On 11 October 2007, I gave a presentation for the Bank of England’s Graduate Induction Programme, titled: “MPC Past Present and Future: the good, the bad and the ugly”. A pdf version of the Powerpoint presentation I gave is available here.

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Two announcements have been made during the past couple of days about official support for Northern Rock – one relating to the asset side of its balance sheet and one relating to the liability side. As regards its assets, Northern Rock is now being provided with additional facilities enabling it to borrow through the Bank of England on a secured basis against all of its assets, rather than just against prime mortgage collateral as was the case up to this announcement. As regards its liabilities, the government’s guarantee of its deposits has now been extended to included new deposits.

The asset-side measure makes good sense and brings the Bank of England’s lender of last resort policy closer to what I have advocated for a while. The liability-side measure is likely to compound the earlier mistake.

By accepting the bulk of Northern Rock’s assets as collateral for borrowing from the Bank of England through the Liquidity Support Facility that was purpose-built for the Northern Rock bail-out, the Bank of England is getting close to turning the Liquidity Support Facility into something approximating the Federal Reserve System’s (primary) discount window. The Bank of England’s own discount window, its Standing lending facility, is a pale and anaemic shadow of the Fed’s discount window, because it only accepts extremely high-grade and already utterly liquid securities as collateral. All the Bank of England does at its Standing lending facility is maturity transformation. It exchanges long maturity (duration) liquid assets for very short maturity (duration) liquid assets. It does therefore not provide liquidity in any meaningful sense.

The Fed can, provided it decides that exceptional circumstances prevail, accept at its discount window as collateral absolutely anything it deems fit. When the (private) Bank of New York (back in the 70s I believe) needed to access the discount window of the New York Fed overnight because of some technical glitch (I think they had to borrow $23 bn), they offered as collateral the entire bank, including the building and the furniture.

If an asset can be valued, it should, properly valued and subject to the appropriate haircut, be acceptable as collateral at the discount window. The central bank should insist on sufficient ‘over-collateralisation’ (in addition to the penalty rate it charges for discount window borrowing) to make sure that the tax payer can expect to benefit from the transaction. If the Bank of England had operated a similar sensible policy at its discount window in August and September 2007, there would have been no need to create the Liquidity Support Facility the Bank dreamt up for Northern Rock. The Fed’s (primary) discount window does everything the Liquidity Support Facility does, and it does so ‘on demand’ and on a scale limited only by the available collateral. It also lends at up to 1 month maturity, unlike the Bank of England’s Standing lending facility, which only lends overnight. Of course, the Fed then went and rather spoilt it, by reducing the spread of its discount rate over its policy rate (the Federal Funds target rate) from 100 basis points to 50 basis points; this is pure pandering to the profits of those institutions that are already able and willing to borrow at the discount window; it would have made more sense to raise the discount rate spread over the policy rate by 50bps (to 150 basis points) to underline the Fed’s commitment to a Bagehotian lender of last resort model: lend freely (against collateral that would be good during normal times, but may have become illiquid during turbulent market conditions) but at a penalty rate. While I am happy about the actions of the Bank vis-à-vis the asset side of Northern Rock’s balance sheet, I am appalled at the Chancellor’s decision to extend the deposit guarantee at Northern Rock to new deposits. This encourages Northern Rock to try to attract new deposits using above-market deposits rates, as long as these are below the penalty rate charged on borrowing from the Liquidity Support Facility. What is especially outrageous about both the old and the new guarantee is that it covers not only retail deposits, but also wholesale deposits and most unsecured lending to Northern Rock.[1]

Why should the unsecured wholesale creditors of Northern Rock get any protection at all? There is no social justice (widows and orphans) argument to support this intervention, nor an efficiency argument – the wholesale creditors to Northern Rock should be expected to be able to pay the cost of verifying its financial viability. No public purpose is served by subsidising, through ex-post insurance, the ‘rate whores’ that are likely to make up the bulk of the wholesale creditors of Northern Rock. Municipalities, charities and professional and institutional investors that were happy to pocket the slightly above-market interest rates offered by Northern Rock should not be able to dump the default risk (whose anticipation/perception was the reason for the higher rates) on the tax payer.

In its statement introducing the deposit guarantee, the Treasury said Since it would otherwise be unfair to other banks and building societies, the arrangements would not cover any new accounts set up after 19 September, other than re-opened accounts as set out above.” Apparently, it now is no longer unfair or it does not matter that it is unfair. The Treasury statement says that Northern Rock will pay a fair price for the guarantee.[2] We shall see. No doubt a small army of mathematically gifted Treasury civil servants are busy pricing the contingent claim represented by the deposit guarantee for Northern Rock. If the customary lack of openness and transparency of the Treasury prevail, we will never get the information to judge whether Northern Rock paid a fair price for the guarantees extended by the state to its creditors.

[1] “These arrangements will cover all retail deposits, including future interest payments, movements of funds between accounts and term deposits for the duration of their term.”(Treasury statement on 09/10/2007); and “In the case of wholesale market funding for Northern Rock plc, the Treasury confirmed that the arrangements would cover: existing and renewed wholesale deposits; and existing and renewed wholesale borrowing which is not collateralised. The arrangements would not cover other debt instruments including: covered bonds; securities issued under the “Granite” securitisation programme; and subordinated and other hybrid capital instruments.” (Treasury statement on 20/09/2007)

[2] “Northern Rock plc will pay an appropriate fee for the extension of the arrangements, which is designed to ensure it does not receive a commercial advantage.”, Treasury Statement, 09/10/2007

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I know this is too long. However, the case for the Baltic countries to be admitted forthwith to the Eurozone is overwhelming; and the obtuseness of the ECB and the European Commission – not to mention their disdainful arrogance towards these countries – is so staggering, that I hope some of you may read this to the end.


Those EU Member States that already have a fixed exchange rate with the euro (Estonia, Lithuania, Latvia and Bulgaria) could and should enhance the credibility of their exchange rate arrangement and strengthen nominal convergence by adopting the euro as joint legal tender alongside their national currencies. The national currency would be retained, alongside the euro, as joint legal tender until full membership in the EMU is achieved. This treatment of the euro as a parallel currency with equal ‘rights’ to the domestic currency, is a way to achieve most of the benefits of unilateral euroisation without finding oneself in conflict with the Treaty and Protocol governing formal EMU membership requirements and procedures.

While for the four countries under consideration the key criteria for EMU membership are the inflation criterion and the exchange rate criterion, I shall briefly summarise all nominal convergence criteria.

1. The Maastricht convergence criteria

The convergence criteria for EMU membership (the so-called Maastricht criteria) are as follows:

The fiscal criteria

The fiscal requirement for EMU membership is that at the time of the examination the Member State is not the subject of a Council decision under Article 104(6) of the Treaty that an excessive deficit exists. An excessive deficit exists if either the deficit criterion or the debt criterion are not satisfied:

(1) the deficit criterion: the ratio of the general government financial deficit to GDP cannot exceed the reference value of 3 percent unless either the ratio has declined substantially and continuously and reached a level that comes close to the reference value; or, alternatively, – the excess over the reference value is only exceptional and temporary and the ratio remains close to the reference value;

(2) the debt criterion: the ratio of the stock of gross general government debt to GDP cannot exceed the reference value of 60 percent of annual GDP unless the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace.

The interest rate criterion

For a period of one year before the examination, a Member State has had an average nominal long-term interest rate that does not exceed by more than 2 percentage points that of, at most, the three best performing Member States in terms of price stability.

The exchange rate criterion

The Member State must observe the normal fluctuation margins provided for by the exchange-rate mechanism of the European Monetary System (15 percent on either side of a central rate defined with respect to the euro), without severe tensions for at least two years before the examination, without devaluing its currency’s bilateral central rate against the currency of any other Member State on its own initiative.

The inflation criterion

As it was the inflation criterion that has kept Estonia[1] and Lithuania out of the EMU, it is worthwhile to spell it out in detail, and specifically to bring out where the Treaty and the Protocol speak and where the ECB and the Commission are themselves making up criteria, reference values and benchmarks.

The Treaty and Protocol requirements

Article 121 (1), first indent, of the Treaty requires:

“the achievement of a high degree of price stability; this will be apparent from a rate of inflation which is close to that of, at most, the three best performing Member States in terms of price stability”.

Article 1 of the Protocol on the convergence criteria referred to in Article 121 of the Treaty stipulates that:

“the criterion on price stability referred to in the first indent of Article 121 (1) of this Treaty shall mean that a Member State has a price performance that is sustainable and an average rate of inflation, observed over a period of one year before the examination, that does not exceed by more than 1½ percentage points that of, at most, the three best performing Member States in terms of price stability. Inflation shall be measured by means of the consumer price index on a comparable basis, taking into account differences in national definitions.”

The ECB’s and European Commission’s interpretation and operationalisation of the inflation criterion in the Treaty and Protocol

As stated in the Treaty and Protocol, the inflation criterion is non-operational, as it does not explain what is meant by “… the three best performing Members States in terms of price stability”.

It would seem, however, that this ought not to pose a problem, because the ECB, the European institution whose mandate it is to maintain price stability, has, not surprisingly, developed an operational, numerical definition of what is meant by price stability in the euro area. On its website, the ECB states: The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.”[2] It elaborates on this elsewhere on its website as follows:

“While the Treaty clearly establishes the maintenance of price stability as the primary objective of the ECB, it does not give a precise definition of what is meant by price stability.

Quantitative definition of price stability

The ECB’s Governing Council has defined price stability as “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. Price stability is to be maintained over the medium term”.

The Governing Council has also clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term.”[3]

This would seem to carry the logical implication that the three best performing Member States in terms of price stability would be the three Member States whose inflation rates would be closest to but below 2%. The inflation threshold that a Member State wishing to join EMU should not exceed, would therefore be given by 1½ percent plus the average rate of inflation of the three Member States with inflation rates closest to but below 2 percent

Strangely, however, the operational definition of price stability that the ECB uses for itself (that is, for the existing members of the euro area) is not the operational definition the ECB and the Commission impose on Member States wishing to join the EMU. That rate is defined as follows in the ECB’s 2007 Convergence report (ECB (2007)) (similar statements can be found in all earlier Convergence Reports by the ECB and the Commission, e.g. European Monetary Institute (1996; 1998), European Central Bank (2000; 2002; 2004; 2006a,b), European Commission (1998; 2000; 2002; 2004; 2006a,b,c; 2007a,b)).

“…the notion of “at most, the three best performing Member States in terms of price stability”, which is used for the definition of the reference value, has been applied by taking the unweighted arithmetic average of the rate of inflation of the following three EU countries with the lowest inflation rates: Finland (1.3%), Poland (1.5%) and Sweden (1.6%). As a result, the average rate is 1.5% and, adding 1½ percentage points, the reference value is 3.0%.”

To calculate ‘the notion of “at most, the three best performing Member States in terms of price stability”’, the ECB and the Commission therefore take the average of the three lowest (but non-negative) inflation rates among all EU members – those already full members of the EMU, those who are actively trying to meet the EMU membership criteria, and those who are not actively pursuing EMU membership. Not actively pursuing full EMU membership could be legally the case for the two countries with an opt-out, the UK and Denmark. In practice, any country not wishing to join but not in possession of an opt-out, can always choose not to meet one of the criteria for membership. Sweden does this with respect to the exchange rate criterion.

2. ECB and Commission: better consistently wrong than inconsistent but right?

It is clear that it makes no sense to have one concept of price stability for existing Eurozone members (inflation below but close to two percent over the medium term) and a completely different, and in practice much more restrictive, price stability concept for would-be new members (the average of the three lowest inflation rates among all EU Member States, as long as these inflation rates are not negative). Why set a higher standard for candidate members than for existing members?

