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.

First, Mr. Blythe asserts that my claim – that the BoE leaked information about a liquidity rescue plan for Northern Rock to the BBC – is unfounded. Never mind that the Bank of England has been unable to clear itself by fingering a non-BoE source of the leak. Mr. Blythe then attempts to make his case with a one-two punch, in the form of a non sequitur wrapped in an argument ad verecundiam.  

Specifically, Mr. Blythe informs us that no less than the Governor of the BoE gave evidence to the Treasury Committee of the House of Commons, in which he argued that the BoE “…wanted to provide support to Northern Rock covertly…”

Fine. But, I did not report on what the BoE planned to do. It was the leak, not the plan, which set off the bank run that proved to be Northern Rock’s downfall.

Second, Mr. Blythe then attempts to absolve the BoE of responsibility by challenging my conclusion that Northern Rock was undergoing a “minor, temporary liquidity problem” at the time of the bank run. By insinuating that Northern Rock was insolvent in the first place, Mr. Blythe not only contradicts the Bank of England’s press release of 14 September 2007, but also embraces yet another fallacy; he places the effect before its cause. Indeed, it was only as a result of the BBC’s scoop that Northern Rock’s liquidity problem morphed into a solvency problem.

At the end of the day, Mr. Blythe does get one thing right: “…even when it was supplied with abundant liquidity Northern Rock could not find a buyer...” To that, I would simply add: “…thanks to the Brown government’s bungling of the prospective sale – specifically, the terms that it imposed.”

In short, Mr. Blythe’s erroneous letter only underscores the fact that the Northern Rock affair – from start to finish – was a textbook case of government failure.