Thursday, October 11, 2007

Getting my Northern Rocks Off, Again

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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