A further unfortunate feature of the Maastricht inflation criterion, as interpreted by the Commission and the ECB (the Treaty and protocol are rather vague) is that its benchmark is based on the 3 lowest (non-negative) inflation rates among all EU members, (25 at the time of Lithuania’s and Estonia’s unsuccessful first attempts to join the EMU), and not just on the inflation performance of the Eurozone members (12 in number when Lithuania was formally turned down, currently 13 and soon 15, with Cyprus and Malta joining on January 1, 2008). When Lithuania failed the test, two of the three lowest inflation rates used in the calculation of the inflation benchmark were for countries that are in the EU but not in EMU – Poland and Sweden. The inflation rates of countries in the EU but not in the EMU are no more relevant for whether a candidate country should be admitted to the EMU, than would be the inflation rates of countries in Sub-Saharan Africa.

Once can see how and why, historically, these now inane (indeed insane) criteria were put together. What the authors of the Treaty and Protocol were thinking of was the creation ab initio of EMU through the joining in monetary union of a significant number of countries. They wanted not just a monetary union with a common rate of inflation among member states, but one with a common and low rate of inflation. All EU members were expected to be striving actively for EMU membership, so best-performing was naturally measured with respect to the complete set of EU members.

That was then. We now have a functioning EMU with a low EMU-wide rate of inflation. Common sense now calls for the same definition of price stability to be used for candidate members as for the existing EMU members. Actually, as there is only one monetary policy for the entire EMU, even the inflation rates of the individual EMU Member States is irrelevant for the construction of an inflation benchmark. Both the economics and the politics of a monetary union dictate that the benchmark be based on the inflation performance of just the EMU area as a whole.

When one points out to the ECB and the Commission that their inflation criterion and numerical benchmarks make no sense, all they say in reply is, that this is how it was done in the past. Because the ECB and Commission got it wrong before, they are honour-bound to repeat the mistake again today and tomorrow. To do otherwise would violate equity vis-à-vis those who managed to pass the (wrong) tests in the past. The fact that until Lithuania was rejected for membership and Estonia was strongly discouraged from pressing its application, no application for EMU membership had ever been rejected rather undermines the ‘fairness vis-à-vis earlier applicants argument.

For reasons understood only by themselves, the ECB and Commission therefore continue to make these nonsensical demands, even if the Treaty and Protocol do not require it. The Commission and the ECB don’t mind doing things that are illogical, costly and potentially destructive, as long as there is a precedent for it. They would rather be consistently wrong than inconsistent but right.

3. Dirty politics: why is the inflation criterion the only one for which the ECB’s and Commission’s interpretation is rigidly enforced?

In the case of Lithuania and Estonia, the ECB and the Commission have chosen to stick rigidly to their interpretation and quantitative implementation of the inflation criterion, even though this made no economic sense. Strangely enough, the Commission and the ECB have, in the past, forgiven or waved through many clear violations of numerical criteria stated explicitly in the Treaty and the Protocol, rather than just dreamed up by the Commission or the ECB.

To me this suggests either that the ECB’s and Commission’s decision processes as regards the Maastricht criteria being met are deeply political – indeed a dirty game – or that a monumental mistake was made when Lithuania was blackballed and Estonia was pressured into postponing its application for EMU membership.

Forgiving failures to meet the exchange rate criterion

Italy and Finland did not meet the exchange rate criterion for EMU membership.[4] While they had spent 2 years in the exchange-rate mechanism of the European Monetary System when they joined the EMU, they had not observed the normal fluctuation margins provided for by the exchange-rate mechanism of the European Monetary System without severe tensions for at least two years before the examination - as was the requirement of the Treaty. The Commission judged that, by the time of the examination, the currency, despite not having been in the ERM for two years, had displayed sufficient stability for two years. This is a triumph of good sense over the letter of the law and the exact wording of the Treaty and Protocol. Why could this good sense not be called upon when the inflation criterion was being evaluated for Lithuania and Estonia?

Forgiving failures to meet the fiscal criteria

Both Italy and Belgium had debt-to-GDP ratios well above 100 percent when they were admitted to the EMU. While Belgium has consistently reduced its debt ratio since then, Italy’s debt-to-GDP ratio even today is above 100 percent. Allowing it into the EMU violated both the spirit and the letter of the Treaty and Protocol.

Germany did not meet the debt criterion for EMU membership at the time of the examination and should not have been admitted. In 1998 its debt-to-GDP ratio was 60.9 percent and in 1999 it was 61.2 percent. So it was above 60 percent and rising! Despite some attempts to get serious about its public debt, even in 2006 the German debt to GDP ratio still was 67.9 percent.

The most extreme example of a country not meeting the Maastricht fiscal criteria and yet becoming an EMU member is Greece. Greece did not, by any stretch of the imagination, meet the debt criterion for EMU membership. In addition, the Greek authorities fiddled the data for the calculation of the general government deficit. Until this cheating was discovered, it appeared Greece had met the deficit criterion (general government deficit less than 3 percent of GDP), as is clear from Table 2.3 below (Table 2.3 and Table 2.5, including the Table numbers, are taken from the Convergence Report 2000 of the ECB). The convergence programme for Greece when it was admitted to EMU is included as Table 2.5 below, as a reminder of just how out of touch with reality the ECB and European Commission were when they admitted Greece into the EMU.

When the statistical cheating was discovered and the deficit data were revised upwards, it was clear that both on the deficit and the debt criterion, Greece would have failed to qualify for EMU membership starting January 2001. The debt ratios remain above 100 percent of annual GDP even today.

Rather than suspending Greece’s membership in the EMU after the discovery of the irregularities in its qualification for admission, and requiring it to qualify again (which would have required at least a two-year transition period) Greece was allowed to continue as a full member without any sanctions. The integrity of the vetting process for the Maastricht criteria was further compromised through this. The message is clear: “do anything necessary to formally meet the criteria at the time”. Cheat if necessary. If you are found out after you are allowed in as a member, nothing will happen to you.”

Recently, the Greek government has discovered that there is a second way of lowering a ratio that is uncomfortably high: if reducing the numerator is not practicable, then increasing the denominator may be an option. Eurostat are currently reviewing the merits of the Greek statistical authorities’ request for a significant increase in measured GDP, reflecting, according to the Greek authorities, the informal sector and other unrecorded economic activity.

4. The problem: the inflation criterion for countries with a fixed exchange rate with the euro

Countries that have a fixed exchange rate with the euro face special problems meeting the inflation criterion for EMU membership. The inflation criterion makes no sense from an economic perspective for countries wishing to join an already existing monetary union when that monetary union has a price stability objective, operationally expressed as a target for inflation in the medium term. The first-best solution would be for all countries wishing to join the EMU and meeting the fiscal, interest rate and exchange rate criteria to be allowed to do so. This is the only solution that makes sense. However, politics and logic are not often encountered in the same space.

Candidate EMU members on a fixed exchange rate with the euro have to deal with the problem that their efficient, optimal rate of equilibrium inflation may well be higher than the existing EMU average. That is because of the Balassa-Samuelson effect. When transition countries with a lower level of productivity and per capita income than the existing EMU average succeed in converging gradually but effectively to the higher levels of productivity and per capita income of the EMU, productivity in the traded goods sectors typically catches up faster than productivity in the non-traded good sectors. The result is that transition countries achieving successful real convergence will experience an appreciation of their real exchange rates. With a fixed nominal exchange rate, real appreciation means higher inflation in the candidate EMU members than in the EMU.

What are the solutions?

One solution would be to abandon the fixed exchange rate regime (the currency board), float the currency and allow it to appreciate in nominal terms for at least a year to get inflation down to the benchmark level. Once that has been achieved, the exchange rate gets locked in irrevocably. I hope that not even the ECB and the Commission recommend such an extraordinary policy sequence. You have the closest thing to a common currency (a currency board); you have to abandon this currency board to float the exchange rate for a year or longer to meet the inflation criterion; if you succeed you get rewarded by going back to where you started from. This would be insane.

Another solution is to create a reduction in the output gap of sufficient depth and duration to bring down the inflation rate to the level of the inflation benchmark. Fiscal policy or credit controls could be used to reduce the domestic output gap and lower inflation. Unless the economy is overheating (that is, unless in addition to the Balassa-Samuelson inflation premium there is also a cyclical inflation premium), contracting demand would mean deliberately creating a recession: a pointless sacrifice of output and employment. It should be rejected.

5. A partial solution: make the euro joint legal tender with the national currency

One way for an EU member wishing to become a full EMU member to give visible expression to its desire for and commitment to eventual full EMU participation, is for it declare the euro to be joint legal tender for all transactions under the country’s jurisdiction, on the same terms as the national currency. This would also allow the country to achieve effectively all of the benefits of full monetary union, with the exception of (1) a share in the ECB’s seigniorage (profits), (2) access to the ECB/ESCB as lender of last resort, and (3) a seat on the ECB Governing Council (further development and discussion of this proposal can be found in Bratkowski and Rostowski (2002), Schoors (2002), Buiter and Grafe (2002), Buiter (2005) and Buiter and Sibert (2006a,b)).

Legal tender, also called forced tender, is payment that, by law, cannot be refused in settlement of a debt denominated in the same currency. Currently, in Estonia, only the Estonian kroon is legal tender. This is clear from the Currency Law of the Republic of Estonia, some key clauses of which are reproduced below in Box 1.[5] An important part of legal tender status is that taxes and fines payable to the state can be paid in legal tender, and that indeed the state can require this.

Box 1

Extracts from the Currency Law of the Republic of Estonia

Clause 3. Legal tender

The sole legal tender in the Republic of Estonia is Estonian kroon. The legal persons and single individuals located in the Republic of Estonia have no right to use any other legal tender except Estonian kroon in the accountancy between them.

Clause 4. Obligation to accept the legal tender of the Republic of Estonia without restrictions

Eesti Pank, as well as all other banks and credit institutions of the Republic of Estonia are obliged to accept the legal tender of the Republic of Estonia without restrictions. Other legal persons are obliged to accept valid coins up to the amount of 20 Estonian kroons at a time, but banknotes without any restrictions.

Clause 5. Exchangeability of Estonian kroon with other currencies

The exchangeability of Estonian kroon with other currencies will be determined by law. The conditions and procedure of exchanging Eesti kroon into foreign currencies will be determined by Eesti Pank.

Clause 71 Refusal to accept legal tender

(1) Refusal to accept legal tender upon sale of or payment for goods or services is punishable by a fine of up to 200 fine units.

(2) The same act, if committed by a legal person, is punishable by a fine of up to 30,000 kroons.

Box 1

Extracts from the Currency Law of the Republic of Estonia

Clause 3. Legal tender

The sole legal tender in the Republic of Estonia is Estonian kroon. The legal persons and single individuals located in the Republic of Estonia have no right to use any other legal tender except Estonian kroon in the accountancy between them.

Clause 4. Obligation to accept the legal tender of the Republic of Estonia without restrictions

Eesti Pank, as well as all other banks and credit institutions of the Republic of Estonia are obliged to accept the legal tender of the Republic of Estonia without restrictions. Other legal persons are obliged to accept valid coins up to the amount of 20 Estonian kroons at a time, but banknotes without any restrictions.

Clause 5. Exchangeability of Estonian kroon with other currencies

The exchangeability of Estonian kroon with other currencies will be determined by law. The conditions and procedure of exchanging Eesti kroon into foreign currencies will be determined by Eesti Pank.

Clause 71 Refusal to accept legal tender

(1) Refusal to accept legal tender upon sale of or payment for goods or services is punishable by a fine of up to 200 fine units.

(2) The same act, if committed by a legal person, is punishable by a fine of up to 30,000 kroons.

Legally, all that is required to make the Estonian Kroon and the euro joint legal tender in Estonia, is the rewriting the Currency Law of the Republic of Estonia along the lines suggested in Box 2.

