Mervyn King said in times of crisis, it is right that central banks step in quickly to support private lenders, but at a cost
Szu Ping Chan 28/02/16
Lord King says the financial crisis of 2008 shows the concept of a central bank acting as “lender of last resort” when financial institutions have run out of options is “in need of updating”.
- Extract one: why throwing money at financial panic will lead us into a new crisis
- Extract two: why the eurozone doesn’t work
- Extract three: Alchemy should be squeezed out of the world’s banking system
In his new book, serialised exclusively in The Telegraph, he says that in times of crisis, it is right that central banks step in quickly to support private lenders, but at a cost.
The most recent financial meltdown showed that these emergency facilities often “failed to penalise banks that took advantage of such support”, offering “inadequate haircuts [on collateral] and low or zero penalty rates” as panic gripped markets.
“It is time to replace the lender of last resort by the pawnbroker for all seasons,” he writes.
“A pawnbroker is someone who is prepared to lend to almost anyone who pledges collateral sufficient to cover the value of a loan – someone who is desperate for cash today might borrow $25 against a gold watch.”
Only by ensuring that “liquidity insurance” is “paid for upfront” will the “incentive for bank runs” be eliminated, he says. “Private financial intermediaries should bear the cost of alchemy,” he says.
“It is time to replace the lender of last resort by the pawnbroker for all seasons.”
“In 2008, banks had very few ‘gold watches’ and plenty of broken ones, and central banks were forced to lend against inadequate collateral in order to save the system.
“Before the next crisis it would be sensible to make sure that the banking system has sufficient pre-positioned collateral, including central bank reserves, to be able quickly to raise the funds to meet the demands of fleeing depositors or creditors who had decided not to roll over funding.”
Mervyn King: Alchemy should be squeezed out of the world’s banking system
Mervyn King, former governor of the Bank of England
29 February 2016 • 9:34pm
An exclusive extract from the former Bank of England governor’s new book
For centuries, alchemy has been the basis of our system of money and banking. Governments pretended that paper money could be turned into gold even when there was more of the former than the latter. Banks pretended that short-term riskless deposits could be used to finance long-term risky investments. In both cases, the alchemy is the apparent transformation of risk into safety.
For much of the time the alchemy seemed to work. From time to time, however, people realised that the Emperor had far fewer clothes than the Masters of the Universe wanted us to believe. The pretence that the illiquid real assets of an economy – the factories, capital equipment, houses and offices – can suddenly be converted into money or liquidity is the essence of the alchemy of the present system.
Banks and other financial intermediaries will always try to finance illiquid assets by issuing liquid liabilities because they make profits by paying less on the latter than they earn on the former. The problem is that the liquidity promised to investors or depositors can be supplied only if at each moment a small number of people wish to convert their claim on the bank into cash. Liquidity simply disappears if everyone wishes to convert their claim into money at the same time. What may be possible for a small number of people is self-evidently impossible for the community as a whole. And the problem is made worse by the fact that if a depositor believes that others are likely to try to take their money out, it is rational for him or her to do the same and get to the front of the queue as soon as possible – a bank run.
Liquidity is, however, only one aspect of the alchemy of our present system. Risk, and its impact on the solvency of banks, is the other. And in the recent crisis, concern about solvency was the main driver of the liquidity problems facing banks. When creditors started to worry that bank equity was insufficient to absorb potential losses, they decided that it was better to get out while the going was good. Concerns about solvency, especially in a world of radical uncertainty, generate bank runs. To reduce or eliminate alchemy, we need a joint set of measures to deal with both solvency and liquidity problems.
The toxic nexus between limited liability, deposit insurance and lender of last resort means that there is a massive implicit subsidy to risk-taking by banks. After the 1980s, when banking was liberalised, the degree of alchemy, and hence of subsidy, inherent in the risk and maturity transformation in the system increased. No individual bank could easily walk away from the temptation to exploit the subsidy. Each bank faced a prisoner’s dilemma. Only by running down its holdings of liquid assets, and financing itself as cheaply as possible by short-term debt, could it keep up with the rising profitability of its peers.
