Select Committee on Treasury Written Evidence


Memorandum from Julian D A Wiseman

SUMMARY

  1.  The Bank of England is better at implementing monetary policy than it was, but not as good as it should be. Unnecessary complexity in the Bank's operations worsened the effect of the credit crunch on the UK. Better implementation of monetary policy would be simple and cheap.

HISTORY

  2.  The Bank of England has traditionally been abysmal at implementing monetary policy, whether measured by the variance of short-term interest rates around the policy rate,[2] or by market participants' opinion of the quality of implementation. Why does this matter? Under normal circumstances it leads to unnecessary volatility and a waste of resources, as well as allowing insiders to manipulate the market to their own advantage. And under crisis conditions holes in systems tend to widen as participants become less willing to trust each other's solvency.

  3.  In 2003, the last full year of the previous regime, the success of the Bank of England at implementing monetary policy in £ was worse than the implementation of policy in dollars, euro, yen, Swiss francs, Canadian dollars, Australian dollars, New Zealand dollars, Danish krone, Swedish krona, Czech koruna, and Taiwanese dollars. To be fair, the Old Lady's implementation was better than that in Norwegian krone, Icelandic krona, and several, but not all, emerging-market currencies. For a central bank that thought and thinks of itself as market-savvy, this was less than impressive.

  4.  So with this background in mind this critic of the Bank's implementation of policy was delighted to hear, on 28 July 2004, the Executive Director Markets quoting Charles Goodhart's description of an earlier version of Bank operations as "confused and silly".[3] Maybe this time the Bank would get it right!

OBJECTIVE

  5.  In Reform of the Bank of England's Operations in the Sterling Money Markets, 7 May 2004[4] the Bank describes its objectives, the first of which says:

    The first and primary objective is for sterling overnight interest rates to be in line with the MPC's repo rate, leading to an essentially flat money market curve out to the next MPC decision date, with very limited day-to-day or intra-day volatility in market interest rates at maturities out to that horizon. Beyond the next MPC decision date, market interest rates will be free to reflect market expectations of future MPC interest rate decisions.

  6.  By "overnight interest rates", the Bank means the cost of borrowing money against collateral (collateral being discussed later). So the "first and primary objective" is for the cost of secured overnight money to be very close to the policy rate. This is good; and this is measurable.

  7.  Also of note, because of the margin by which the Bank failed, is the third objective:

    A simple, straightforward and transparent operational framework.

DOING IT THE SIMPLE WAY[5]

  8.  In the UK, and in most countries, the banking sector needs to borrow money from the central bank. Banks withdraw physical cash from the central bank, and—mostly—need to pay for this cash with borrowed money. In sterling the banking system needs to borrow about £28 billion from the Bank of England—the £41 billion banknote issue less the government's £13 billion overdraft in the Ways and Means account. These numbers vary along with the size of the note issue—larger at weekends and over public holidays—but nonetheless the banks are almost always in the position of borrowing from the Bank of England.

  9.  So why not do this the easy way? To implement a policy rate of 5% the Bank of England should be willing to lend money to good counterparties against good collateral, overnight and in good size, at the policy rate of 5%; and also be willing to accept overnight deposits from counterparties at a slightly lower rate, say, 4.9%.

  10.  That would be enough: against good collateral the cost of overnight borrowing could not rise above the assumed policy rate of 5%, and it could not fall below 4.9%. With banks being net borrowers from the Old Lady, the price would typically trade near the top of this narrow band. And every commercial bank would know that collateral is as good as money: if the collateral is put with the Bank of England, then money can be borrowed at the policy rate.

  11.  For reasons of prudence the central bank's standing facilities should not be in?nite in size. If a counterparty were to become insolvent the collateral would have to be sold, and this might entail a loss. Since the banking sector needs to borrow a total of about £28 billion, a sensible upper limit for lending to any one large bank might be something of the order of £20 billion. As the banks are net borrowers, the limit on a counterparty's remunerated deposit with the central bank could be smaller: perhaps half the maximum overdraft, so £10 billion per bank. Larger borrowings would be prohibited; larger deposits would be unremunerated.

