In a little-noticed press release in June 2014, the Bank of England announced changes to its policy of providing information on its balance sheet and monetary policy operations. The revisions roll back the bank’s practice, established by law in 1844, of publishing a weekly balance sheet entitled “Bank Return.” Specifically, the Bank no longer reports its current total assets and liabilities on a weekly basis. The rationale for the change was rooted in the Bank’s experience during the financial crisis and its provision of emergency liquidity assistance to Northern Rock, the Royal Bank of Scotland and HBOS (formed by the merger of Halifax plc and the Bank of Scotland in 2006).
The notice refers to the work of the British journalist Walter Bagehot, who laid out in his seminal book Lombard Street in 1873 the critical role that central banks should play in providing emergency liquidity to banks experiencing temporary liquidity shocks. In the book, Bagehot argued that to avert a panic and runs on banks, a central bank should lend freely and without limit to solvent firms. Loans should be based upon sound collateral and bear a high rate of interest (presumably a penalty rather than a subsidy rate).
The Bank of England then goes on to make a bizarre set of arguments for not disclosing its weekly balance sheet, none of which relate to either Bagehot’s rules or to what the Bank of England actually did during the crisis. While the Bank of England did lend freely to RBS and HBOS, and subsequently provided support to others, those two institutions were clearly insolvent. Their liquidity problems were not temporary. Borrowers were not charged a high interest rate, and the quality of the collateral was questionable. These assertions are supported by the following set of facts, many of which are detailed in public documents and a report (“Review of the Bank of England’s Provision of Emergency Liquidity Assistance in 2008-2009,” October 2012), prepared by Ian Plenderleith pursuant to an order by the Court of the Bank of England.
First, the liquidity problems were prolonged rather than short-lived in the way envisioned by Bagehot. Specifically, the liquidity problems first emerged in early April 2008 and persisted into 2009. As the Plenderleith report indicates, “… strains that were destabilizing the financial system had been evident for over a year.” Second, the rate charged was only 200 basis points, which is not high for risky lending, and indeed was actually a subsidy rate. The BoE’s official bank rate was above 4% before the crisis, at over 3% in October and November of 2008 during the peak borrowing period of RBS and HBOS, and at 2% by the end of 2008. Leading up to the crisis, credit spreads for both institutions accelerated through 2008. In HBOS’s case the spread was nearly 500 basis points, and it was nearly 225 basis points for RBS. These spreads were less than the BoE was charging. Furthermore, the stock prices of both institutions steadily declined throughout 2007 and 2008.
The Plenderleith report provides much more detail on the specifics of the various forms of assistance provided to the two banks and to the system more broadly, but the basic conclusion is that there were significant subsidies to essentially insolvent institutions in each of the programs he details. Third, the quality of collateral was questionable. The Bank of England lent UK Treasury bills to both institutions against unsecuritised mortgage and loan assets, albeit with significant haircuts in many instances. We know now that housing values were inflated in the UK, perhaps even more so than in the U.S., and that credit ratings on MBS and other mortgage assets were inflated as well. So the ability to accurately assess credit risk, even with the haircuts, was problematic. Finally, the ultimate government takeover, recapitalization, and continued public ownership of these institutions support the inference that these institutions were not experiencing temporary liquidity problems but were in fact experiencing solvency issues, just like many money-center banks in the United States.
What stretches credulity, however, is the Bank’s argument that while it is committed to transparency in its monetary policy operations, it believes that it is critical to the maintenance of financial stability to preserve the ability to secretly provide liquidity and support during the financial crisis. It argued that “[E]xperience suggests that it is more effective for such operations to remain covert [emphasis added] at the time, so as not to further undermine confidence in the institution receiving support.” So, in balancing the competing needs of transparency for monetary policy purposes versus financial stability, the Bank has chosen to hide the fact that it might be providing liquidity potentially to insolvent institutions. Thus, the Bank no longer discloses its total balance sheet on a weekly basis, as it had been doing for over 140 years. It discloses only its complete balance sheet on a quarterly basis with a lag of five quarters. We would note, as an aside, that this policy was put in place prior to Mark Carney’s becoming the current Governor of the Bank of England. Hence he was not responsible for the new policy and presumably would find it politically difficult to rescind it should he wish to do so.
There are several problems with this new policy that should concern not only British citizens but also central bankers across the world. First, covert and undisclosed lender-of-last-resort activities serve to reinforce morally hazardous behavior and undermine the lender-of-last-resort principles articulated by Bagehot. Insolvent institutions that can knowingly borrow covertly from their central bank are thereby insulated from market discipline that would otherwise serve to force management to deal promptly with solvency and capital problems. In fact, one could argue that public knowledge that an institution was borrowing from the lender of last resort on the kind of terms that Bagehot proposes could signal its solvency and hence dampen the incentive for the public to panic. Unfortunately, the tendency for central banks, including the Bank of England, to support insolvent institutions only serves to reinforce the stigma associated with such borrowing. Knowledge of such borrowings will rationally lead the public to jump to the conclusion that accessing the lender of last resort is a sign that the institution may actually be insolvent or facing pending insolvency. The support further serves to undermine the usefulness of institutions’ financial reports, to the detriment of shareholder and debt holder interests, since there is no way to learn whether institutions are or are not borrowing from the central bank. The situation is even worse in the Bank of England’s case, since RBS, HBOS, and remnants of Northern Rock have significant government ownership. Not disclosing their borrowing enables officials to hide financial problems in such institutions while accessing government subsidies through emergency lending facilities. This tactic ultimately avoids taxpayer accountability and permits the institutions to engage in “Hail Mary” risk taking.
In short, the Bank of England’s decision and rationale reflects a fundamental misreading of the financial crisis and its causes. It is likely to increase moral hazard, contribute to financial instability, and burden British taxpayers with the costs of future regulatory failures.