Letter to the Editor: Basel Bends on Liquidity Rule

Dear Sir:

Your leader, “Basel bends on liquidity rule” (8 January 2013) 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 9 August 2007, the 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 Bank of England 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 13 September 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 is a professor at The Johns Hopkins University in Baltimore, MD, and a Senior Fellow at the Cato Institute.