a seven-member FSC, with three internal or executive members (the Governor, the Deputy Governor responsible for Financial Stability, and the Bank’s Executive Director for Markets) and four external members. ( I would use the opportunity to remove the Deputy Governor for Financial Stability and the Executive Director for Markets from the MPC, bringing its size down to seven also; only the Governor would serve on both the FSC and the MPC). If a majority of external members for the FSC (and the MPC) is deemed unacceptable (no reason why it should be, but I can see steam rising from the chimneys at Threadneedle Street), we could have a 5-member FSC with the same three internal members and two external members. Five MPC members would also be better than the current nine, although I have a slight preference for seven-member committees.

There is no point in making the FSC an advisory body only. Advice is like wallpaper. If the Governor does not like it, he can ignore it and paper it over again. The FSC should have liquidity policy making responsibilities, through a majority voting rule, the same way the MPC decides on Bank Rate using a majority voting mechanism.

A purely advisory FSC would be like the Court of the Bank of England, a body of staggering irrelevance as regards the design and implementation of monetary policy and liquidity management. This is partly by design (the Court is explicitly not responsible for the conduct of monetary policy, by the Bank of England Act 1998) and partly a possibly unintended result of the size of the Court and its composition.

The current Court has 19 members: three executive members (the Governor, the two Deputy Governors and sixteen Non-Executive Directors). The Non-Executive Directors are appointed for three year renewable terms. This is almost two football teams. Far too large a body to provide effective oversight. Apart from the Chair of the FSA, whose presence obviously makes sense, the rest of the non-execs tend to be chosen according to the criteria of ‘representativeness’ and ‘nearly great and good’. Competence and relevant experience are present, but not by design. Representatives means a trade unionist, a captain of non-financial industry, a consumer advocate, at least one woman, an aged professor, some non-threatening city types.

The line between ‘great and good ‘ and ‘boring old fart’ is a thin one. During my three years on the MPC, the external MPC members once tried to involve the Court in a matter that ought to have been of interest to the Court, given its role in the governance of the institution. This was during the conflict between the external members of the MPC and the Bank’s executive leadership, about the creation of a dedicated research unit to support the external MPC members, independent of the Bank’s Executive. The Court was utterly ineffective and resolved nothing.

Even a smaller Court would not be the right body to fulfil the FSC role. The external members of the FSC should not be subject to potential conflicts of interest. That means that they cannot hold remunerated positions with banks or other City institutions. The notion that a bunch of bankers would advice the Governor and the Deputy Governor for Financial Stability on how much liquidity to provide and on what terms, to institutions including their own, is ludicrous. The notion that a banker or any other person with an active private financial sector interest should co-determine liquidity policy or policies to bail out private financial institutions, is criminal.

So the external members of the FSC should be recruited on the same basis as the external members of the MPC. Competence and independence. And absence of conflict of interest. Therefore no full-time or part-time remunerated engagement in the private financial sector.

One of the most striking features of the securitisation/complex financial structures crisis that has boosted political (and academic) interest in the financial stability role of central banks has been the staggering ignorance of most senior bankers about the products their high-flying underlings were cobbling together. It wasn’t just the majority of central bankers that were ignorant of the role of SIVs, Conduits, CPDOs, ABS, ABCP and the rest of the alphabet soup. Most senior private bankers did not have a clue either. They liked the wave of profits generated by the new structures, products and vehicles. They feared doing anything that might cause this goose to stop laying its golden eggs.

Do we really want the ‘experienced private bankers and captains of finance’ that brought us the subprime crisis to advise the Governor of the Bank of England how to bail them out in the not too distant future when they and the institutions they serve will once more be about to hit the rocks because of a prior wave of reckless lending and borrowing, and excessive leverage? These are the same people that partook of the evil weed of ‘this time it’s different’, ‘we are in a new paradigm’ and ‘these new instruments don’t just allow us to trade risk - they eliminate it’. The FSC will need people that are thoroughly familiar with both the detailed operation of money markets, credit markets, foreign exchange markets and capital markets, and with their dynamic interactions at the macro level. The FSC will need people who understand the strenghts and weaknesses of banks and other financial institutions, and the incentives and other behavioural impulses that drive them. The FSC does not need people who currently make a living in these markets or in these financial institutions. They are the ones that screwed it up.

Information vs. capture

In deciding the role of the central bank as supervisor and regulator of banks, other financial sectors and financial markets, the issue of regulatory capture must be faced. It is no accident, in my view, that among the Fed, the ECB and the Bank of England, the only central bank to exhibit manifest excess sensitivity to financial sector concerns is the Fed - the only one of the three with a formal regulatory function vis-à-vis the banking sector. The benefits to the quality of monetary policy, liquidity management and the performance of the LLR and MMLR functions from greater information about and familiarity with individual banks and other financial institutions appear to come bundled with an excessive internalisation by the central bank of the objectives, fears and worldview of the banks and other financial institutions they supervise and regulate.

Openness and accountability are the best antidote against regulatory capture. This is true emphatically in the performance of the central banks’ LLR and MMLR functions. To discourage future moral hazard (in the form of excessive risk taking), the central bank should make sure that any securities accepted as collateral or purchased outright at the discount window, through repos or through any special-purpose liquidity facility it may have created, are valued properly, that is, punitively. In the case of illiquid collateral, the central bank should price these securities itself, and it should put both its models for pricing these illiquid securities and the actual valuations attached to specific types of collateral in the public domain.

The Bank of England should not be given responsibilities without commensurate powers. I would therefore try to minimize its regulatory and supervisory responsibilities over individual institutions, other than the right to demand information relevant to its liquidity managements, LLR and MMLR responsibilities.

The responsibility for the Special Resolution Regime for banks and other highly leveraged institutions, with its Prompt Corrective Action and Special Regulatory Insolvency armoury, should not be given to the Bank. Neither should it be given to the FSA. It should be given to the new agency of Authority that ought to be created to manage deposit insurance in the UK (by analogy with the FDIC in the USA). The Bank and the FSA, as well as the Treasury, should of course always be consulted by this new Authority.

So, a warm welcome to the Financial Stability Committee, as long as it is structured to prevent the capture of the Bank of England by the City of London.

June 11th, 2008 in Economics, European Union, Financial Markets, Monetary Policy, Politics | Permalink