Easing the squeeze – make the Bank more independent

Today’s news that the Bank of England is making liquidity available to the markets is a sensible move, but we should not expect too much of it. The mismanagement of the Northern Rock liquidity crisis has made UK based banks very worried about borrowing from the Bank of England, at the very time when they need to without fear of anyone concluding they are in difficulties because they are so borrowing. This is a tight year end for most banks, which accounts for their reluctance to lend to each other when they need to conserve cash to show stronger balance sheets in their December 31st Reports.

The Bank’s traditional weapons to fight a credit squeeze of cutting interest rates and offering liquidity in money markets have been blunted by the Northern Rock disaster. The Chancellor and Bank need to take other action at the same time as easing money to rebuild confidence. Without confidence, offering liquidity and cutting rates will not be enough to end the squeeze.

The first thing the Chancellor should do is to convene a meeting with the FSA and the Bank and work out a new regulatory structure for the money markets and main banks. We read in the press that the government thinks the right answer is to set up a Cobra type crisis committee chaired by the Chancellor the next time there is a run on a bank or some such similar problem. Far from rebuilding confidence, this type of irresponsible briefing to newspapers undermines it further.

We do not want to hear they are planning to handle a run on a bank better next time. We want to hear they are taking regulatory action to prevent a run on a bank. We do not want to hear that the second most important politician in the government is to be given the job of day by day supervision of money markets and banking as well as all his other duties. We do want a thought through response to the crisis, set out in a Statement to Parliament and followed promptly by whatever institutional reform is necessary.

I would suggest that the government does the following:

1. Give management of government debt back to the Bank of England, so the Bank sees all the government transactions in money and debt markets and influences the timing of them.
2. Give day by day supervision of the main banks back to the Bank of England: not because the FSA did badly, as they alerted the system to the crisis weeks before it became critical, but because the Bank of England needs to see day by day the positions of each bank in money market and debt instruments to inform its decisions about the needs of the system.
3. Reaffirm the Bank’s central role in ensuring a liquid and functioning money market, as the complement to its role in inflation fighting and establishing interest rates
4. To remind people that the Chancellor needs to be kept informed on a regular basis of general progress and urgently if there is a major problem as he has to explain the Bank’s actions to Parliament and has to make the decision on appointments to the top of the Bank.

Items 1 and 2 recreate the more powerful Bank before Brown’s reforms. The misnaming of these reforms as creating an independent Bank of England? has been particularly damaging, as they did the opposite in the crucial areas of debt management, bank supervision and running effective money market activities.

The government then needs to sort out Northern Rock. Some transparency would help. Taxpayers and markets need to know how much has been lent by the Bank to the Rock, when it will be repaid and what security has been taken to protect the taxpayer. If the government offers us more transparency of its own actions, it then has the moral authority to demand the greater transparency it says it is seeking from clearing banks over the valuation of their off balance sheet items. It should not nationalise Northern Rock, but act as its tough but concerned bank manager.

Restoring confidence does require market participants to be able to assess the damage done to the financial system by the decline in asset values on both sides of the Atlantic. The government must not kid itself that this is just a sub prime US crisis. UK market participants also want to know what impact the decline in UK commercial property values already well underway will have on bank balance sheets and the collateral they have taken for loans. They also wish to form a better view of how far residential property prices in the UK might fall, and what impact this could have ?along with job losses and the personal income squeeze on UK mortgage assets and loans held by banks.

There is a lot to do to relax the squeeze. It may be that once the year end is out of the way for the banks, and we have seen their year end balance sheets, things will start to loosen. To be sure they do the government needs to make that statement on the future regulatory position, and needs to get on with leading the market to greater transparency by explaining its own ?and the Bank’s complex and large transactions in markets since the Northern Rock run began.

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4 Comments

  1. Matthew
    Posted December 18, 2007 at 11:16 am | Permalink

    The news today that the Treasury is going to guarantee more of Northern Rock's deposits is another step on the road to nationalisation, but also exposes the problem with your suggestion the other day that lending 1/3rd is better than full nationalisation – it's not a steady situation.

    Reply: Today's announcement is a bad move. My proposal is for the Bank to act as a tough bank manager. That would work.

  2. Tony Makara
    Posted December 18, 2007 at 12:26 pm | Permalink

    I must admit to be very nervous about the idea of central banks increasing the money supply. Liquidity is of necessity, but is there not a danger that inflation will result? With interest rates falling, the pound will fall with it, this combined with artificially created liquidity provides all the ingredients for inflation.

    On the subject of BOE independence, its a good idea in theory, but if government is to have a macroeconomic policy it must surely have a degree of imput into BOE operations? How could the government of the day have any sort of economic strategy if the BOE ran the whole show? Plus there is the question of accountability. To my mind a better policy would be to have a corporate-state style economic body made up of politicians, captains of industry, academic economists, and central bankers. All working to determine the best economic course for the country to undertake.

    Reply: Inflation is likely to rise in the short term because of past mnonetary excess. In the medium term this credit crunch is severe so I do not see an inflaitonary threat.
    The Bank in my proposed model has to follow government policy – the government sets the inflation target, chooses tax rates, and sets the budget.

  3. Stuart Fairney
    Posted December 18, 2007 at 1:03 pm | Permalink

    JR This is becoming deeply worrying, can you tell me how much each UK income tax payer has effectively lent Northern Rock at Darling's behest and what our final liabiity might amount to ?

    Reply: As taxpayers have now lent or guaranteed over

  4. Matthew
    Posted December 18, 2007 at 6:15 pm | Permalink

    Come on, this is misleading as to the final liability. Northern Rock has assets (its mortgages) worth over

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    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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