Box 2

Proposal for a revised


Clause 1. Monetary unit

The monetary units of the Republic of Estonia are the Estonian kroon, which is divided into one hundred cents, and the euro, which is divided into one hundred cents. The cash of the Republic of Estonia is in circulation in the form of banknotes and coins.

Clause 2. Issuing Estonian kroon

The sole right to issue and to remove from circulation the Estonian kroon belongs to Eesti Pank. Eesti Pank determines the denominations of the banknotes and coins as well as their design.

Clause 3. Legal tender

The sole legal tender in the Republic of Estonia are the Estonian kroon and the euro. The legal persons and single individuals located in the Republic of Estonia have no right to use any other legal tender except the Estonian kroon or the euro in the accountancy between them.

Clause 4. Obligation to accept the legal tender of the Republic of Estonia without restrictions

Eesti Pank, as well as all other banks and credit institutions of the Republic of Estonia are obliged to accept the legal tender of the Republic of Estonia without restrictions. Other legal persons are obliged to accept valid coins up to the amount of 20 Estonian kroons at a time or up to the amount of 1.28 euros at a time, but banknotes without any restrictions.

Clause 5. Exchangeability of Estonian kroon with other currencies

The exchangeability of Estonian kroon with other currencies will be determined by law. The conditions and procedure of exchanging Eesti kroon into foreign currencies will be determined by Eesti Pank.

Clause 6. Damaged and spoilt currency

Damaged and spoilt banknotes and coins of the Republic of Estonia will be received and replaced by Eesti Pank and banks authorized by it, in condition that at least half of the banknote is preserved and the serial number is fully legible; on a coin, at least the denomination and time of minting must be legible.

Other legal persons are not obliged to accept damaged and spoilt banknotes and coins.

Clause 7 Refusal to accept legal tender

(1) Refusal to accept legal tender upon sale of or payment for goods or services is punishable by a fine of up to 200 fine units.

(2) The same act, if committed by a legal person, is punishable by a fine of up to 30,000 kroons or 1,917.35 euros.

(3) The provisions of the General Part of the Penal Code (RT I 2001, 61, 364) and of the Code of Misdemeanour Procedure (RT I 2002, 50, 313) apply to the misdemeanours provided for in this section.

(4) Extra-judicial proceedings concerning the misdemeanours provided for in this section shall be conducted by: 1) the Consumer Protection Board; 2) police prefecture.

In principle, a variety of monetary and exchange rate regimes are consistent with having the euro as a parallel currency and joint legal tender. This includes managed and freely floating exchange rate regimes. A fixed exchange rate regime with the euro, and especially a currency board is, however, the natural vehicle for the euro as joint legal tender. It is also a natural waiting room for the eventual full EMU membership.19

Some further refinements

The exchange rate of the Estonian kroon and the euro is 15.64664 Estonian krooni for one euro. That is not a very convenient number. It would make sense to have a currency reform that creates a new Estonian kroon (perhaps called the Estonian eurokroon, or eurokroon for short, whose value is 15.64664 old Estonian krooni. One new Estonian eurokroon would therefore equal one euro – nice and simple.

It would also make sense to make the coins and currency notes of the new Estonian eurokroon sufficiently similar in shape, weight and appearance (without, however, risking accusations of counterfeiting!) that all new vending machines and other electro-mechanical, digital and optical instruments that handle coins and notes can use both euros and eurokrooni interchangeably.

Formally, the exchange rate regime would remain a currency board. In the strict version of a currency board, the entire domestic base money stock (coin and currency and banks’ balances with the central bank) must be backed by international reserves (euros in practice). It would therefore make sense, since there is no opportunity cost involved in replacing domestic coin and currency with euros, to gradually reduce the issuance of krooni coin and currency. Effective complete euroisation of cash could take place without the formal abolition of the domestic currency. The eurokroon would continue to exist, as a numeraire, means of payment/medium of exchange, store of value and legal tender alongside the euro, but you just would not see very many of them.

By encouraging de facto euroisation, that is, the increased use of the euro as the unit of account in contracts (including financial contracts and instruments) and for pricing, as the medium of exchange/means of payment and as store of value, the risk associated with the status of being almost-but-not-quite in the EMU would be much reduced. Exchange rate risk (as regards the exchange rate of the domestic currency vis-à-vis the euro) would cease to be a concern as fewer and fewer contracts and financial instruments are denominated in domestic currency. To avoid giving ammunition to the forces of darkness in Brussels and Frankfurt, however, it is essential that establishing the euro as joint legal tender is not formally and legally the unilateral adoption of the euro as the only legal tender, and the abolition of the domestic currency.

6. The euro as joint legal tender is not unilateral euroisation and is consistent with the provisions and requirements of the Treaty and Protocol for full EMU membership

According to the letter of the Treaty, unilateral euroisation, is not compatible with the Maastricht criteria if it involves the unilateral abolition of the national currency. The argument is that, once the national currency has been abolished, there no longer is any way for the Council of Ministers to determine the irrevocably fixed conversion rate at which the candidate EMU member’s currency eventually joins EMU. The candidate EMU member would have been able to determine its irrevocably fixed euro conversion rate unilaterally. That would be a bridge too far. The ECB and the Commission will have to cross that bridge if and when Montenegro, which has the euro as its sole legal tender today, prior to EU membership, joins the EU and the EMU, but it is too early to speculate about how that conundrum will be resolved.

In addition to Montenegro, the euro plays a key role in the domestic monetary arrangements of a number of small European countries, none of which are formally members of the EU. The euro is legal tender in Monaco, San Marino and Vatican City, which are licensed to issue and use the euro. Like Montenegro, Andorra has the euro as legal tender but is not licensed to issue any euro coins or notes. The same holds for the sub-national entity Kosovo.

There are also some obvious parallels with the pre-Euro Belgium-Luxembourg Economic Union (1922-2002); from 1944, the Belgian franck was joint legal tender in Luxembourg with the Luxembourg franc, and the Luxembourg franc was joint legal tender in Belgium with the Belgian franc (although you would not have thought so, if you tried to pay with Luxembourg francs in Brussels!)

The ECB’s position on the issue is the following “Any unilateral adoption of the single currency by means of “euroisation” outside the Treaty framework would run counter to the economic reasoning underlying Economic and Monetary Union, which foresees the eventual adoption of the euro as the end-point of a structured convergence process within a multilateral framework. Unilateral “euroisation” cannot therefore be a way of circumventing the stages foreseen by the Treaty for the adoption of the euro” (European Central Bank (2003)).

This argument is correct only if unilateral euroisation means the unilateral abolition of the domestic currency and its replacement by the euro. Having the euro as a parallel currency and joint legal tender without abolishing the domestic currency, and leaving the Council of Ministers the opportunity to determined the eventual irrevocably fixed conversion rate between the domestic currency and the euro, is quite consistent with the Treaty and Protocol.[6] There is no circumventing of the stages foreseen by the Treaty for the adoption of the euro. The structured convergence process is not encumbered or undermined in any way.

7. What the euro as joint legal tender does not achieve

Adopting the euro as joint legal tender does not achieve three things:

  1. A seat on the Governing Council of the ECB;
  2. A share of the seigniorage (profits) of the ECB;
  3. Access to ECB/ESCB resources by domestic banks for lender of last resort operations.

These continuing lacunae are, of course, the same ones experienced by the would-be euro area members under their current currency board arrangements. They are ‘deficiencies’ only when compared to a situation of full membership in the EMU. Since there is no reason why adopting the euro as joint legal tender would delay full membership in the EMU, the opportunity cost of doing so is really zero.

8. Safety in numbers

The ECB and the European Commission are unlikely to welcome with open arms the adoption of the euro as joint legal tender. It is my view that there is not much they can do about it. Still, there is safety in numbers. If, say, all four currency board countries in the EU, Estonia, Latvia, Lithuania and Bulgaria, were to take the identical action simultaneously, the odds on even token attempts to interfere with this decision by Brussels or Frankfurt would be negligible.

I also believe that while the official response may be frosty, at best, there is a lot of sympathy for the Baltic countries and a lot of covert support for their ambition to adopt the euro as soon as possible. It is quite likely that the failure of Lithuania and Estonia to become full members in 2007 was just the result of a big error of judgement in Brussels.

I share the view of many observers that those in charge of the EMU convergence assessment in Brussels believed that Lithuania and Estonia would be willing to cheat to achieve membership. The candidate EMU members could have done this by fiddling with VAT or other indirect taxes and by messing with utility tariffs – that’s what Slovenia did, after all, and Slovenia was rewarded for it with EMU membership. They could even have followed the Greek example and simply have doctored the price data. Finally, the great and the good in Brussels and the national capitals probably did not believe it possible that the ECB would produce quite the eruption of self-righteousness and stupidity that it did by denying Lithuania EMU membership when its inflation rate exceeded the benchmark rate by barely one tenth of one percent. There may be a lot of sympathy in Brussels and in many of the EU capitals , and even some surreptitious support for the adoption of the euro as joint legal tender by the currency board countries of Central Europe and the Baltics.

The very creation of EMU was a triumph of political will over technocratic timidity. Distinguished economists (quite a few of them, like Martin Feldstein, from the USA) said it could never happen, and if it happened it would collapse in short order. Perhaps history will repeat itself. Ultimately it is the politicians in the Council of Ministers rather than the technocrats in Frankfurt and Brussels who determine whether a country will be allowed to join the EMU (the ECB and the Commission have only an advisory function). It is therefore possible that a country that starts of by adopting the euro as joint legal tender, may end up with full euroization, not through unilateral euroisation but through consensual euroisation with the blessing of the Council of Ministers. But it is time to press on with joint legal tender regardless.


The frightening financial turmoil of the past few months has provide a stark reminder of the truth that small open economies with unrestricted financial capital mobility have only one sensible monetary option: to join the nearest big currency area/monetary union. This is true not just in Europe. New Zealand is a model of monetary and fiscal rectitude and of deep structural reform. Yet it is a rudderless plaything of the international capital markets. It cannot control its exchange rate. It has to do incredible things to its monetary policy interest rate to keep any kind of control over domestic inflation. It is not surprising that monetary union with Australia is being talked about in responsible policy circles as an option.

For Estonia and the other currency board countries, the earliest possible full membership of EMU is the dominant policy option. To minimize the risk of monetary and financial instability in the period until full membership is achieved, adoption of the euro as joint legal tender is a sensible transitional option. It will not delay the EMU membership process, but it will make the transition less hazardous.

References Bratkowski, A. and Rostowski, J. (2002), ‘Why Unilateral Euroization Makes Sense for (some) Applicant Countries,’ in Beyond Transition eds. M. Dabrowski, J. Neneman and B. Slay, Ashgate

Buiter, Willem H. (2005) “To Purgatory and Beyond; When and how should the accession countries from Central and Eastern Europe become full members of the EMU?”. In Fritz Breuss and Eduard Hochreiter (eds.) Challenges for Central Banks in an Enlarged EMU, Springer Wien New York, pp. 145-186.

Buiter, Willem H. and Clemens Grafe (2002), “Anchor, Float or Abandon Ship: Exchange Rate Regimes for the Accession Countries”, in Banca Nazionale del Lavoro Quarterly Review, No. 221, June 2002, pp. 1-32.

Buiter, Willem H. and Anne C. Sibert (2006a), “Eurozone Entry of New EU Member States from Central Europe: Should They? Could They?”, in Development & Transition, UNDP-LSE Newsletter, 4, June, pp. 16 -19.

Buiter, Willem H. and Anne C. Sibert (2006b), “When Should the New Central European Members Join the Eurozone?”, Bankni vestnik – The Journal for Money and Banking of the Bank Association of Slovenia, Special Issue, Small Economies in the euro area: Issues, Challenges and Opportunities, 11/2006, pp. 5-11.

