Thursday, September 20, 2007

Why didn't the Bank of England adopt the discount window rule book of the Fed or the ECB?

Governor Mervyn King today gave an impressive defense of the Bank of England’s actions in the months preceding the run on Northern Rock. He was, however, let off lightly on one key point: the whole Northern Rock debacle was avoidable, including the creation of a dedicated Liquidity Support Facility for Northern Rock and the Chancellor’s guarantee of all of its deposits (and of the deposits of any UK bank that might find itself in similar circumstances). All that would have been required were two obvious (and legal!) modifications of the Bank’s discount window operating procedures - modifications which would have brought them in line with those of the Fed and the ECB. In response to the question: could the Northern Rock debacle have been avoided if the Bank of England had acted like the Fed and the ECB, the Governor answered that he was unable to offer covert support to Northern Rock, as he would have preferred to do and as he would have done under the ancien regime, because the (Brussels) Market Abuse Directive (technically the 2005 UK Implementation of the EU Market Abuse Directive) made such assistance illegal or at least legally doubtful. The Governor's interpretation of the Market Abuse Directive seems strained, and was promptly denied by Brussels: "It is crystal clear that there is sufficient flexibility to delay information by the issuer of the type that the Governor of the Bank of England would have been referring to," said a spokesman for the European Commission on Thursday. "There is also no obligation for central banks to disclose its activity under the market abuse directive." "The very notion of the directive including such a limitation is outlandish as it would render any central bank activity to help an ailing institution virtually impossible." Whatever the merits of the legal case, what the Governor forgot to mention was that the Bank could have used its existing discount window facility (formally its standing (collateralised) lending facility), to offer effective support to Northern Rock, if the Bank had been willing to modify the rule-book for the standing lending facility to make it more like the Fed’s primary discount window and the ECB’s marginal lending facility. The Bank has the ability to make these operational modifications without the need for legislation and without fear of running foul of Brussels. No need for special lender of last resort (LOLR) arrangements, including the Liquidity Support Facility that was in the end purpose-built for Northern Rock. The existing standing lending facility, which is available to all banks and building societies, could have provided all the LOLR support that was needed (and given).
As currently operated, the standing lending facility was of no use to Northern Rock for two reasons. First, it only provides overnight finance. Second, it requires as collateral “…gilts (gilt strips), UK government foreign currency debt securities, sterling Treasury bills, Bank of England foreign currency debt securities, and certain sterling and euro-denominated securities issues by EEA (European Economic Area) central governments, central banks and major international institutions where the issuing entity is rated Aa3 or higher by two of the three major ratings agencies.” (Bank of England Redbook). Northern Rock did not hold sufficient amounts of these securities.
The Fed has recently extended the maturity of the loans it can provide at its primary discount window to one month. It also can accept as collateral anything it deems fit, including, even during normal times, Municipal or Corporate Obligations, Corporate Market Instruments, Commercial Paper, Bank Issued Assets and Customer Obligations (specifically mentioned are commercial loans, consumer loans and one-to-four-family mortgage loans). The ECB can accept as collateral at its discount window (formally its marginal lending facility) in addition to the Eurozone version of the collateral accepted by the Bank of England at its standing lending facility, securities issued by private entities, both marketable and non-marketable. For Northern Rock, the most interesting class of assets acceptable as collateral at the ECB’s discount window are non-marketable retail mortgage-backed debt instruments. The ECB requires this collateral to be at least of singe A standard, that is a minimum long-term rating of “A-” by Fitch or Standard & Poor’s, or “A3” by Moody’s (it could change these requirements, at its discretion).
The prime mortgages or securities backed by prime mortgages that constitute much of the assets of Northern Rock would have been acceptable as collateral at both the Fed’s primary discount window and at the ECB’s marginal lending facility. With the term of the Standard lending facility loans extended to one month, Northern Rock should have been able to finance its maturing obligations and stay in business.
If covert support is desirable, it also happens to be the case that the Bank of England (or other central banks) do not normally reveal the identity of the discount window customers. Only the aggregate use of the facility is disclosed.
The Liquidity Support Facility created specifically and visibly for Northern Rock, stood out as an emergency facility par excellence and cause an (individually) rational run on the deposits of the bank. The standard lending facility, modified along Fed-ECB lines, could have mimicked all essential properties of the Liquidity Support Facility, but without turning Northern Rock into a pariah. The discount windows are accessible on demand by the banks that are members of the scheme, and the amount that can be borrowed is limited only by the collateral the borrower can offer. The lending is at a penalty rate (100bps over Bank rate in the UK, 100 bps over the policy rate in the Eurozone and 50 bps over the Federal Funds target rate in the US).
The use of the standing lending facility, augmented as outlined above, would not have contributed to moral hazard, because it is at 100bps over Bank rate, and because the Bank of England could have been as demanding, indeed punitive, in its collateral requirements, as it would have wanted. The mortgages or mortgage-backed securities would not have been valued at par but at some discount on their notional or face value. Further liquidity haircuts could have been applied to the Ban’s valuation of the collateral to safeguard the financial position of the Bank, and ultimately the tax payer. Discount window finance is not cheap finance. The liquidity is available only on penalty terms.
I cannot understand why the Bank did not modify its discount window rules. Is it an example of 'not invented here'? Did the Bank, mistakenly, believe that extending the maturity of discount window borrowing and widening the class of eligible collateral would inevitably create unacceptable moral hazard? The proposed operational changes would not have violated any UK or EU laws, directives or regulations.
Yesterday, the Bank had no trouble extending its class of eligible collateral for the 3-month repurchase operations it announced for next week, to include mortgages and mortgage-backed securities. The extension of its liquidity-enhancing operations to include three-month maturities as opposed to just the overnight market, represents a change in the Bank’s operating practices. In these 3-months repos, funds will be priced at least 100 bps over Bank Rate. They are therefore effectively the same as three-month maturity discount window borrowing with mortgages or mortgage-backed securities as collateral. If that option (or even just one-month borrowing using mortgages or mortgage-backed securities as collateral) had been available from August 9 on, odds are that Northern Rock would still be a viable bank and that the Bank, the FSA and the Treasury would not be wiping egg from their faces.


Anonymous said...

Actually it does ppear that they have/had Treasury Assets as below:

"Northern Rock Treasury invests in high quality and well diversified assets. The statutory balance
sheet in our interim results reported Treasury assets of £15.4 billion. At 31 August 2007 Treasury
assets were rated 35% AAA, 31% AA, 25% A and 9% BBB. Our largest exposures were 24% to
sovereigns, 46% to financial institutions and 22% to asset backed securities."

Tim Young said...


I would be grateful if you could explain why three month money was so important to the banks (perhaps in a comment on this post). How could three month LIBOR trade so far above any plausible path of the BoE repo rate, while overnight LIBOR was only about 15bps above? Why were the banks not content to roll over the overnight money?

I am sure that you are right that the crisis would not have occurred if the BoE had lent against mortgages, but it seems to me that this represents a significant subsidy to the banks that needs careful thought. Unless the price of loans against mortgage collateral is penally high, such a facility absolves mortgage banks from needing to hold a liquidity buffer of their own in the form of, say, relatively low-yielding government bonds.