Memorandum from the Bank of England
TURMOIL IN FINANCIAL MARKETS: WHAT CAN CENTRAL
The recent turmoil in financial markets has
increased uncertainty in the world economy. Problems that surfaced
first in the US sub-prime mortgage market are now visible more
widely. All those involved, whether banks, other financial institutions,
regulators or central banks, need to analyse carefully the causes
of the recent turmoil and think through the long-term consequences
of any actions if they are to respond appropriately.
So in this note I shall try to answer two questions.
First, what are the immediate causes of the recent turmoil and
what are its implications? Second, what can and should central
banks do to alleviate the problems? In due course we shall all
have time for a more detailed examination of this episode and
the lessons to be learned from it.
1. What are the immediate causes of the recent
turmoil and what are its implications?
Since the beginning of August, there have been
sharp movements in financial markets: prices of loans, and assets
backed by loans, have fallen; prices of government securities
have risen; and interest rates on inter-bank lending have risen.
Rising default rates on sub-prime mortgages
in the United States were the trigger for the recent financial
market turmoil. It is important, though, to put recent events
in perspective. The world economy has been strong for the past
five years. Our own economy has been growing at a steady rate
for a considerable period. There are major problems in the US
housing market to which the authorities there are responding with
both macro and micro measures. But the losses from defaults so
far remain small relative to the capital of the banking system.
None of this is meant to say we should be complacent.
But the source of the problems lies not in the state of the world
economy, but in a mis-pricing of risk in the financial system.
And it is on that set of issues that we need to focus to determine
the remedies, both short-term to address the current problems
and long-term to prevent a recurrence.
Why have developments in one part of the US
mortgage market proved so important for a wide range of financial
markets? Sub-prime mortgages are one type of loan that banks have
parcelled together into securities backed by the cash flows from
those loansa process known as securitisation. Those securities
have been sold by banks to investors. They have also been sold
to investment vehicles, many of which have been established by
the banks themselves. Many of these vehicles have financed their
purchases by issuing short-term commercial paper.
Securitisation of loans has separated the information
held by loan originators from those exposed to the risk of defaultinvestors
in asset-backed securities or commercial paper. The unexpected
losses sustained on assets backed by US sub-prime mortgages have
highlighted the potential costs to investors of uncertainty about
the types of loans underlying the assets they purchase. So for
the time being the markets in these instruments have either closed
or become very illiquid. Vehicles financed by short-term commercial
paper are holding assets which can no longer be traded in liquid
markets. They now find that they have borrowed short to lend longnormally
thought of as a function of banks.
As a result of this maturity mismatch, vehicles
set up by banks and others are now finding it extremely difficult
to obtain funding through asset-backed commercial paper. The markets
are now withdrawing short-term funding from such vehicles, a process
not unlike a bank run. Many investment vehicles have been forced
to shorten the maturity of their commercial paper, making their
borrowing even more short-term and their maturity mismatch even
greater. Other vehicles have been unable to issue at all. For
example, since the beginning of August the value of asset backed
commercial paper outstanding in the US has fallen by almost 20%.
Some investment vehicles will need to be wound
up. In many cases, however, the sponsoring bank will have written
a backup line to the vehicle, guaranteeing its funding. Many of
the securitised loans may now be re-priced, restructured or taken
back by the banks. A process is starting that will expand the
balance sheet of the banking system. But how far that process
will go is hard to tell.
The vehicles can be taken back onto banks' balance
sheets. Banks as a whole are well capitalised and should be able
to do this. Moreover, the funds that were directed to asset-backed
securities and commercial paper will now be available elsewhere.
In the end, that funding will come back to the banking system,
although between banks the distribution will differ. So the adjustment
period may be awkward and, during it, banks are placing a premium
on holding assets which can quickly be turned into cash.
The increase in demand for liquid assets during
the adjustment period is one reason why, in all the major economies,
yields on liquid assets like government securities have fallen.
It also helps to explain why the compensation needed for banks
to lend to other banks over periods longer than overnight has
risen and why the volume of inter-bank lending has been increasingly
concentrated at shorter maturities. Since the beginning of August,
the spread between interest rates for three-month inter-bank lending
and central bank interest rates expected over that period has
risen in all the major economies. At present, the average spread
is 110 basis points in sterling and 90 basis points in dollars.
This is the natural economic result of a change in the preferences
of banks over the composition of the assets they wish to hold
on their balance sheets.
In addition, banks have raised their demand
for reserves at central banks. Banks settle payments with each
other using central bank money and they hold reserves at the Bank
of England to manage their daily payment needs. Conditions in
financial markets have made their payment needs less predictable.
As a result, banks have wanted to hold more reserves. They have
tried to fund those reserves by borrowing overnight from other
banks. Over the past month, interest rates on secured overnight
borrowing have averaged 5.9 1%16 basis points above Bank
Rate. That spread was wider than usualsince the introduction
of the current money market regime, it has averaged three basis
These changes in the distribution of assets
across the financial sector, and ba s' preferences over different
assets during the adjustment period, are likely to have consequences
for the wider economy through the interest rates for borrowing
and lending faced by households and companies. It is too soon,
however, to quantify the impact on the economy as a whole.