  12  This system would have satis?ed the Bank of England's objective of "simple, straightforward and transparent".

DOING IT A COMPLICATED WAY

  13.  Instead, the Bank has a system with a corridor that is usually ten times wider than above, and various bells and whistles to try to keep the price within this corridor. Each commercial bank has a reserve account, and can also deal on a separate account via open market operations (which are neither open nor at a market price). The Bank of England's February 2007 Red Book[6] provides the following explanation of its "reserves-averaging scheme":

    UK banks and building societies that are members of the scheme undertake to hold target balances (reserves) at the Bank on average over maintenance periods running from one MPC decision date until the next. If a member's average balance is within a range around their target, the balance is remunerated at the official Bank Rate.

  14.  The Bank's most recent Quarterly Bulletin says that aggregate reserves targets are about £17 billion. Since the banks are required to keep this £17 billion on deposit with the Bank, the central bank will have to lend this money to the same banks, as well as lending the £28 billion explained earlier. Again from the Red Book:

    Open Market Operations (OMOs) are used to provide to the banking system the amount of central bank money needed to enable reserves scheme members, in aggregate, to achieve their reserves targets. OMOs comprise short-term repos at the official Bank Rate, long-term repos at market rates determined in variable-rate tenders, and outright purchases of high-quality bonds.

  15.  But, rightly, the Bank understands that the two features above, between them, would not be sufficient. For example, one private-sector bank might be able to borrow so much money from counterparties that, on the last day of the reserves period, it becomes a de facto monopoly supplier of funds, presumably at an extravagant rate. Accordingly, the Bank maintains a corridor of "standing facilities":

    Standing deposit and (collateralised) lending facilities are available to eligible UK banks and building societies. They may be used on demand. In normal circumstances they carry a penalty, relative to the official Bank Rate, of +/-25 basis points on the final day of the monthly reserves maintenance period, and of +/-100 basis points on all other days.

  16.  These standing facilities resemble the proposal above, albeit with some changes. First, these facilities need to be invoked actively, rather than being applied automatically to end-of-day balances. Second, because the Bank endeavours to supply the correct amount of central bank money via the three types of open market operations, these standing facilities are centred on the policy rate. Third, the band is very wide, on most days being ±100 basis points around the policy rate. Even on the last day it is still a "penalty" of ±25 basis points away from policy.

  17.  This complication is a mess, and a mess with consequences.

DOING IT A COMPLICATED WAY: EVERYDAY PROBLEMS

  18.  The complication caused problems before the credit crisis, albeit problems less widely reported than those that came later. Too few funds were taken at the end-June OMO, causing inter-bank interest rates to trade abnormally high relative to the policy rate in the following week.[7]

  19.  This sudden increase in inter-bank interest rates could not have happened with a simpler arrangement, lending day-by-day against collateral, at the policy rate, as much as each counterparty wants, subject to some huge counterparty-by-counterparty limit. But the complexity of the Bank's system caused a coordination problem: individual actions by counterparties failed to solve the collective problem.

DOING IT A COMPLICATED WAY: SIGNALLING PROBLEMS

  20.  But the system's complications caused worse problems not mentioned in the Quarterly Bulletin. In August the rarely used standing facilities were used by Barclays, reported by the Daily Mail on the 31st:

    The financial health of Barclays was being questioned after it was forced to ask for huge loans to bail it out.

    The lender has tapped an emergency credit facility with the Bank of England twice in 10 days.

    The loans for almost £2billion are fuelling fears that it has become too deeply involved in high-risk debt investments.

  21.  For the last decade the Bank of England has been very keen to signal to a wide range of economic agents that future in?ation will be close to its target. Given this care in monetary signalling, why does it allow this careless signal about financial instability? It is impossible to know whether this smoke helped give the impression of fire in the banking system, and hence the run on Northern Rock, but why has the Bank created a system that needlessly gives this false and dangerous signal?

  22.  The problem is that if a feature is little used, and is then used during any sort of market turbulence, some will believe that use of that feature contains signi?cant negative information. The solution is a simpler system that actually works, all parts of which are often used.

