Tag: central banks

A Threadneedle Street Kerfuffle

On January 10, 2013, I penned a letter to the Financial Times, pointing out an error in its characterization of lending-of-last-resort operations. As the letter below describes, these central bank operations often do not go according to plan:

Sir, Your leader “Basel bends on liquidity rules” (January 8) asserts that: “Central banks can always provide liquidity, and while their facilities should not be a first resort for banks, the Basel Committee is right to signal it will incorporate access to them in its rules.”

You might have added: “But, central banks have a propensity to make a muddle out of what should be routine operations – like those associated with the provision of lender-of-last-resort liquidity.” The Bank of England provides the most recent evidence of this in what turned out to be a catastrophic government failure and arguably the start of the current financial crisis.

On August 9 2007 European money markets dried up after BNP Paribas announced that it was suspending withdrawals from two of its money market funds. This put Northern Rock – a profitable, solvent bank – in a liquidity squeeze. Northern Rock turned to the BoE for a relatively small infusion of liquidity.

This routine lender-of-last resort operation would have worked, according to the textbooks, but for a BoE leak to Robert Peston at the BBC. The BBC story broke on September 13 2007 and the next morning a devastating bank run ensued.

In a flash, Northern Rock went from being solvent (if temporarily illiquid) to bust. Indeed, it was government failure – the BoE’s bungled attempt to provide emergency liquidity – that transformed the Northern Rock affair from a minor, temporary liquidity problem to a major solvency crisis.

So, when it comes to central banks, there is often a wide gulf between the textbooks and reality. It’s time to close the book on Basel III and its liquidity coverage ratio, and to focus on fixing central banks, so that they can properly deliver liquidity, when needed, at a price.

Steve H. Hanke, The Johns Hopkins University, Baltimore, MD, US

To my surprise, what I thought was a simple factual clarification of a Financial Times editorial quickly drew the ire of none other than The Old Lady of Threadneedle Street. Indeed, Nils Blythe, the Bank of England’s communication director was quick to reply in the next morning’s FT:

Sir, In a recent letter (January 11) Professor Steve Hanke made the unsubstantiated claim that the Bank of England leaked information about a lender-of-last-resort operation at Northern Rock to the BBC. This claim is wholly untrue. As the governor made clear in evidence to the Treasury Committee of the House of Commons, the Bank wanted to provide support to Northern Rock covertly, precisely because of the risk of a run by retail depositors.

Prof Hanke also argues that Northern Rock was suffering “a minor, temporary liquidity crisis”. It is worth noting that even when it was supplied with abundant liquidity Northern Rock could not find a buyer and had to be nationalised. With hindsight it is clear that Northern Rock was an early example of the solvency crisis which gripped much of the banking sector in the following years.

Nils Blythe, Communications Director, Bank of England

To put it plainly, I am quite underwhelmed by Mr. Blythe’s argument and evidence. Although it would appear that his response is in line with standard central banking protocol, I found his letter quite concerning for two reasons.

How to Increase the Money Supply, Without Increasing the Government’s Debt

In my August 2012 Globe Asia column, “Money, Where’s the Money?”, I explained why the global economy is still sputtering, and proposed a partial solution. In short, I called for governments (not central banks) to engage in debt market operations – a way to increase the money supply directly, without increasing the overall level of government debt. A number of readers have since contacted me with questions about the specific example I discussed in my column. The most frequent question was:

“Isn’t your proposal just the same as the Fed’s Operation Twist, where the Fed purchases long-term government securities from the public and increases high-powered money?”

The answer is, in short, no – and here’s why:

The first thing that should be noted is that both a central bank and a government can conduct debt market operations. Debt market operations constitute either central bank, or government, transactions with non-banks, which change the bank deposits held by those non-banks. There are many combinations of such operations that can be employed, but with all debt market operations of the type I am envisioning, long-dated debt is replaced with short-dated debt (and so, in one sense, there would be some similarity with Operation Twist).

In my Globe Asia example, however, the government would conduct the debt market operations with no involvement by the central bank. The government would borrow from private banks and purchase outstanding long-dated government debt from the public, and then cancel the debt that had been purchased. The result would be an increase in the money supply, with no change in the monetary base. If the government were instead to borrow from the central bank, both base money and broad money would increase – a fundamental difference.

