tony's blog

Friday, June 22, 2012

How Central Banks should work

I was heartened to hear Deputy Governor of the Bank of England, Paul Tucker’s words last week hinting that there needs to be a shift in approach as to how the British authorities deal with the lack of affordable credit being made available to British companies and households. Mr Tucker went so far as to say that recent regulation could be proving counter-productive and that banks should be ready to draw on their liquidity buffers rather than hoarding cash.

And then we had the George Osborne/Sir Mervyn King announcements of making funding and liquidity available to the banking sector last Thursday night.

This is a very significant change in policy for the Bank of England and should be noted.

It has been interesting to see how Central Banks have focussed their efforts in a continuing and volatile market situation: in the US the Federal Reserve Bank has extended its ‘Operation Twist’ – a scheme to lower long-term interest rates, which had initially been due to end this month.

It also confirmed its intention to keep short-term borrowing costs at ‘exceptionally low levels’ amid concerns over the US jobs market but they have stopped short of unleashing a third wave of money-printing, or QE3. They have also been active in purchasing debt instruments to ensure a strong supply of credit to the markets.

But the Bank of England has been more conservative and until now at least have eschewed the traditional role of the Central Bank which is to be a lender of last resort, particularly in times of financial distress. The widely accepted critical role of a Central Bank was defined by Walter Bagehot - a 19th century English intellectual who summarised the lender of last resort function with the dictum “lend freely at a high rate, on good collateral.” This has been an anathema to the Bank of England until now where the view has been that it is not to the role of the Bank of England to support the banks – that way leads to moral hazard and encourages loose lending and liquidity practices with the knowledge that the Bank of England will be there to pick up the pieces if it goes wrong.

But all that now appears to have changed.

With the broad supply of money contracting (cash and money in bank accounts), the money multiplier is no longer functioning. Add to that the tendency for banks to hoard cash and rebuild capital reserves and it’s no wonder that the economy has been grinding to a halt amid fears of another credit crunch. Add to this the Eurozone worries and it has been enough to create a major policy change for the Bank of England.

Thus far the Bank of England has been reluctant to take a revised course of action directly to ease banks’ funding costs, preferring to use their quantitative easing (QE) programme to improve liquidity. However it is apparent that banks have not using the facility as intended, choosing to stockpile the money in safe assets and deposits with the Bank of England rather than inject the money into the economy as intended.

It was time for a radical rethink and I’m pleased for the change in stance. Now is not the time for an excess of caution. The markets may be the best capitalised and have superb liquidity positions but if we are not careful the markets and economy will stagnate.

Now is the time for the Bank of England to act like a traditional Central Bank and be prepared to lend against good collateral. I’m delighted that it is doing so now even though it’s taken an awfully long time to get here.

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