In the UK, as in the US and much of continental Europe, the liquidity crunch has become but the epiphenomenon of the threat of insolvency of a large chunk of the banking sector (‘banks’ being defined broadly to include such companies like AIG and GE, which in addition to their non-banking activities, have become engaged in highly leveraged financial intermediation involving massive asset-liability mismatch.
Since solvency is the main issue now, the central banks are no longer central to the management of the crisis. At most they can act as the agents or hand-maidens of the fiscal authorities, offering their expertise and reputations, but not their financial resources.
Still, just because illiquidity has now become the tail rather than the dog, there is no reason to mismanage it. Unfortunately the Bank of England is doing just that. I am not referring to the costly and embarrassing announcement of the closure to new business on October 21 of the SLS. This probably cost HBOS its independence, but never mind. The closure-to-new business decision was rescinded, or rather postponed, until the end of January 2009. This provides an ideal focal point for a new set of speculative attacks on financial institutions with large holdings of SLS-conforming assets.
I am not even referring to the refusal of the Bank of England to accept at the SLS securities backed by assets originated after the end of 2007. This unnecessarily restricts the effectiveness of the SLS as a catalyst for new mortgage lending.
I am referring to the Bank of England’s continuing failure to inject liquidity into the markets at the maturities where it is needed. Following the Lehman/AIG/HBOS kerfuffle, the Bank of England has drowned the markets in overnight liquidity. This has been done to the point that commercial banks have now hoarded almost £6 bn of overnight liquidity in the standing deposit facility. They did this, despite getting a rate 100 basis points below the official policy rate on these deposits with the Bank of England, because they fear lending it out to any private counterparty, including any other commercial bank.
So the Bank of England has been mopping up overnight cash again. While that’s fine, it should have injected large amounts of liquidity, against a wide range of aggressively priced collateral, at maturities of one month and longer (up to one year). The spreads of Libor over the OIS rate and the TED spread (the spread of 3-month Libor over the 3-month Treasury bill rate) have been rising dramatically again, reflecting market perceptions of increased bank default risk and illiquidity.
With no private counterparty considered trustworthy for unsecured transactions, and with the private tripartite repo markets also drying up because of lack of confidence in the ‘intermediaries’ that act as counterparties for both legs of a tripartite repo market transaction, it is time for the Bank of England to take up the role of universal counterparty in tripartite repo transactions between private entities, and indeed also in the unsecured interbank market. The Bank of England must become the interbank market. Indemnification of the Bank of England by the Treasury for any credit-risk related losses incurred as a result of its universal counterparty role will, of course, be necessary.
Beyond that, what can be done?
- The Treasury should take the SLS away from the Bank of England. It already is off the Bank of England’s books, and there is no reason for the Bank to manage it and to have a de-facto veto over any modifications.
- The SLS should be made open-ended in duration and uncapped as regards the amount of swaps it can engage in.
- The SLS should be extended to included securities backed by assets originated after December 31, 2007.
- A UK version of US Treasury Secretary Paulson’s TARP should be created and funded to permit outright purchases of toxic assets by the government.
- New capital must be injected into the banking sector, either by a mandatory conversion of debt into equity or through a capital injection by the state, in return for preference shares and warrants (options to buy common stock or convert the preference shares into common stock at a set price).
- Start cutting the official policy rate this month. It won’t do much to resolve the liquidity crunch or to recapitalise the banks (in the short run) but it won’t hurt, and with the further decline in economic activity that can be expected as a result of this latest worsening of the crisis, the inflation target no longer presents an obstacle to measured rate cuts.
With the Bank of England barking up the wrong liquidity tree once more and the Treasury paralysed by the political infighting in the Labour party and the terminal indecision of its leadership, the urgent change in the direction of monetary policy and liquidity policy and the urgent need for an injection of capital in the UK banking sector may not be enough to produce the desired outcomes. In that case a long and deep recession, some might say depression, will be the inevitable outcome.