It’s too bad that what the Bank of England does well – setting the official policy rate (Bank Rate) – is much less relevant to our economic wellbeing in this crisis that what it does poorly – maintaining financial stability through liquidity management. Adding to the vulnerability of the UK’s financial system, the UK Treasury continues to stand on the sidelines, fiddling while London burns.
With the real economy slowing down and inflation showing signs of softening at last, interest rates will be cut. The Treasury also knows enough basic macroeconomics not to engage in active pro-cyclical behaviour by raising taxes or cutting spending today. Tax increases and spending cuts will have to wait until, sometime in 2010, the economy strenghthens again. The combined actions of the Bank of England and the Treasury, however, will do little or nothing to unfreeze key financial wholesale markets, including the markets for securitised residential mortgages, or to recapitalise the tottering British banking system.
After a very bad start in August 2007, when the Bank of England followed a ‘Treasuries only’ policy (that is, it accepted only Treasury securities or better as collateral at its discount window and repos) and injected inadequate amounts of liquidity at longer maturities, the Bank of England has bounded up its learning curve, repoing against a wider range of collateral and injecting larger volumes of liquidity at longer maturities. The creation of the Special liquidity Scheme, which provides liquidity at up to one-year maturity by offering Treasury Bills in exchange for a range of asset-backed securities and covered bonds, was a signficant step forward. It was, judging from the groans and moans emanating from the banking sector, quite expensive to access, but it has so far done £100bn worth of business, which is not bad.
But then progress halted and even went into reverse. The Bank of England announced it was going to close the SLS for new business in October 2008. In mid-crisis, this was an insane decision. When the Lehman/Merrill Lynch/AIG/HBOS crisis erupted, the Bank announced that it had decided to move the ‘closed for new business’ date to January 2008. Better, but still insane.
Economics distinguishes between two kinds of rules: time-contingent rules and state-contingent rules. Setting a terminal date for new business at the SLS is an example of a time-contingent rule. With the financial crisis still raging around us, such a rule provides a perfect focal point for a speculative attack on the UK banking system. So what is required instead, is a state-contingent rule for closing the SLS to new business – a rule of the following kind: we will close it when, in the view of the Bank of England, there is no longer any need for it, that is, when financial markets have re-opened and stabilised. They should change to a state-contingent rule as yet.
Restricting the SLS to securities backed by assets originated before the end of 2007 also severely hampers its effectiveness as a mechanism for restoring orderly markets. Provided the SLS is restricted to new orginations that satisfy a ‘Gold Standard’ (in the case of residential mortgages this would mean: income and asset verification, credit history verification, a strict limit on the loan-to-value ratio of, say, 80 percent and no cute features that push the mortgage servicing costs into the future), and provided the haircuts and other terms applied to securities backed by new originations are sufficiently hefty, moral hazard can be minimized.
The Bank’s reluctance to do the obviously sensible and necessary thing appears to be due to its binary, all-or-nothing view of moral hazard (creating bad incentives for future excessive risk taking by ex-post subsidising past excessive risk taking). Moral hazard bad. No moral hazard good. Therefore, no moral hazard.
Actually, there is a trade-off in many cases between the effectiveness which which the authorities deal with current financial instability and the incidence and severity of future financial instability. You can have a little more impact on financial stability today by allowing a little more moral hazard and a greater risk of future instability. I don’t believe that the optimal position on the ‘putting out fires-moral hazard trade off’ curve is a zero moral hazard position. Mervyn King and the Bank of England seem to believe, however, that the zero moral hazard corner solution is the place to be. I disagree. The Bank is not being righteous; it is acting self-righteously. This creates unnecessary risks for the real economy.
I am not arguing, as some appear to do, that zero weight be given in a crisis to moral hazard – that all that matters is to get through today in the best possible shape and to hell with the consequences for longer-term financial stability. There is quite a bit you can do, even in the most acute phase of the crisis, to punish past recklessness and so to set the right guideposts for future risk taking. The US government could have underwritten the shareholders of Fannie Mae and Freddie Mac, in addition to the creditors. It did not. It could have bailed out Lehman. It was left to sink or swim and it sank. The shareholders of AIG were heavily diluted when the government took a 79.9 percent equity stake the company. The $85 bn Fed loan to AIG was overcollateralised and priced punitively, at 850 basis points over Libor.
The authorities should always, in the measures they design and implement for alleviating the crisis, look for ways to address future moral hazard. More could have been done even by the US authorities. It is most unfortunate that the creditors to Fannie, Freddie and AIG have been made whole, rather than being subjected to a capital charge or being made subject to a compulsory conversion of some of their debt into equity.
The UK Treasury, of course, does not need the Bank of England to run the existing SLS or to expand it to an augmented SLS that also accepts new orginations. After all, the SLS offers liquidity in the form of Treasury Bills and who better to provide Treasury Bills than the Treasury? The Treasury can and should itself run the kind of SLS it wants, if the Bank is being difficult about it.
Apart from the provision of liquidity, the UK authority have restricted their crisis management to a series of reactive, ad-hoc interventions. This includes the Liquidity Support Facility for Northern Rock, the extension of deposit insurance, the nationalisation of Northern Rock, leaning on the underwriters when rights issues were about to flop in the case of Bradford & Bingley and HBOS, and some friendly nudges and a suspension of competition rules in the take-over of HBOS by Lloyds-TSB.
Ad-hoc measures are not, in my view, enough at this stage. The authorities need a plan, other than hoping that all this will go away. The UK authorities have to stand ready to act more aggressively as market makers of last resort and be prepared to take steps to recapitalise and de-leverage UK banks. Both types of measures are mainly the responsbility of the Treasury. The role of the Bank of England is limited to that of agent of the Treasury, offering its expertise and reputation, but not its financial resources. The problems are now increasingly those of insolvency. Illiquidity is the visible manifestation of the fear of insolvency of counterparties. Fiscal resources, that is, the tax payer must back the government’s interventions for them to be effective.
It may no longer be enough to support prices of illiquid assets (mainly ABS) by accepting them as collateral at the standing lending facility, in repos or at the SLS. In the UK as in the US, the time for outright purchases of illiquid ABS (at deep discounts to face value to minimise moral hazard) by the Treasury has come. The UK Treasury should create a TAD (Toxic Asset Dump) for systemically important ABS (including RMBS), using tax payer funds to purchase these securities and either hold them to maturity (the good thing about the Treasury is that it is not liquidity-constrained) or sell them off (preferably at a profit for the tax payer) when market conditions improve. I would start with £100 bn fund, which should be able to purchase a multiple of £100bn worth of illiquid securities at face value.
Second, the Bank of England, the FSA (the financial regulator) and the Treasury should determine minimal capital adequacy ratios well above those required by Basel II for all bank-like financial institutions. Equivalently, you can think of these as maximum leverage ratios. For banks with leverage ratios above their ceiling levels, there would be compulsory debt-to-equity conversions, with the share of the conversion in the total amount of debt outstanding varying inversely with the seniority of the debt. This would reduce leverage ratios both by lowering the numerator and by raising the denominator. It would dilute the exising shareholders, which would be further good news from a moral hazard perspective.
I never thought I would use the word pro-active (ugly, ugly!) but here it comes. The UK authorities must stop ‘Kurieren am Symptom’. They need to move pro-actively both as market makers of last resort, through outright purchases of illiquid systemically important instruments, and by mandating a recapitalisation through debt-to-equity conversions or some similar mechanism.