In the short term, some corporate loan rates
will rise in line with inter-bank rates. Banks that are unable
to sell pools of loans that they had securitised, or who need
to support off-balance sheet vehicles, may cut back on new lending.
But banks whose potential funding liabilities to vehicles or conduits
are small as a proportion of their balance sheet may be able to
exploit profitable lending opportunities, which may not be as
open to those banks which are now hoarding liquidity. So there
may be a redirection of borrowing from within the banking system.
This is part of a normal market adjustment.
Funds that had been invested in asset-backed
commercial paper issued by vehicles and conduits will find their
way back to the financial system, perhaps directly through bank
deposits or indirectly via the corporate sector by purchases of
corporate debt. It is notable that yields on investment-grade
corporate bonds are unchanged since the beginning of August. And
companies, including some financial institutions, have been able
to issue long-term debt.
Nevertheless, there has since mid-July been
a widespread reassessment of the compensation investors seek for
bearing risk. Equity prices have fallen in all major economies.
Most of that adjustment took place in Julybefore the turmoil
in credit markets. The FTSE All-Share today is 6% below its level
at the beginning of July. As this re-pricing of risk passes through
to borrowers, the supply of credit faced by households and companies
may lighten somewhat.
In summary, the turmoil in financial markets
since to beginning of August stems from a reluctance by investors
to purchase financial instruments backed by loans. Liquidity in
asset-backed markets has dried up and a process of re-intermediation
has begun, in which banks move some way back towards their traditional
role taking deposits and lending them. That process is likely
to be temporary but it may not be smooth. During that process,
demand for liquidity by the banking system has increased, leading
to a substantial rise in inter-bat rates.
2. What can and should central banks do to
alleviate these problem?
Three distinct policy instruments can be deployed
by central banks: interest rates, money market operations, and
other general liquidity support operations.
First what role should monetary policy play
in the present situation? The answer is to protect the public
from the consequences of the recent turmoil by continuing to maintain
economic stability. That is done by setting interest rates in
order to meet the 2% target for inflation. Interest rates are
a flexible tool and can be adjusted quickly when necessary. If,
in the wake of a shock to the financial system, the terms on which
the financial system extends credit to the private sector become
less favourable, then borrowing and overall demand would weaken.
Other things being equal, that would lower the inflation outlook
Of course, other things are not equal. When the Monetary Policy
Committee meets each month it reviews all the evidence on the
outlook on inflation before reaching a judgment. The August Inflation
Report implied that some slowdown from recent strong rates of
economic growth was needed to meet the inflation target The new
element introduced by the recent turmoil is that effective borrowing
rates facing households and companies will rise somewhat So, as
we said in the August Report, the Committee is monitoring credit
conditions intensively. It is too soon to tell how persistent
and how large any change in credit conditions for household and
corporate borrowers will prove to be. A new Bank of England Credit
Conditions Survey will be available to the MPC at its next meeting.
Second, the central bank is responsible for
the smooth functioning of the payment system among banksthe
short-term money markets and what is known as the high value payment
system. Central banks discharge that responsibility by providing
reserves that enable banks to settle among themselves. In the
reform of our money market operations a year ago, we made very
clear, and this is a unique feature of the British system, that
the banking system as a whole will get the reserves that it itself
requests. Each month, at the beginning of what is known as the
maintenance period, running from one MPG meeting to the next,
banks set their own reserve targets. They are not imposed. We
then supply the reserves that the banking system as a whole requests.
The objective is to allow banks to deal with their own day-to-day
liquidity needs and, by supplying in aggregate the banks' demand
for reserves, to keep the overnight interest rate close to Bank
Rate set by the Monetary Policy Committee. If any individual bank
has misjudged its reserves target and finds that on any day, due
to unusually large payment flows, it needs additional liquidity,
then that is supplied against eligible collateral at a penalty
rate. There is automatic and guaranteed access to the standing
facility in return for eligible collateral and a penalty rate
of 1% above Bank Rate. It should be clear that because standing
facilities are available at the borrower's discretion and against
eligible collateral, they are quite distinct from what is known
in other financial centres as "emergency liquidity assistance",
and under the UK tripartite framework as lender of last resort
arrangements, where the central bank decides that there is a policy
objective in lending to one or more institutions. Reflecting these
different aims, the collateral required is different.
The interest rate for secured overnight borrowing
was, in August, unusually high relative to Bank Rate, indicating
that banks' aggregate demand for central bank reserves had risen
since they set their reserves targets. For the current maintenance
period, which began on 6 September, the reserves banks raised
their target levels of reserves by 6%. That larger quantity of
reserves was supplied by the Bank of England in its open market
operation on 6 September.
As expected, some pressure on interest rates
for overnight borrowing was relieved. Last week, we announced
that, during the current maintenance period, we will make available
to banks additional reserves, up to 25% of the reserves target,
if the secured overnight rate remains higher than usual relative
to Bank Rate. The reason for this is that there are grounds for
suspecting that banks may, at the start of the current maintenance
period, have underestimated their demand for reserves, and the
additional reserves will help to bring the overnight rate into
line with Bank Rate. We will announce the terms of this week's
operation on Thursday. Provision of central bank reserves, in
exchange for high-quality collateral, cannot be expected to narrow
the spreads between anticipated policy rates and the rates at
which commercial banks can borrow from each other at longer maturities,
and has not done so elsewhere.