Égert, Balázs, Imed Drine, Kirsten Lommatzsch and Christophe Rault (2003), “The Balassa-

Samuelson Effect in Central and Eastern Europe: Myth or Reality? Journal of Comparative

Economics, vol 31, pp 552–572, in September, 2003.

European Commission (1998), “Convergence Report 1998”,

European Economy, No 65. 1998. Office for Official Publications of the EC. Luxembourg. 411pp. Tabl. Graph. Bibliogr.. CM-AR-98-001-EN-C; ISSN0379-0991.ISSN 0379-0991 http://ec.europa.eu/economy_finance/publications/european_economy


European Commission (2000), “Convergence Report 2000”,

European Economy, No 70. 2000. Office for Official Publications of the EC. Luxembourg. 393pp. Tabl. Graph. Bibliogr.) KC-AR-00-001-EN-C; ISBN 92-828-9708-7; ISSN0379-0991



European Commission (2002), 2002 Convergence Report on Sweden, http://ec.europa.eu/economy_finance/publications/


European Commission (2004), “Convergence Report 2004”, European Economy, Special Report 2/2004. Office for Official Publications of the EC. Luxembourg



European Commission (2006a), “2006 Convergence Report on Slovenia”, European Economy, Special Report. No. 2. 2006. Office for Official Publications of the EC. Luxembourg. 104pp. Tables, Graphs, Bibliog.) KC-AF-06-002-EN-C; ISBN 92-79-01218-5; ISSN 1684-033X.



European Commission (2006b), “2006 Convergence Report on Lithuania”, European Economy, Special Report. No. 2. 2006. Office for Official Publications of the EC. Luxembourg. 104pp. Tables, Graphs, Bibliog.) KC-AF-06-002-EN-C; ISBN 92-79-01218-5; ISSN 1684-033X.



European Commission (2006c) “2006 Convergence report”. European Economy No. 1. 2006. Office for Official Publications of the EC. Luxembourg. 184pp. Tables, Graphs, Bibliog., KC-AR-06-001-EN-C; ISBN 92-79-01202-9; ISSN 0379-0991., http://ec.europa.eu/economy_finance/publications/european_economy


European Commission (2007a), “2007 Convergence report on Malta”, European Economy,. No. 6/2007. Office for Official Publications of the EC. Luxembourg.



European Commission (2007b), “2007 Convergence report on Cyprus”, European Economy. No. 6/2007. Office for Official Publications of the EC. Luxembourg.)



European Central Bank (2000), Convergence Report 2000, May, Frankfurt am Main, ISBN 92-9181-061-4 http://www.ecb.int/pub/pdf/conrep/cr2000en.pdf

European Central Bank (2002), Convergence Report 2002, May, Frankfurt am Main, ISBN 92-9181-282-X, http://www.ecb.int/pub/pdf/conrep/cr2002en.pdf

European Central Bank (2004), Convergence Report 2004, May, Frankfurt am Main, November, ISSN 1725-9312 (print), ISSN 1725-9525 (online), http://www.ecb.int/pub/pdf/conrep/cr2004en.pdf

European Central Bank (2006a), Convergence Report May 2006, Frankfurt am Main, May, ISSN 1725-9312 (print), ISSN 1725-9525 (online)


European Central Bank (2006b), Convergence Report December 2006, Frankfurt am Main, December, ISSN 1725-9312 (print); ISSN 1725-9525 (online), http://www.ecb.int/pub/pdf/conrep/cr200612en.pdf

European Central Bank (2007), Convergence Report May 2007, Frankfurt am Main, May, ISSN 1725-9312 (print), ISSN 1725-9525 (online), http://www.ecb.int/pub/pdf/conrep/cr200705en.pdf

European Monetary Institute (1996), Progress towards convergence, November. Frankfurt am Main, ISBN 92-9166-011-6, http://www.ecb.int/pub/pdf/conrep/cr1996en.pdf

European Monetary Institute (1998), Convergence Report; Report required by Article 109 j of the Treaty establishing the European Community, March, Frankfurt am Main, ISBN 92-9166-057-4, http://www.ecb.int/pub/pdf/conrep/cr1998en.pdf

Schoors, Koen (2002), “Should the Central and Eastern European Accession Countries Adopt the Euro before or after Accession?” Economics of Planning, Springer, vol. 35(1), pages 47-77.

* © Willem H. Buiter 2007[1] Only Lithuania had its application for membership to start on January 1, 2007 officially rejected. Estonia had decided before the ECB and Commission made a formal, public recommendation, to withdraw its application for membership to start on January 1, 2007.[2] http://www.ecb.int/mopo/html/index.en.html

[3] http://www.ecb.int/mopo/intro/html/benefits.en.html

[4] Italy and Finland joined EMU at its start, on January 1, 1999, even though at the time the decision to admit these two countries was made, they had not yet spent two years in the ERM. This tension is clearly reflected in the language used in the Commission’s Convergence Report. “Although the lira has participated in the ERM only since November 1996, it has not experienced severe tensions during the review period and has thus, in the view of the Commission, displayed sufficient stability in the last two years.” (European Commission (1998, p24). This assessment was made, that is, the examination took place, in March 1998.

As regards Finland, the Commission writes as follows: “Finland has been a member of the ERM since October 1996; in the per iod from March 1996 to October 1996 the Finnish markka (FIM) appreciated vis-à-vis the ERM currencies; since it entered the ERM the FIM has not been subject to severe tensions and Finland has not devalued, on its own initiative, the FIM bilateral central rate against any other Member State’s currency;…” and “as regards the convergence criterion mentioned in the third indent of Article 109j(1), the currency of Finland, although having entered the ERM only in October 1996, has displayed sufficient stability in the last two years.” European Commission (1998, p. 20). In both the Italian and the Finnish case, the statement of the Commission clearly violates the requirement of the Treaty that the candidate country be a member of the ERM for at least two years before the examination.

[5] See Eesti Pank http://www.bankofestonia.info/pub/en/dokumendid/dokumendid/ oigusaktid/seadused/_4.html

[6] Note that it might be possible to respect the letter of the Treaty in this regard, while violating its spirit. Consider the case where the euro is made joint legal tender with the national currency, and the candidate EMU member’s own currency is not formally abolished and remains joint legal tender with the euro. The use of the local currency as a means of payment, numéraire and store of value could be discouraged in a variety of ways. In the limit, the last domestic banknote could lead a perfunctory existence, hanging framed on the wall of the office of the Governor of the central bank. The conversion rate ultimately decided by the EU Council of Ministers would be irrelevant if the local currency had de facto if not de jure become defunct.

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Joint blog by Willem H. Buiter and Anne C. Sibert

An earlier version of this blob appeard in the Financial Adviser, 27 September 2007, under the title: “Walking the line, not chalking it”.

A brief history of securitisation and off-balance sheet finance

Once upon a time banks dominated the financial landscape. They raised funds through deposits that could be withdrawn on demand on a first-come-first-served basis. Their assets consisted mainly of loans, both secured and unsecured, to businesses and households. Specialised mortgage lenders (called building societies in the UK) made long-term loans to homeowners secured against property. Northern Rock was one of these. It was a mutual society, not a public limited company. The home loans were non-marketable and therefore illiquid. Its other assets were typically safe and liquid government securities

With liquid liabilities and mostly illiquid assets, banks, including mortgage banks, were vulnerable to ‘runs’. If enough depositors believed their money was safe, they would all keep their money in the bank. If enough depositors believed that enough other depositors wanted to withdraw their money, there would be run and the bank would fail. When there was a run on a solvent, but illiquid, bank, the central bank, acting as lender of last resort (LOLR) stood ready to provide that bank with liquidity by lending to it freely, but at a penalty rate of interest and against collateral that would be good in normal times. The government provided or mandated deposit insurance, at some cost to the banks; government-imposed capital requirements forced banks to hold more capital than they liked. There were restrictions on what banks could do with their assets; serious reporting obligations and thorough independent audits were the rule.

Banks, however, did not like holding illiquid assets. Thus, in the 1970s securitisation was invented and pools of previously illiquid asset were sold to ‘off-balance-sheet’ special purpose vehicles (SPVs) that sliced and diced them, mixed them with other assets, enhanced them in various ways and issued tranched securities backed by the entire asset pool. We got ‘multi-layered securitisation’ as securitised assets themselves became the underlying assets for the next level of securitisation.

There are good aspects to this, pooling assets reduces risk and making non-traded assets tradable enhances opportunities for risk trading. But, securitisation destroys information: the orginator of the loan (often the party that continued to monitor the original mortgage borrower on behalf of the SPV) was now the agent rather than the principal in the investment relationship. Incentives for acquiring information and for monitoring inevitably decline when these activities are delegated. The information that was acquired ended up in the wrong place because it remained with the originators of the loans. By the time a conduit of a German Landesbank bought some tranche of the securitized home loans from a Paris-based hedge fund, neither the buyer nor the seller knew much about the risk associated with the underlying assets.

In came the rating agencies to solve this information problem. How they would acquire the information dispersed among myriad individual originators of the underlying loans was a question no one asked. Moreover, there were conflicts of interest as the rating agencies were paid by the issuers of the products they were rating. They often advised those whose structured investment products they would rate on how to engineer the product to obtain the best rating! The result was a ratings inflation for structured instruments. In the US, triple A silk purses were made out of the pigs ears of subprime-mortgage-backed securities. Regulators could not keep up and central bank warnings about excesses in credit markets were ignored.

Banks also did not like the restrictions, such as capital requirements and reporting obligations, that were the quid pro quo for access to the lender of last resort. Many of them (although not Northern Rock) outsourced their riskier activities to off-balance sheet vehicles and other less regulated or unregulated entities, including conduits or other structured investment vehicles (SIVs), hedge funds and private equity funds. The banks often remained exposed to these entities through credit lines or reputation considerations, but did not pay much attention to this. More information vanished; nobody knew any longer who owned what and who owed what and to whom.

Banks, including Northern Rock, disliked having to raise funds by attracting depositors and found capital markets to be an obvious alternative. Northern Rock de-mutualised and became a regular public limited company. Asset-backed securities (including covered bonds) and unsecured corporate loans permitted a faster expansion of business than the pedestrian process of attracting depositors.

The securitisation and disintermediation boom caused many market players to believe that risk had not only been repackaged, but that it had disappeared. After 2003, credit risk spreads of all kinds shrunk to miniscule proportions, assisted by unduly expansionary monetary policies in the US, Japan and the Eurozone. Low long-term real interest rates further boosted the leverage frenzy in the new financial sector.

Then it happened. In 2006 default rates on US subprime mortgages rose to levels inconsistent with the ratings of the securities they backed. By July 2007, many asset-backed securities markets were becoming illiquid, and de-securitisation was beginning. In August, interbank markets and asset-backed corporate paper markets began to seize up in the US, the Eurozone and the UK. The first victims were hedge funds (in the US and in France) and small banks in Germany that had been directly exposed to the US subprime and other risky mortgage markets. On September 13, Northern Rock had to seek emergency funding from the Bank of England, not because it had any significant exposure to the US subprime sector, but because it was unable to fund itself in the wholesale markets.

Although the bail out of Northern Rock was a joint decision of the UK Treasury, the Financial Services Authority and the Bank of England, these parties’ Memorandum of Understanding (MOU) makes it clear that ultimately the decision belonged to the Treasury: Ultimate responsibility for authorisation of support operations in exceptional circumstances rests with the Chancellor”. This makes sense, because ultimately the tax payer funds the losses when public resources are put at risk. The reputational damage of this debacle, however, affects mainly the Bank: it had to provide the line of credit within days of taking a strong public line against bail outs.

Northern Rock engaged in reckless borrowing. It could not survive without external assistance not because its assets were bad (its exposure to the US subprime market is tiny) but because it used a high-risk funding policy to finance its breakneck expansion, with three quarters of its funds coming from the wholesale markets rather than from depositors. It gambled and lost and it urgently needs a buyer with deeper pockets and a more sensible funding strategy.