The central bank could engage directly in debt market operations (and several have done so in recent QE operations). But, in this case, the long-dated bonds purchased by the central bank would end up on the central bank’s balance sheet. The debt would not be canceled out, as it would be if the government was to conduct debt market operations. It is this fact that defines one of the fundamental differences between debt market operations conducted by a central bank and those conducted by a government. A central bank engaged in debt market operations would be left with holdings of long-dated government debt and be exposed to interest rate risk on those securities. It could incur large accounting losses if interest rates were to rise. This would not be the case if the government conducted debt market operations.

If Not Fannie, then Who?

A common defense offered for keeping Fannie Mae and Freddie Mac, or something like them, is that the market simply cannot absorb the same level of mortgage lending without them.  The central flaw in this argument is that Fannie and Freddie themselves must be funded by the market.  So if the financial markets can absorb X in GSE debt, then the financial markets can absorb X in mortgages.

Different market participants currently face different capital requirements for the same assets.  To some extent, Fannie and Freddie were a vehicle for shifting mortgage risk from higher capitalized institutions to less capitalized.  If the Obama administration and bank regulators are serious about closing “regulatory gaps” then all entities backed by the govt, implicit or otherwise, should hold the same capital against the same risks.  In the following I will thus assume that differences in capital requirements behind mortgages are irrelevant.

So to determine who could absorb the GSEs’ buying of mortgages, let’s look at who holds GSE debt.  Of the approximately $5 trillion in GSE debt and mortgage backed securities (MBS), about a trillion is held by commercial banks and thrifts.  Another trillion is held by insurance companies and pension funds.  Close to a trillion is held by mutual funds.  That quickly gets one to 3 trillion.  Households and state/local governments also hold close to a trillion.  That leaves us with about a trillion left, held mostly by foreign governments (usually central banks).  For this analysis, I am using data pre-Federal Reserve purchases of GSE debt/MBS.

Given that banks hold about a trillion in excess reserves and over 9 trillion in deposits, I think its fair to assume commercial banks could easily absorb another $1 trillion in mortgages, as represented by foreign holders.   Some holders of GSE debt are legally prohibited from holding mortgages.  These entities can generally hold bank commercial paper (think mutual funds) which could then fund the same level of mortgages.  

The point here should be clear, by swapping out GSE debt for mortgages, our financial markets have sufficient capacity to replace Fannie and Freddie.  In fact, we are the only advanced country that does not fund our mortgage market primarily or exclusively with bank deposits.  This analysis also does not assume any reduction in the size of our mortgage market, which should actually be an objective of reform.  We devote too much capital to mortgages, at the expense of more productive sectors of our economy.

Great Moments in Bureaucracy

The picture below, taken from a story in The Economist, shows that France, Germany, and Italy are among the nations with the most central bank employees (as a share of the population). In some sense, this is a dog-bites-man factoid. After all, is anyone surprised that Europe’s major welfare states have bloated public payrolls? But there’s more to this story. All three of these central banks ceased to have a monetary policy, starting back in 2002, when their nations adopted the euro. The mission is gone, but the bureaucracy lives on.

Central bank bureaucrats

To be fair, the bureaucrats in these nations presumably are not sitting in quiet rooms playing minesweeper. Perhaps these central banks are responsible for other functions, such as financial regulation. Of course, given how governments around the world pursued policies that led to a financial crisis, perhaps all of us would be better off if bureaucrats did play computer games all day.

Congress Grows Fed Up

The Wall Street Journal reported that Congress likes Fed Chairman Bernanke, but not the institution that he heads. There is growing consensus that the Fed needs to be reformed and restructured.  Most notably, there are calls to strip the Fed of its supervisory authority.  In practice, the new sentiment reflects the failure of the Fed to rein in risk taking by the largest banks.

The Fed is pushing back.  One reserve bank president said that removing the Fed’s supervisory authority “would affect our ability to conduct monetary authority effectively.” He went on to say that without the supervisory authority, the Fed wouldn’t know enough about risks brewing in the economy.  This argument is shop worn. The Fed had the authority. It fueled the housing boom with its monetary policy and failed to head off the banking crisis with its supervisory powers. And let us not forget the regional banking crises of the 1990s; the fallout of the Latin American debt crisis for Citibank; and others (e.g., the failure of Continental Illinois National Bank).  All on the Fed’s watch.

Around the world, some central banks have supervisory authority over banks and some do not.  There is no clear pattern for either monetary policy or bank regulation with respect to how the powers are structured and distributed.  Other factors seem to matter much more. It would be useful to identify what they are.

Congress is moving a few deck chairs around as the ship sinks. No fundamental rethinking of bank regulation is occurring. The Fed is probably being made a scapegoat for Congress’s own failings.  But that is how Washington works.