So, third, is there a case for the provision
of additional central bank liquidity against a wider range of
collateral and over longer periods in order to reduce market interest
rates at longer maturities? This is the most difficult issue facing
central banks at present and requires a balancing act between
two different considerations. On the one hand, the provision of
greater short-term liquidity against illiquid collateral might
ease the process of taking the assets of vehicles back onto bank
balance sheets and so reduce term market interest rates. But,
on the other hand, the provision of such liquidity support undermines
the efficient pricing of risk by providing ex post insurance for
risky behaviour. That encourages excessive risk-taking, and sows
the seeds of a future financial crisis. So central banks cannot
sensibly entertain such operations merely to restore the status
quo ante. Rather, there must be strong grounds for believing that
the absence of ex post insurance would lead to economic costs
on a scale sufficient to ignore the moral hazard in the future.
In this event, such operations would seek to ensure that the financial
system continues to function effectively.
As we move along a difficult adjustment path
there are three reasons for being careful about where to tread.
First, the hoarding of liquidity is a finite process. When any
transfers of the assets of vehicles back onto banks' balance sheets
are complete, the demand for additional liquidity, and the associated
rise in LIBOR spreads, will fall back. The fragility of sentiment
at present means that the system is vulnerable to her shocks and
it is important to monitor financial conditions extremely closely.
But the banking system as a whole is strong enough to withstand
the impact of taking onto the balance sheet the assets of conduits
and other vehicles.
Second, the private sector will gradually re-establish
valuations of most asset backed securities, thus allowing liquidity
in those markets to build up. Indeed, there are market incentives
to speed up the process both of taking assets back onto balance
sheets and to re-open markets in securities that have closed.
Already there are tentative steps in this direction which will
allow the price discovery process to restart. Strong institutions
have incentives to reveal their positions to obtain better access
to funding. Some are tapping long-term paper. And there are opportunities
to make money for those who can assess and value instruments and
eventually repackage and reissue them. Difficult and time-consuming
though that process may be, it will also slowly reduce that pa
of the rise in market rates which reflects counterparty risk.
Third, the moral hazard inherent in the provision
of ex post insurance to institutions that have engaged in risky
or reckless lending is no abstract concept. The risks of the potential
maturity transformation undertaken by off-balance sheet vehicles
were not fully priced. The increase in maturity transformation
implied by a change in the effective liquidity in the markets
for asset-backed securities was identified as a risk by a wide
range of official publications, including the Bank of England's
Financial Stability Report, over several years. If central banks
underwrite any maturity transformation that threatens to damage
the economy as a whole, it encourages the view that as long as
a bank takes the same sort of risks that other banks are taking
then it is more likely that their liquidity problems will be insured
ex post by the central bank. The provision of large liquidity
facilities penalises those financial institutions that sat out
the dance, encourages herd behaviour and increases the intensity
of future crises.
In addition, central banks, in their traditional
lender of last resort (LOLR) role, can lend "against good
collateral at a penalty rate" to an individual bank facing
temporary liquidity problems, but that is otherwise regarded as
solvent. The rationale would be that the failure of such a bank
would lead to serious economic damage, including to the customers
of the bank. The moral hazard of an increase in risk-taking resulting
from the provision of LOLR lending is reduced by making liquidity
available only at a penalty rate. Such operations in this country
are covered by the tripartite arrangements set out in the MOU
between the Treasury, Financial Services Authority and the Bank
of England. Because they are made to individual institutions,
they are flexible with respect to type of collateral and term
of the facility. LOLR operations remain in the armoury of all
The path ahead is uncertain. There are strong
private incentives to market players to recognise early and transparently
their exposures to off-balance sheet entities and to accelerate
the re-pricing of asset-backed securities. Policy actions must
be supportive of this process. Injections of liquidity in normal
money market operations against high quality collateral are unlikely
by themselves to bring down the LIBOR spreads that reflect a need
for banks collectively to finance the expansion of their balance
sheets. To do that, general injections of liquidity against a
wider range of collateral would be necessary. But unless they
were made available at an appropriate penalty rate, they would
encourage in future the very risk-taking that has led us to where
we are. All central banks are aware that there are circumstances
in which action might be necessary to prevent a major shock to
the system as a whole. Balancing these considerations will pose
considerable challenges, and in present circumstances judging
that balance is something we do almost daily.
The key objectives remain, first, the continuous
pursuit of the inflation target to maintain economic stability
and, second, ensuring that the financial system continues to function
effectively, including the proper pricing of risk. If risk continues
to be under-priced, the next period of turmoil will be on an even
bigger scale. The current turmoil, which has at its heart the
earlier under-pricing of risk, has disturbed the unusual serenity
of recent years, but, managed properly, it should not threaten
our long-run economic stability.