COLLATERAL

  23.  Next we come to the separate issue of what collateral a central bank should accept against its monetary policy operations. (Financial stability operations are different: a central bank might have to lend against poor collateral, or even against no collateral. But that shouldn't be happening whilst the borrower's previous management are still on the payroll.) Unlike the question of how to implement monetary policy given a definition of collateral, the optimal definition of collateral for monetary-policy operations is a genuinely difficult problem.

  24.  If a central bank lends against a wide range of collateral, and allows counterparties to manufacture collateral, it risks exacerbating a mis-pricing of risk. Also the central bank would be taking far greater credit risk. For example, consider a commercial bank that has lent money to households in the form of mortgages. These mortgages are bundled into securities. If the central bank were to accept these securities as collateral, this would mean the following.

    24a  If the households should start defaulting in significant numbers, the counterparty would be insolvent just as the collateral provided by the counterparty is dropping in price—a credit loss for the central bank.

    24b  Because the central bank is holding the credit risk, in some sense it is doing the lending to the households. If the interest rate does not re?ect the creditworthiness of the households, how is the central bank to know?

  25.  Alternatively the central bank could lend only against the best collateral: bonds issued by the government of the jurisdiction of the central bank—for the Bank of England, gilts.

  26.  Before the recent loosening of the rules, the Bank had a mixed stance.

    26a  The Bank did not allow counterparties to manufacture collateral, as acceptable collateral are securities issued by European Economic Area central governments and central banks and major international institutions.

    26b  However, the Bank's collateral policy implicitly entailed and entails substantial credit risk—without admitting that it does so. This needs explanation: the Bank accepts as collateral euro-denominated paper. Imagine that Deutsche Bank has borrowed some £20 billion from the Bank of England (an unremarkable thing, as Deutsche is a major player in £ markets), and has provided as collateral euro-denominated bonds issued by Germany. Then, for some reason, Deutsche goes bust. In theory the Bank of England would sell the German Bunds for euro cash, and then sell the € for £ in the foreign exchange market. In theory. But in practice, central bank politesse would ensure that the Bank would not be willing to be seen to be selling the government bonds and the currency of a country whose largest bank had just defaulted. (Consider the reverse: Barclays goes under, and the following day the Bundesbank is seen selling gilts and selling £—how not to make friends.) So the Bank of England would have to wait for at least several weeks, and more likely several months, before converting the collateral into the currency of the loan. And, in the three months following Deutsche's default, how far might the euro fall? It might lose 5% to 10%; and it might tumble more than 15%. Certainly very plausible is a -10% move in the euro, which would cost the Bank of England some £2 billion (more than the Bank's £1.86 billion equity reported in the 2007 accounts). Hence the Bank of England, by allowing euro-denominated collateral, is taking substantial credit risk.

  27.  This is not necessarily a bad policy, but the Bank should not be pretending to itself or to others that its collateral policy protects it from credit risk. Indeed, the Treasury Committee might like to ask the Bank to explain the purpose of taking collateral, and judge this credit risk against that purpose.

November 2007






2   Consider the difference between the policy rate and £ repo fixing, using maturities of 1 day, 1, 2 and 3 weeks, and 1 month. Score the standard deviation of this difference. Consider the same measure in the non-£ currency, for € using the repo fixing (because it exists), and for the other currencies the Libor fixings or local equivalent. If £ is worse in each of the five maturities for which non-£ data exists, then £ is deemed worse. Back

3   www.bankofengland.co.uk/publications/speeches/2004/speech225.pdf Back

4   www.bankofengland.co.uk/markets/money/smmreform040507.pdf Back

5   This closely follows the text of The pretend market for money, originally appearing in the August 2007 edition of the journal of Central Banking, and also available via www.jdawiseman.com/papers/finmkts/implementing-monetary-policy.html. Back

6   www.bankofengland.co.uk/markets/money/publications/redbookfeb07.pdf Back

7   Described on page 356 of the 2007 Q3 Quarterly Bulletin under the heading "June-August maintenance periods": www.bankofengland.co.uk/publications/quarterlybulletin/mo07aug.pdf. Back


 
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