Northern Rock’s bail-out cannot be justified on systemic financial stability grounds: as the UK’s fifth largest mortgage lender it is just too small to be a threat to financial and economic stability. A bail out should only be undertaken if there is, in the words of the MOU, “… a genuine threat to the stability of the financial system to avoid a serious disturbance in the UK economy.”

Ironically, the Liquidity Support Facility failed to restore confidence and a run on the deposits of Northern Rock developed. Calm was restored only when the Chancellor guaranteed in full all deposits of Northern Rock and of any other bank that might be granted recourse to a Liquidity Support Facility in the future. Instead of this socialisation of UK-wide depositor risk, it would have been preferable to take Northern Rock into public ownership. It could have resumed operations immediately in support of its existing commitments and could have been re-privatized at some later date.

Getting the monetary authority out of the Lender of Last Resort business and into the Market Maker of Last Resort business

We believe that the Bank’s understanding of the distinction between its Lender of Last Resort (LOLR) role for individual banks and its responsibility for providing broad liquidity support for financial markets, and specifically for the longer-term money markets (see e.g. the Governor’s Paper submitted to the Treasury Committee on12 September 2007), is flawed. The Bank should support key financial markets and other institutions such as the payments system and the clearing and settlement systems. The Bank should leave bailing out individual banks to the FSA, which has the institution-specific knowledge, and the Treasury, which can call on tax payers for funding. Ending the active role of the monetary authority as LOLR would require the FSA to have a credit line or overdraft facility with the Bank, guaranteed by the Treasury and would require a change in the MOU. The Bank would take no part in the decision as to whether some bank should be bailed out, and the Bank’s role in funding any bail-out decided by the Treasury and the FSA would be entirely passive.

Bank intervention in longer-term money markets

The Bank has made a mistake in its unwillingness to intervene at longer maturities than the overnight market. The Bank’s own primary money market objective is for “Overnight market interest rates to be in line with the official Bank Rate, so that there is a flat money market yield curve, consistent with the official Bank Rate, out to the next MPC decision date ….”. This means that, following the last MPC meeting on 6th September 2007, when there was a month to go till the next scheduled MPC meeting, the one-month interbank rate on unsecured lending (LIBOR) should have been close to the Bank’s policy rate of 5.75%. In fact it was only just below the three-month LIBOR rate of 6.68% (see Chart 1).

There are four explanations for the sizable spread of three-month LIBOR over the Bank Rate. The first is an expectation that the Bank Rate will rise over the next three months, but this highly unlikely. Second, there could be a pure term premium, but this must be tiny over such a short horizon. Third, there is a risk that borrowers will default. This is clearly not zero, but it is difficult to believe that there is a one percent probability that a typical UK money centre bank will default with a zero recovery rate during the next three months. Finally, there is a liquidity risk and we attribute the lion’s share of the recent spread of three-month LIBOR over Bank Rate to liquidity factors.

Currently liquid banks may be reluctant to make three month loans, not because they are afraid that their borrowers will be insolvent in three months, but because they are afraid that both they and their borrowers will be illiquid in three months. If enough banks have these fears, an interbank ‘lending strike’ results.

Banks everywhere are gearing up to take on their balance sheets the illiquid assets of conduits, other SIVs and other off-balance sheet SPVs that they are exposed to through credit lines or reputational considerations. Fear of future illiquidity is widespread and banks are hoarding excess liquidity rather than lending it out in the interbank market, even at nearly seven percent. The Bank could address this unfortunate situation by injecting liquidity, through repos with, say, a three-month maturity to eliminate the liquidity premium. Such repos are likely to be more effective if they are against a wider range of eligible collateral that what the Bank currently accepts, including illiquid assets.

It is true that the ECB’s massive injections of three-month have not prevented significant spreads (albeit lower than in the UK) of Euribor over the policy rate in the Eurozone (see Chart 2). But, in the United States, the spread on three-month LIBOR has fallen to less than 50 basis points since the Fed lowered its discount rate by 50 basis points on 17 Aug 2007, in addition to more modest open market and discount window operations (see Chart 3). However, what is most important is not the spread, but the amount of lending taking place. In the UK 3-month LIBOR has become the rate at which banks will not lend to each other.

The Bank as Market Maker of Last Resort

We have proposed (Willem H. Buiter and Anne C. Sibert “Three Steps to Calm the Storm”, Financial Times Comment, 5 Sept 2007) that the Bank should accept a wider range of collateral, including lower-rated illiquid private assets, as long as it is punitively priced, and subject to a suitable ‘haircut’ (discount) as well. The Bank should ‘make market’ for such illiquid securities, by holding auctions in which it purchases these securities; it should then hold them on its books, taking the credit risk, until they can be sold off again under more orderly market conditions, preferably at a profit for the tax payer. To encourage participation by investors who do not want to mark-to-market their securities, the Bank and FSA could require that all similar securities not priced at the auction be marked-to-market at the price established in the auction.

There would probably have been no need for a bail-out of Northern Rock if the Bank of England had had a sensible collateral policy for its regular open market operations. Unlike the ECB and the Fed, the Bank only accepts European Economic Area sovereign debt instruments, high quality debt issued by a few international organisations and, exceptionally, US Treasury debt. More sensibly, the ECB also accepts private securities rated at least A-, including asset-backed securities. If Northern Rock had a Eurozone subsidiary, it could have funded itself through the eurozone three-month repos conducted by the ECB last week, using its high-grade mortgages (or securities backed by them) as collateral. The Fed can, in an emergency, accept anything it deems appropriate as collateral at its discount window, not only from banks, but from individuals, corporations and non-bank financial institutions as well.

On September 19, the Bank suddenly had a double change of heart: it announced it would initiate repurchase operations at 3-month maturity and would accept as collateral private assets, including mortgages.


We know that the Chancellor authorised the Bank to “provide a liquidity support facility to Northern Rock against appropriate collateral and at an interest rate premium.” But, this is not sufficient information. Is the support uncapped and open-ended, as Northern Rock informs us? What is the premium charged for the use of the facility? What is the arrangement fee for the facility? Exactly what collateral will be offered, how will it be valued and what ‘haircut’ will it be subject to? The public are funding this risky venture and they are entitled to know. There is no commercial confidentiality argument for keeping any of this information secret. The accountability of the Bank and the Treasury are at stake. The Chancellor should provide this information forthwith, and if he does not, Parliament should insist.


The Chancellor, and possibly also the FSA and the Bank, do not want even a systemically insignificant mortgage lender to fail on their watch, regardless of the moral hazard created by the bail-out. The Chancellor is willing to risk tax payer money to prevent it. The Bank, however, should not be directly involved in the decision making; nor should it play an active role in the funding of the liquidity support facility. Depositor protection is the job of the FSA and the Financial Services Compensation Scheme. Redistribution of income belongs to the Treasury. If the Bank remains an active participant in an inherently political bailout process for individual banks, the Bank’s independence in the realm of monetary policy could be compromised.

Charts Source: Bank of England

Source: European Central Bank

Source: Federal Reserve Board

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A pdf file of a Powerpoint presentation titled “What should the authorities have done?”, prepared for The London Financial Regulation Seminar, ‘The Financial Crisis Conference’ on October 1, 2007 at the London School of Economics, can be found here.

The mess surrounding the rescue operation for Northern Rock demonstrated that the UK’s Tripartite arrangement for handling financial crises is not working properly.

There are three distinct sets of problems. First, the UK deposit insurance scheme is both limited in the degree to which it guarantees retail deposits and too slow in paying out on any claims submitted under the scheme. Second, the division of labour among the Treasury, the Bank of England and the Financial Services Authority, as expressed in the Memorandum of Understanding, was disfunctional, mainly because it separated the agency in possession of the relevant information from the financial resources to act effectively upon that information. Third, the Bank of England’s liquidity-oriented open market operations through repos, and its discount window are flawed in three ways: first, the eligible collateral is too restricted; second, the maturity of the operations (loans) is too short; and, third, the list of eligible counterparties is too restricted.

Specifically, five issues can be raised about the current set of arrangements:

(1) The UK deposit insurance arrangements did not work properly.

(2) The lender of last resort (LOLR) mechanism for dealing with individual financial institutions in distress did not work properly.

(3) The Bank of England’s Standing Lending Facility (its discount window) did not work properly.

(4) The Bank of England’s liquidity-enhancing open market operations did not work properly.

(5) The financial stability mess, and the Bank’s about face as regards the collateral requirements and the maturity of its liquidity-enhancing open market operations have created confusion about exactly what it is the Monetary Policy Committee decides on when it sets the official policy rate, or Bank Rate.

All these points will be considered in what follows.

Deposit insurance This needs to be overhauled to provide guaranteed 100 percent cover up to, say, £50,000.00 per person per institution. This would correspond to the level of coverage currently in effect in the USA ($100,000). The £100,000.00 figure that has been bandied about seems excessive. The same person could have accounts in different institutions. Provided these institutions are indeed separate legal entities, the same person could have £50,000.00 insurance cover in each one of number of separate banks.

The insurance should be for retail accounts only. Wholesale deposits would not be covered. A simple rule could be that only deposits owned by natural persons would be covered. Deposits of entities with legal but not natural personality (partnerships, charities, companies etc.) would not be covered.

Apparently, the Chancellor’s deposit guarantee for Northern Rock covers not only all deposits (retail and wholesale), but most other unsecured creditors of Northern Rock as well. Only holders of subordinated debt appear not to be covered. This degree of coverage is ludicrously excessive. Such ex-post insurance and socialisation of investment risk by municipalities, charities and other institutions who were chasing the above-market rates offered by Northern Rock is without justification on equity, efficiency or systemic stability grounds. For these non-widows and non-orphans, the lesson that above-market returns often represent risk premia, and that risk has the unpleasant habit of materialising from time to time, would have been a highly salutary one.

The deposit guarantee scheme should be able to pay out on claims effectively instantaneously, and certainly no longer than 2 working days after a claim has been submitted. The current situation where a bank that goes into administration has its deposits frozen, clearly has to be addressed with legislation.

Deposit insurance, or any form of consumer protection, should not be the responsibility of the monetary authority. The FSA would be a natural body for administering it. The scheme should be self-financing, through levies on the deposit-taking industry. Should there be widespread insolvency in the banking sector, the financial resources to meet the deposit insurance guarantee might exceed the combined resources of the deposit-taking institutions. For such system-wide calamities, a fiscal back-stop would be required. One easy way to do this is to give the deposit insurance agency an overdraft facility with the central bank (the Bank of England), guaranteed by the Treasury.

Liquidity provision

The UK’s arrangements for dealing with illiquid institutions and illiquid markets are a shambles.

Open market operations The Bank has to extend its recently announced policy of providing liquidity to the markets at maturities longer than overnight and against a wider range of collateral. It should effectively adopt the policies of the ECB and the Eurosystem, which accepts as collateral in repos (overnight and at longer maturities), private instruments, including illiquid and non-marketable instruments, as long as they are rated at least in the A category. Clearly, intervening in the markets at the same time in different maturities makes no sense when markets are orderly; when markets are disorderly, however, there may be extraordinary liquidity premia at different maturities (on top of the regular term premia, conventional market risk or default risk premia and expectations of future changes in the policy rate) that can be influenced both by repos at varying maturities and by outright purchases of securities with differing remaining maturities. Such open market purchases or outright purchases should not be at penalty rates. This would blur the distinction between open market operations and discount window operations. The Bank of England’s 3 month repos against illiquid collateral (mortgages and mortgage-backed securities) (the first of which did not attract any takers) was therefore in my view a mistake.

