The â€œindependentâ€ Bank of England allowed its Financial Stability Report to be published just before the local elections, and allowed the spin to be placed on it that the losses in the financial sector will prove to overstated, that the Credit Crunch has not reached its worst point, and that from here we should expect some improvement. It is difficult to make up such a story.
A truly â€œindependentâ€ Bank should have left such a publication for the day after the elections, to avoid being dragged into the political argument. It would also have insisted on a balanced presentation of what the long and serious underlying Report actually says.
The report shows just how persistent and deep seated the liquidity and valuation problems in the banking market have become. The Bankâ€™s own measures of liquidity are summed up in an Index. This has fallen off a cliff, and is at its weakest level since the dives of 1998 and 2000. It goes on to explain why market participants have to mark to market (use market prices to value the financial assets they own), why markets are reluctant to value more risky paper at higher prices, and states that there could be more bad news to come.
Indeed, it says that tight credit conditions can be expected â€œto lead to a pick-up in defaults among vulnerable borrowers, including a subset of households, parts of the commercial property sector, and some highly leveraged non financial companiesâ€. In addition â€œFinancial difficulties could emerge in some emerging markets, including countries in Central and western Europe with large current account deficitsâ€. In other words, some of the losses have not been overstated, but will materialise.
The report goes on to recommend actions that banks and regulators should take to improve the position. It recommends better risk management by the banks themselves â€“ an unexceptional request.
It proposes â€œStrengthened regulatory standards for liquidityâ€. This is more contentious. It would be odd to require tougher cash requirements today, in the middle of a credit squeeze which the Bank seems to want to end, than they sought in the inflationary credit bubble days of 2006. The Bank itself sees the dangers of â€œpro-cyclicalityâ€ in regulatory rules â€“ regulators relaxing the amount of capital needed in good times, fuelling the boom, and then demanding more regulatory capital in bad times, tightening the squeeze. It concedes that the new Basel II rules coming in could well make just this mistake, and confines itself to wise words suggesting something might be done about this. It should be cause for immediate action.
It seeks â€œdifferentiated ratings for structured productsâ€ which is code for saying it wants Rating Agencies to be more cautious about they evaluate the credit worthiness of some of these packages of debt that have caused problems in the last few months. That too makes sense.
It wants â€œsharper regulatory incentives for banks to control risks through the credit cycleâ€. That presumably means they want banks to lend less and lend to fewer people than they did in the last few years. One way they could achieve that is by keeping interest rates higher. There is a reluctance to blame the Monetary Policy Committee, yet their low rates underpinned the credit boom of recent years. This approach needs careful control, lest they lurch from the boom of 2006-7 to a bust, by being too tough.
They also seek â€œstrengthened UK and cross border crisis management arrangementsâ€. A good place to start would be to recommend to the UK government strengthened arrangements for the Bank to supervise the UK markets, instead of relying on the tripartite approach which let us down so badly over Northern Rock. We have not, fortunately, had a bank crash recently that fell owing to errors in cross border surveillance â€“ we have had a run on a domestic bank owing to errors in UK surveillance. The priority should be for UK regulators to get together to re-establish a framework in which the Bank of England can influence money markets decisively, restore the importance of base rate, and monitor bank liquidity day by day.
The body of the Report is more interesting and more realistic than the glib spin placed on it when it was released to the press. It does not make comfortable reading, showing as it does persistent problems with liquidity in banking markets. The government should take the initiative, recognise that the tripartite system got Northern Rock wrong, and reinstate the Bank as chief controller of commercial banks and manager of money markets. The two jobs go together. It is difficult to do the one without doing the other.