The discount window

For illiquid but solvent institutions, the discount window at the Bank of England (its Standing Lending Facility) has to be the port of call. As currently constituted, the Bank’s Standing Lending Facility is useless: its list of eligible collateral is too restrictive – all it does is trade longer-maturity liquid assets for instantaneous liquidity; it only lends overnight; and it only lends to banks. This discount window should be modified in three ways.

(1) The Bank should create a wider range of eligible collateral. The Bank of England should accept as collateral at its discount window (Standing Lending Facility) private securities, including illiquid and non-marketable private securities. Their market price or fair value would be subject to a ‘haircut’ that would be larger to the more illiquid the collateral that is offered. Where no market price is available, the Bank should ‘make market’ for the illiquid securities, by holding auctions in which it purchases these securities; it should then hold them on its books, taking the credit risk, until they can be sold off again under more orderly market conditions, preferably at a profit for the tax payer. To encourage participation by investors who do not want to mark-to-market their securities, the Bank and FSA could require that all similar securities not priced at the auction be marked-to-market at the price established in the auction.

(2) The Standing lending Facility should offer longer maturity loans than overnight. The Fed already offers up to 1 month maturity loans. I see no reason why both 1 month and 3 month collateralised loans could not be offered at the discount window. The penalty rate (current 100 basis points for overnight loans) could be made to increase with the maturity of the loan, say 150 basis points for 1 month maturity and 200 basis points for 3 month maturity. The Fed’s decision to cut the penalty premium of the discount rate over the policy rate from 100 basis points to 50 basis points was a big mistake – pandering to the profits of those banks willing and able to borrow at the discount window.

(3) There should be a wider range of eligible counterparties. In the UK the Standing Lending Facility of open only to a limited number of banks and other deposit-taking institutions. I would favour widening this to all financial institutions that are subject to and meet the demands of, a regulatory and supervisory regime approved by the Bank. This could include investment banks, hedge funds and private equity funds. The Fed can do much more than that, and can, in principle, open its discount window to individuals, partnerships and corporations (financial and non-financial).

With (1), (2) and (3) in place, it is clear that the Standing Lending Facility, which is open to all eligible institutions on demand, and for any amount of funding for which they can provide eligible collateral, is not so much part of the traditional lender of last resort arsenal, which is targeted at specific institutions that are in trouble, but instead is a form of market support, specifically support for markets trading normally liquid securities that have become illiquid.

The Lender of Last Resort

Institutions that are insolvent as well as illiquid should not be bailed out unless they are deemed to be systemically important. It is hard to think of any bank in the UK that would be systemically signficant, once adequate deposit insurance removes the risk of bank runs. Bail-outs should therefore be for two kinds of institutions: those that are illiquid and about whose solvency there is some uncertainty and those that are insolvent and systemically important.

The decision on whether to bail out the institution should be made by the regulator (the FSA), which has the institution-specific knowledge and information, and the Treasury, which has the resources. The Bank of England’s input will not doubt be required, as it is the systemic significance of an individual institution or set of institutions that is at stake, and the primary responsibility for and understanding of systemic risk is presumably found in the Bank.

Should the Standing Committee on Financial Stability (chaired by the Treasury, with representatives of the Treasury, the Bank and the FSA) decide that a specific institution needs to be bailed out, there are a number of options.

For a bank that is illiquid and perhaps insolvent, the kind of dedicated lending facility created for Northern Rock would be appropriate. It wouldn’t be named a “liquidity support facility”, since more than an injection of liquidity may be required. It is clear that such a LORL facility targeted at an individual institution should not be initiated or managed by the Bank. The Bank does not have the information about individual institutions. It should not be asked to take decisions about individual institutions. Nor should it be required to put its resources at risk.

The institution that should decide who gets a LOLR facility has to be the regulator and supervisor, that is, the FSA, because only the FSA has the necessary information. It does not, however, at the moment have the financial resources to act as LOLR. It should therefore be given the resources to fulfil the LOLR function. These resources can only come from the Treasury. Operationally, this could be done conveniently through a credit line or overdraft facility of the FSA with the Bank (uncapped and open-ended), guaranteed by the Treasury. The Bank’s role in the LOLR function vis-à-vis individual banks is therefore entirely passive. The decision is made by the FSA and the Treasury and the funds are provided through the FSA by the Treasury. There would be a presumption that the existing management of a bank in need of an LOLR facility would be fired, sans golden parachute.

Insolvency and public ownership

The facility would be operated until it is clear to the FSA whether the troubled bank is insolvent or not. If it is solvent, it is weaned off the facility. If it is deemed to be insolvent and systemically insignificant, it goes into the normal (hopefully revised) insolvency procedures for banks. If it is insolvent and deemed to be systemically important, it is taken into public ownership, rather like Railtrack was. Once in public ownership, the bank could continue to operate and meet its existing commitments.

The nationalisation would be temporary. Once orderly conditions have been restored and the value of the bank’s assets and liabilities has been established, the bank can be privatised again as a going concern, sold off in toto to its competitors or liquidated, broken up and sold in parts. The incumbent management would presumably lose their jobs as soon as the bank was taken into public ownership, if they had not already lost it while the bank was using the LOLR facility (if it went through the LOLR process earlier on, because its insolvency was then not yet obvious). After compensating itself for the cost of the LOLR facility, the FSA would pay the creditors of the bank, including those depositors who were not covered by the deposit insurance scheme. The original shareholders of the bank would be last in line and would, if the bank was indeed insolvent, receive nothing.

The schematic below shows how illiquid institutions would be dealt with in a new, improved Tripartite Arrangement. OMOs + and Discount Window + stand for the augmented open market operations and discount window operations I advocated earlier (wider set of eligible collateral, longer maturities, wider set of eligible counterparties at the discount window and in OMOs.)

The overdraft facility or credit line with the Bank of England, guaranteed by the Treasury, which the FSA would have, could serve both to finance its LOLR activities and its deposit insurance activities, were these to exceed the financing capacity of the banking system.

What does the MPC set when it sets Bank Rate?

The monetary policy committee of the Bank of England sets Bank Rate. What is Bank Rate? Under the current set of arrangements for implementing monetary policy, the Official Policy Rate, or Bank Rate, is the target rate for the overnight sterling interbank rate (also called the sterling money market rate). This target is pursued through the sale and purchase of ‘repurchase agreements’ (repos and reverse repos). To the layman these are collateralised loans.

You will be forgiven for wondering why, if the MPC sets the target rate for the overnight rate, the actual overnight rate in the interbank market can ever differ from that rate. Basically, there are two reasons for any discrepancy between Bank Rate and the overnight interbank rate. The first is that the Bank does not rigorously fix the repo rate every minute of very day. They could do this. They could simply stand ready to repo or reverse repo at any time any amount the private sector wants to throw at them. They don’t do that. Instead they inject a certain amount of repos or reverse repos into the market – and amount they expect will meet the normal market demand, and wait to see what happens. Why they do this, I do not know. I think it would be helpful if they simply pegged the repo rate by standing ready to buy or sell in any amount at that rate.

The second reason why the actual overnight interbank rate can differ from Bank rate, is that the overnight repo rate can differ from the overnight interbank rate. This is simply because the overnight interbank rate is a rate on unsecured lending, why the repo rate is a rate on a collateralised, secured loan. When the Bank of England expands liquidity through a repo, the loan to the private sector is almost free of default risk. Both the borrowing bank and the issuer of the collateral would have to default for the Bank to be exposed to counterparty risk through the repo. When a bank lends to another bank overnight in the interbank market, there always is a small probability that the borrowing bank will fail overnight.

Once there is counterparty risk, illiquidity risk becomes a possibility. So there can be a gap between the overnight repo rate and the overnight interbank rate because of market perceptions of default risk and illiquidity risk.

It would clarify the division of labour between the Bank of England’s Monetary Policy Committee and those in the Bank of England responsible for market operations and financial stability, if the Bank were to give the highest priority to its task as agent for the MPC, by keeping the overnight interbank rate as close as possible to Bank Rate. I would start by pegging the overnight repo rate, undertaking repos or reverse repos in any amount required to keep the market repo rate equal to Bank Rate throughout the maintenance period. Market perceptions of overnight default risk is, of course, not something the Bank of England should try to do anything about. Overnight illiquidity can, however, be addressed, by injecting additional liquidity into the repo market, over and above what is required to keep the overnight repo rate at the level of Bank Rate, up to the point that the overnight interbank rate, minus the market’s counterparty risk premium, is at the level of Bank Rate. It is possible that this requires the overnight repo rate to be below Bank Rate. So be it.

The Bank’s operations in the money markets at maturities longer than overnight, and the Bank’s Standing Lending Facility operations are not part of the remit of the MPC.

The merits of an argument or the truth of a proposition are independent of the motives and the moral character of the person making the argument or advancing the proposition. Still there are times when I go back to the intellectual drawing board for further scrutiny of fact and logic simply because of the source of the support or opposition that I encounter when I advance a particular argument. The most telling example was a comment on a blog on racism and freedom of speech I received from a KKK member in the US, who wrote he quite agreed with me on freedom of speech, but took a line different from me on racism. Another example was the letter I received in response to a blog by Anne Sibert and myself on the National Health Service , first published in the Daily Telegraph – arguing for its abolition and replacement by a continental European-style comprehensive and mandatory insurance mechanism. The author informed me that we made “…no mention that the NHS has been weakened and weighed down by the enormous number of immigrants entering this country since its formation,…”. Perhaps I should have sent him the following answer: I know exactly what you are talking about. Immigrants – they’re everywhere. I even got four of them living in my own home: my son (from Peru), my daughter (from Bolivia), my wife (from the USA) and myself (from the Netherlands). Sometimes being judged by the uninvited company you keep can be rather embarrassing. Still, just because Hitler, Stalin, Mao and Pol Pot probably would have agreed with me, most of the time, that two plus two equal four, is no reason for abandoning that bit of arithmetic. So we hold our noses and proceed.

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An earlier version of this blog appeared as a comment on Larry Summers’ contribution to Martin Wolf’s Economists’ Forum, “Beware the moral hazard fundamentalists”,

Larry Summers’ contribution contains a nugget of sense about liquidity, but this is buried deep under several layers of dross about moral hazard – a term I consider unhelpful. Its use encourages getting sidetracked into a didactic, essentialist argument about whether the bail-outs and other official financial support operations under discussion are indeed creating moral hazard in the strict insurance-technical sense of the word. What we should be talking about is bad incentives producing bad – inefficient and inequitable – outcomes.

Providing liquidity to support markets

Liquidity is a key property of assets. It refers to the ability to sell the asset at short notice and at low transaction cost at a price close to its fundamental or fair value (fundamental or fair value is what you would pay for the asset if it could be bought and sold instantaneously and at zero transaction cost, that is, if ownership could be transferred costlessly and instantaneously). Liquidity is distinct from maturity or duration. Securities can have long remaining maturities or duration, yet be highly liquid because of the existence of deep, well-functioning secondary markets. Market liquidity is about trust and confidence. When normally liquid markets dry up, only the central bank can provide the public good of trust that restores liquidity swiftly and at little or no private or social cost. So it should be done.

More formally, correcting or mitigating market failure need not distort private incentives; injecting liquidity into a market that has become illiquid need not create moral hazard by distort private incentives for appropriate risk management in the future. Markets, that is, mechanisms for matching willing buyers and sellers at a price acceptable to both, are, in the case of assets like securities (or any store of value that can be resold in the future), subject to an inherent network externality: the likelihood of my being willing to buy a security at a price close to its fundamental or fair value is a an increasing function of the likelihood I attach to my being able to find a willing buyer for that security in the future at a price close to its future fundamental or fair value. When I believe that (1) I may have to sell the security in the future (possibly unexpectedly) and that (2) the future probability of finding a buyer is high, I am likely to buy now. If there are a lot of market participants with similar beliefs, the market today will be liquid. If there are a lot of market participants today with pessimistic beliefs about finding a future buyer at a price close to future fair value, the market today will be illiquid. Such a market will have at least two kinds of equilibria. One has self-fulfilling optimistic beliefs about future liquidity. Such a market will be liquid today. The other has self-fulfilling pessimistic ideas about future liquidity. Such a market will be illiquid today.

When the bad (illiquid) equilibrium prevails, one way to move to the good (liquid) equilibrium is for an agency whose liabilities have unquestioned perfect liquidity to inject liquidity into that market. In doing so it supports the market for the illiquid security. It does not bail out individual private businesses, that is, it does not act as a Lender of Last Resort (LOLR). The action will help the private businesses that hold the illiquid securities, but this assistance efficient: it corrects a distortion. The intervention renders liquid those securities that, because of fundamentally arbitrary albeit self-fulfilling beliefs, have become illiquid. The agency acts as a Market Maker of Last Resort (MMLR). The central bank is the natural agency to ‘liquidify’ (or should that be ‘liquefy’?) normally liquid markets that have become illiquid. That is because it is the source of ultimate, unquestioned, costless and instantaneous liquidity – the monetary liabilities of the central bank: commercial bank reserves with the central bank and currency.

Unlike the Fed and the ECB, the Bank of England does not appear to understand the nature of market liquidity and what could cause it to disappear and reappear. Instead of thinking of liquidity as a public good, it thinks of it as a private good that should be managed by individual financial institutions the same way they manage default risk or price risk.

Indeed, liquidity can be managed privately. Commercial banks could hold as assets only things that are highly liquid, like reserves with the central bank and government securities for which the secondary markets are normally deep and orderly (Treasury bills, gilts etc.). This would eliminate liquidity risk. However, such highly liquid asset portfolios would be socially inefficient (as well as unprofitable). We want our intermediaries to intermediate in support of long-term commitments by households and non-financial corporations. Some of the most productive assets are inherently illiquid. Someone has to hold them. If it can only be the originator of the illiquid asset (say a private entrepreneur investing in plant and equipment) the productive efficiency of the economy would be gravely impaired. Confidence that when some key financial market becomes illiquid, the central bank will support that market, by acting as MMLR (or buyer of last resort), is essential if our economy is to optimise its ability to generate productive but illiquid assets.

The Bank of England, until it changed its mind last week and decided to intervene in the 3-month repo market against illiquid collateral (mortgages), appeared to believe that any market operations by the Bank at longer than zero maturity (overnight), represented a bail-out of all potential or would-be sellers of the illiquid collateral. That is a nonsense. It may be that some banks and other financial institutions indeed had too few liquid assets on their books, even for orderly market conditions. In that case, charging a premium over the Bank’s marginal cost of funds (Bank Rate) on the Bank’s lending in the 3-month repo market makes sense. The Bank has decided to do so, setting the rate it charges for access to the Standing Lending Facility (the Bank’s discount window, 100 basis points above Bank Rate) as the floor for the rate it will charge on its 3-month repos. It should also value the illiquid collateral according to its fair value rather than its face value, and impose other constraints to safeguard the interests of the tax payer. Finally, it should impose an appropriate haircut (discount) on the (conservatively estimated) fair value of the collateral. If all that is done, market liquidity support (overnight or at a 1, 3, 6, 12 or 24 month horizon) is not a reward for past reckless lending or borrowing. It is correcting a distortion – mitigating market failure.

Bailing out undeserving private financial businesses

Larry’s rather blanket support for bailing out distressed financial businesses (as distinct from supporting markets) is quite unconvincing. Arguments by analogy are cute but prove nothing. No, smoking in bed is not an argument against have a fire department. It is, however, an argument for having a clause in the homeowners’ insurance contract stating that no valid claim exists if the house burns down because one of the occupants was smoking in bed.

Contagion (in the sense of irrational herd behaviour) is as frequently mentioned (and modelled in neat academic papers) as it is uncommon in practice. When many private institutions or many countries are being dragged down by a common tidal wave, it tends to be because they have the same flawed fundamentals, not because of contagion. Contagion is an argument for deposit insurance, if the contagion takes the form of panicky depositors. It takes the form of market support (MMLR) action rather than support for individual financial businesses (LOLR) action if the contagion affects the liquidity of the markets for other financial instruments. State entities, including the central bank, the deposit insurance agency and the Treasury should support markets and other social mechanisms with clear public good properties, like the payment, settlement and clearing systems. Individual private businesses should be directly supported only if this is necessary for the safeguarding of some socially valuable ‘institution’ (in the proper sense of the word institution, as opposed to its use in financial ‘institution’, where it simply means ‘business’).

I cannot think of a single financial institution that is too big to fail, in the sense that it would damage some systemically important social institution. If deposit insurance is deemed important, whether because deposits are deemed an important part of the payment mechanism or because of distributional, social or political concerns, let’s guarantee deposits, but allow the institutions issuing them to fail. In the UK, Northern Rock was both granted an uncapped and open-ended Liquidity Support Facility (credit line) with the Bank of England and an unlimited guarantee for its existing depositors (and most other unsecured creditors, except for the holders of subordinated debt!). You might be able to make a case for either one of these support interventions, but not for both.

To hold out the disgraceful bail-out of LTCM as an example of how to act in a crisis is extraordinary. Indeed no public money was involved. But the Fed (through the Federal Reserve of New York) put is reputation at risk, and in my view damaged it severely, by enabling and facilitating this shoddy arrangement – offering its ‘good offices’.

As a result of the bail-out of LTCM, there was never any serious effort to address the potential conflicts of interest arising from simultaneously financing hedge funds, investing in them, and making money executing trades for them, as many investment banks did with Long-Term Capital. The results are there today for all to see. Things were even worse because apart from the inherent potential conflict of interest that is present whenever a party is both a shareholder in and a creditor to a business, the bail-out created a serious corporate governance problem because executives of one of the financial institutions that funded the bail out had themselves invested $22 mln in LTCM on their personal accounts. Using shareholder resources for a bail-out of a company to which you have personal exposure is unethical, even where it is legal.

To crown it all, the founders of LTCM were allowed to retain some equity in the firm, supposedly because only they could comprehend, work out and unwind the immensely complex structures on its balance sheet. These were the same people whose ignorance and hubris got LTCM into trouble in the first place. Any handful of ABD graduate students from a top business school or financial economics programme could have unravelled the mysteries of the LTCM balance sheet in a couple of afternoons. This was the market establishment looking after its own. The bail-out of LTCM smacks of crony capitalism of the worst kind. The involvement of the Fed smacks of regulatory capture.

It is clear from Larry’s record at the World Bank (1991-1993) and at the US Treasury (from 1993 till 1995 as Under Secretary of the Treasury for International Affairs, from 1995 till 1999 as Deputy Secretary of the Treasury and from 1999 till 2001 as Secretary of the Treasury), that he has never seen a potential bail out he did not like: the United States support program for Mexico in the wake of its 1994-1995 financial crisis, the international response to the Asian financial crisis of 1997 and the 1998 Russian crisis and the Fed’s response to the 1998 LTCM crisis. I recognise the upside of bail-outs for those who arrange them: they look like movers and shakers, making and shaping events. It’s heroic, in an industry where heroism can be rarely displayed. But in all of the examples mentioned above, the bail-out did more harm than good.

Finally, Larry needs to add at least two other questions to his list of three ((1) Are there substantial contagion effects?; (2) is there a liquidity or a solvency problem?; (3) will there be costs to the tax payer?) central banks ought to ask themselves during financial crises. These are:

(4) Will this action (Lender of Last Resort bail-out of individual private financial businesses, Market Maker of Last Resort liquidity injections into the markets) have a material impact on the likelihood and severity of future financial crises?”

(5) Will this action produce any net social benefit?

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Central bankers should not engage in a public war of words with heads of state, heads of government and ministers of finance or the economy. It is a conflict that has no winners, only losers. And the main loser is the ability of the central bank to pursue a policy of flexibility with commitment and credibility. It is especially important that operationally independent central banks not be drawn into a public political slanging match.

Jean-Claude Trichet has failed this test. In an hour-long interview on TV5-Europe1, he laid into the policies of the French government, specifically the high levels of public spending and France’s inability to contain production costs. Such topics are indeed fair game for domestic or foreign political opponents of Nicolas Sarkozy and his government. Mr. Trichet was no doubt provoked by Sarkozy’s incessant banging on about the failure of the ECB to take steps to engineer a weaker external value of the euro, preferably by taking a leaf from Ben Bernanke’s book and cutting interest rates by at least 50 basis points. But the fact that Mr. Sarkozy (not for the first time) ran roughshod over Article 107 of the Maastricht Treaty and Article 7 of the ESCB Statute, does not mean that Mr. Trichet has the right to shout the moral equivalent of “and so’s your sister” at the French head of state. These Articles guarantee the independence of the ECB, the national central banks, and the members of their decision-making bodies in exercising their powers and carrying out their duties. They are not allowed to seek or take instructions from the government of any member state, any organization of the European Community, or any other body. These governments, institutions, and bodies are indeed obliged to refrain from trying to influence the ECB or the national central banks in the performance of their tasks.

It is a mistake for central bankers to express, in their official capacities, views on what they consider to be necessary or desirable fiscal and structural reforms. Examples are social security reform and the minimum wage, subjects on which Alan Greenspan liked to pontificate when he was Chairman of the Board of Governors of the Federal Reserve System. Ben Bernanke has spoken out on free trade, globalisation and inequality and teenage pregnancy. Even when I agree with him, I wish he would stick to his monetary policy brief and his banking supervision and regulation brief, rather than becoming a participant in partisan political debates that have nothing to do with the central bank’s mandate.

It is not the job of any central banker to lecture, in an official capacity, the president, the prime minister of the minister of finance on fiscal sustainability and budgetary restraint, or to hector the minister of the economy on the need for structural reform of factor markets, product markets and financial markets. This is not part of the mandate of central banks and it is not part of their areas of professional competence. The regrettable fact that the Treasury and the Ministry of the Economy tend to make the symmetric mistake of lecturing the operationally independent central bank on what they perceive to be its duties (which generally amounts to a plea for lower interest rates) does not justify the central bank’s persistent transgressions.

There are but a few examples of central banks that do not engage in public advocacy on fiscal policy and structural reform matters. The only examples I am aware of are the Bank of England and the Reserve Bank of New Zealand.

Central bankers indeed have a duty to explain how their current and future interest rate decisions are contingent on economic developments that may include or may be influenced by, the actions of the fiscal authorities and the success or failure of structural reforms. The central bank should clarify what its reaction function is, given the economic environment in which they operate, which includes the fiscal authorities and the government and ‘social partners’ engaged in structural reforms.

Independent central bankers can, and where possible should, cooperate with and coordinate their actions with those of the fiscal authorities and with those charged with structural reform. If central banks, Treasury ministers and ministers of the Economy were to act cooperatively toward each other, and with credible commitment towards the private sector, good things may well happen. The reason this does not happen in the EU, or even in the Eurozone, is not a question of principle, but of logistics. There is no coordinated fiscal policy in the EU or in the Eurozone, so the pursuit of coordination between fiscal and monetary policy in the EU or in the Eurozone is simply not possible. Mr. Jean-Claude Juncker could have private breakfasts and/or public lunches with Mr Jean-Claude Trichet every day of the week, every week of the year, it would not bring monetary and fiscal policy coordination in the Eurozone an inch closer to realisation.

The only time central banks have the right and duty to speak out on issues beyond monetary policy narrowly defined, is when the independence of the central bank is threatened. So Mr Trichet certainly is within his rights to publicly sort our Mr. Sarkozy on Article 107 and Article 7.

Unsustainable public finances are not a matter on which the central bank should speak out, even if they threaten to confront the central bank with the dilemma: live with a sovereign debt default or bail out the improvident government through monetisation that threatens the central bank’s price stability mandate. The central bank’s mandated course of action is clear: they should let the government default on its debt rather than monetise that debt in a way that undermines price stability.

Even when the central bank also has a financial stability mandate, the right policy when faced with and unsustainable fiscal-financial policy programme is no different: it is to let the government default rather than to bail them out with monetary issuance that threatens price stability. After all, default is a re-assignment of property rights, and a recognised contingency for any debt instrument. Fundamentally, it is a redistribution of wealth from the owners of the debt to current and/or future tax payers and current and/or future beneficiaries of public spending. There are political mechanisms for sorting out such deeply political distributional issues. They are not the business of the central bank. Financial regulation should ensure that no systemically important financial institution is so exposed to the debt of any sovereign, that the financial viability of the institution would be threatened by the default of the sovereign.

By publicly attacking the economic policies of the French government, Mr. Trichet politicises the ECB. This threatens its independence. When enough political anger and hostility is generated towards the central bank, neither Article 107 nor Article 7 will save it. Ultimately, the Treaty, like any Constitution, is a piece of paper. It is not the Treaty or the Constitution that is sovereign, but the people. Not even the most independent central bank in the world should forget that.

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This post appeared first as a Comment on Martin Wolf’s Economists Forum on September 21, 2007. John Kay in a recent column considered the case for narrow banking as an alternative to deposit guarantees. Under narrow banking, institutions accepting sight deposits (that is, deposits withdrawable on demand and with a fixed nominal value) would be required to hold as assets only the most liquid and risk-free kinds of instruments, specifically, liquid instruments with a near-constant nominal market value. Possible assets for a narrow bank include cash, short-maturity Treasury bills and longer-maturity Treasury bonds with a variable interest rate and a constant value for which a deep secondary market exists. A narrow bank would always be able to meet any deposit withdrawal by selling its assets. It is clear that a narrow bank would be boring both for its customers and for the people running it. The interest rate it could pay on its deposits would be low – the interest rate on safe government bonds minus the cost of running the institution. Private savers would abandon it in droves, to put their money into higher-yielding instruments that were technically not sight deposits (or deposits of any kind), but could still be withdrawn (under orderly market conditions) with little notice and at negligible cost. Narrow banking would only be a solution to the problem represented by bank runs if effective political pressure for a de facto or de jure government guarantee of saving instruments were limited to fixed nominal value deposits withdrawable on demand and subject to a sequential service (first-come-first served) constraint, used as medium of exchange/means of payments.

I don’t think that’s the case. The people who hold more than £100,000 with Northern Rock don’t hold them as transactions balances. For many it represents their life’s savings. I got one anxious e-mail from someone whose mother was in a nursing home, had all her savings in an account with Northern Rock (as deposits of one kind or another) and paid her nursing home premia from that account. Those were not transactions balances that would be held in a narrow bank.

Would moving savings that are not true transactions balances out of deposit accounts – this is what would happen if narrow banking were introduced – and having narrow banks free of run risk eliminate or weaken the ability of savers (the (former) depositors) to extract a free guarantee of their savings from the state?

Small savers, especially those saving for retirement or already retired and living off retirement savings, want their savings to be safe. Telling them that the world is an unsafe place cuts no ice. They also want a ‘decent’ return on their savings. It so happens that the decent safe rate of return they aspire to exceeds the risk-free rate of interest the economy is generating. The small savers are therefore looking for a handout through the state from their fellow tax payers. If the introduction of narrow banking were to cause these small savers to invest their retirement savings in unit trusts or other non-deposit investment vehicles, the political pressure to get these investments guaranteed by the government, if there were a threat to the value of these investments, would be comparable to what we see today with the deposits.

You would not see a run on the unit trust headquarters, but you would see demonstrations of grey and blue-haired pensioners outside Parliament and petitions at 10 Downing Street.

Is there something uniquely intimidating to politicians about a long line outside a bank of depositors desperate to take their money out? It is interesting to speculate why this would be. The continued withdrawal of Northern Rock’s deposits, once the Liquidity Support Facility (‘credit line’) was in place, no longer had any impact on Northern Rock’s ability to continue functioning. By drawing on the credit line (allegedly uncapped and open-ended!), it could do without depositors completely. Using the credit line would (I hope) be more expensive than raising funds by retaining deposits or attracting new ones, but that only impacts on Northern Rock’s shareholders. It is hard to believe that the deposit guarantee was provided to support Northern Rock shareholders.

What about fears of contagion to other UK banks? With the Liquidity Support Facility extended to these other banks and building societies also (as they all are no doubt solvent), they too could continue to function without depositors and deposits. There would be no threat to the stability of the UK banking system, even though there were lines around the block outside each branch office of every UK bank and building society.

We would have achieved half of the move towards narrow banking through this non-systemically dangerous general bank run. Clearly, deposits would no longer be available for transactions purposes, but this would be a nuisance, not a disaster. Cash, travellers cheques, transferable negotiable bills of exchange and other similar instruments would soon take over the role of transactions medium from the defunct deposits. If narrow banking were nevertheless deemed desirable, we could move to the narrowest form of narrow banking by giving every UK household and business a non-interest-bearing account with the Bank of England, an account that could be accessed through, say, any post office or sub-post office in the land. That’s the retail payments system taken care of.

So if there is an effective Lender of Last Resort, deposit insurance is redundant from the point of view of banking sector survival and financial stability. Deposit insurance is also not sufficient to allow a solvent but illiquid institution like Northern Rock to survive, as it was Northern Rock’s inability to roll over its maturing non-deposit liabilities that was causing it trouble.

If the deposit insurance were to extend to new accounts as well – it does not, of course, in the case of the Liquidity Support Facility, although the LSF covers new deposits in existing accounts, as well as a whole list of other unsecured creditors who don’t hold retail deposits – the wholesale market funding-challenged bank could offer such outrageously high interest rates on its deposits, that it might be able to fund itself entirely through deposits! Indeed, that option is still open to other banks that have not yet sought the shelter of the LSF, but know that the LSF will be available to them should they get into trouble in the future. Any bank experiencing trouble funding itself in the wholesale markets, other than Northern Rock, could simply offer wildly excessive interest rates on its deposits to buy itself more time. Depositors know that there will be ex-post deposit insurance should the bank not be able to service the deposits out of its own resources. A great incentive system has been created.

In summary: if there is a LOLR, deposit insurance is neither necessary nor sufficient for banking and financial stability. Unless the sight of long lines outside the banks would have significant negative effects on consumer and/or business confidence, there are no macroeconomic stability arguments for deposit insurance provided there is an LOLR. Why there would be significant adverse effects on confidence from a bank run that would not threaten the survival of the bank or financial stability is not clear. The British like to queue.

The deposit guarantee offered by the Chancellor was therefore in my view motivated not by concern for the stability of the UK banking system, which had already been safeguarded by the Liquidity Support Facility, but by the intolerable political embarrassment created by the highly visible lack of confidence of the UK public in one of its banks, its central bankers, its regulators and its government.

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The UK’s Tripartite Agreement between HM Treasury, the Bank of England and the Financial Services Authority, including the division of labour set out in the Memorandum of Understanding did not work during the Northern Rock crisis. That is not surprising, as the design is flawed. The fundamental flaw became more obvious every time Sir John Gieve or Paul Tucker included in their answer to some question put to them by the Treasury Committee words like: The Bank of England does not collect/have information on individual banks/institutions.

Since the Bank lost banking supervision and regulation in 1997 to the FSA, when the Bank become operationally independent for monetary policy, only the FSA has had the information on individual banks necessary to perform an individual institution-specific Lender or Last Resort operation. However, the FSA does not have the resources to provide a credit line like the Liquidity Support Facility provided by the Bank of England to Northern Rock. The Bank has the resources, as it is the ultimately source of liquidity through its ability to create legal tender in any amount and at the drop of a hat, but it does not have the institution-specific information to allow it to determine in time which bank is solvent and liquid, which bank is solvent but illiquid and which bank is insolvent (only in Russia did we use to have banks like Sberbank that were insolvent but highly liquid…). So the FSA had (or should have had) the information on individual banks but did not have the resources and the Bank had the resources but not the information. The Bank ended up with the responsibility of providing a LOLR facility without having to information necessary to discharge that responsibility.

So the Tripartite Agreement and the MOU will have to be changed. There are a number of options.

(1) The back to the future model.

Transfer banking supervision and regulation back from the FSA to the Bank of England. The FSA should retain responsibility for the consumer protection and customer protection, as such retail issues are not of systemic significance. The Treasury, then as now, should be responsible for deposit protection/insurance/guarantees, although the Bank should be consulted if changes are made to those arrangements, as it can have systemic implications. This would put the information required for being an effective LOLR and the responsibility for performing the LOLR function in the same institution –the Bank of England.

The main argument against this is that bail-outs, including LOLR operations to solvent but illiquid banks, are always and inevitably deeply political, and can easily become party political (e.g. Northern Rock – a Northern institution brought down by the Southern gnomes of London). Property rights and the distribution of wealth and income are inextricably intertwined with the LOLR function. Should the institution that was granted LOLR assistance turn out to be insolvent after all, the Treasury will have to carry the can, by compensating the Bank for any losses made as part of the LOLR operations. If it failed to do so, the Bank might no longer have the financial resources to pursue its mandated inflation target. How can the Bank be independent in the domain of monetary policy, when it is engaged in deeply political LOLR operations and may need to call on the Treasury to recapitalise it if things go wrong?

(2) The minimalist monetary authority model.

This is the same as (1), but with the Monetary Policy Committee taken out of the Bank of England. The Chairman of the MPC would no longer be the Governor of the Bank of England. It might be interesting to have the Governor of the Bank of England and the head of the FSA as ex-officio external members of such a new-style MPC. The MPC would continue to have the same mandate price stability (with a numerical inflation target set by the Chancellor) and subject to that, growth, employment and all things bright and beautiful. The MPC would have but one instrument, Bank Rate, interpreted as the target for the overnight interbank rate. The Bank would act as agent for the MPC in using its money market and repurchase operations in the overnight market to keep the overnight rate as close to Bank rate as possible. Everything else, the Standing Lending and Deposit Facilities, market operations and repos at maturities longer than overnight and foreign exchange market intervention would be the province of the Bank. So the Bank would have both the LOLR responsibilities for individual banks and the responsibility for providing adequate liquidity to the key financial markets as a whole. Again, the information and the resources required for effective fulfilment of the LOLR role would be with the same institution – the Bank.

(3) The FSA as Lender of Last Resort model

A third model would be the one I proposed in my inaugural lecture at the LSE in 2006. This is to have the current arrangement and division of labour between the FSA and the Bank, that is, the FSA as bank supervisor and regulator and the MPC in the Bank, but with one key modification: the Bank’s role in the LOLR function would be entirely passive. The FSA would be given a credit line (overdraft facility), uncapped and open-ended, with the Bank of England, guaranteed by the Treasury, to make sure the Bank’s financial resources are not impaired. The FSA would have to responsibility to decide whether to make a LOLR facility available to an individual bank, and on what terms. The Bank would be able, through open market operations, to undo any undesirable systemic liquidity consequences of the FSA’s LOLR operations. The Bank’s role in the process would be entirely passive – as the provider of the credit line to the FSA, guaranteed by the Treasury. The FSA’s access to the credit line with the Bank would be unconditional, but it would of course be accountable for its decisions.

This proposal too would put the information and the resources required for effective fulfilment of the LOLR role with the same institution, but here that institution would be the FSA.

I have a slight preference for the third option. There may well be other ways of skinning the cat. One thing is clear, though: any arrangement that, like the existing one, puts the information required to perform the LOLR function properly in a different institution from the one that actually has to perform the LOLR function, is doomed to failure.

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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