Since the crisis, the official sector has been hyperactive. Moreover, the market itself has imposed its own discipline on banks and other financial institutions. As a result, the banking system has changed a great deal since 2008. The largest banks have become smaller; the balance sheet of Goldman Sachs in 2015 was around one quarter smaller than in 2007. Investment banking is not as profitable now as it was when asset prices were rising in the wake of falling real interest rates.
The balance sheet of Goldman Sachs in 2015 was around one quarter smaller than in 2007
Is all this enough? I fear not. Undoubtedly, one of the motives for the bail-outs of the creditors of banks and other financial firms in 2008 was the conviction that failures of such firms would cause the financial system as a whole to freeze up and contract the availability of credit to the real economy. Whatever the merits of the actions taken in 2008, there is no doubt that an observer could say wryly: “I wouldn’t start from here.”
Runs on conventional and shadow banking systems alike led to a collapse of both. The size and cost of creditor bail-outs were increased significantly by the inadequate amounts of equity available to absorb losses in the banking system. And attempts to provide liquidity insurance through central bank facilities as the “lender of last resort” (LOLR) failed to penalise banks that took advantage of such support, not least because to collect insurance premiums when paying out on the policy is rather late in the day and might have made matters worse.
In 1873, the English political economist and editor of The Economist, Walter Bagehot, published a book that was to become a bible for those interested in how to handle financial crises. Lombard Street, a highly successful account of banking and the money market, explained how the Bank of England could and should have prevented earlier banking collapses by the provision of temporary financial support until the crisis had passed.
As Bagehot knew only too well, banking crises are endemic to a market economy. Although his description of a central bank’s responsibility as a lender of last resort has entered the textbooks, and was frequently cited as justification for their lending by central bankers during 2008-9, it is in need of updating. Banking has changed almost out of recognition since Bagehot’s time. The essential problem with the traditional LOLR is that, in the presence of alchemy, the only way to provide sufficient liquidity in a crisis is to lend against bad collateral – at inadequate haircuts and low or zero penalty rates.
Announcing in advance that it will follow Bagehot’s rule – lend freely against good collateral at a penalty rate – will not prevent a central bank from wanting to deviate from it once a crisis hits. Anticipating that, banks have every incentive to run down their holdings of liquid assets and to finance themselves with large amounts of debt, and that is what they did. It is not enough to respond to the crisis by throwing money at the system to douse the fire while reciting Bagehot; ensuring that banks face incentives to prepare in normal times for access to liquidity in bad times matters just as much.
It is time to replace the lender of last resort by the pawnbroker for all seasons (PFAS). A pawnbroker is someone who is prepared to lend to almost anyone who pledges collateral sufficient to cover the value of a loan – someone who is desperate for cash today might borrow $25 against a gold watch. Since 2008, central banks have become used to lending against a much wider range of collateral than hitherto, and it is difficult to imagine that they will be able to supply liquidity insurance without continuing to do so.
In the spirit of not letting a good crisis go to waste, I think it is possible to build on two of the most important developments in central banking since the crisis – the expansion of lending against wider collateral and the creation of money by quantitative easing – to construct a new role for a central bank as such a pawnbroker. I stress this point because so many proposals for reform create alarm among bankers, and often therefore governments, since they are a step into the unknown.
In contrast, the idea of PFAS is a natural extension of measures already introduced. When there is a sudden jump in the demand for liquidity, the pawnbroker for all seasons will supply liquidity, or emergency money, against illiquid and risky assets. Only a central bank on behalf of the government can do this. But it will do so within a framework that eliminates the incentive for bank runs.
The aim of the PFAS is threefold. First, to ensure that all deposits are backed by either actual cash or a guaranteed contingent claim on reserves at the central bank. Second, to ensure that the provision of liquidity insurance is mandatory and paid for upfront. Third, to design a system which in effect imposes a tax on the degree of alchemy in our financial system – private financial intermediaries should bear the social costs of alchemy.
The essence of a successful pawnbroker is the willingness to lend to almost anyone against extremely valuable collateral. In 2008, banks had very few “gold watches” and plenty of broken ones, and central banks were forced to lend against inadequate collateral in order to save the system. Before the next crisis, it would be sensible to make sure that the banking system has sufficient pre-positioned collateral, including central bank reserves, to be able quickly to raise the funds to meet the demands of fleeing depositors or creditors who had decided not to roll over funding.
In 2008, banks had very few ‘gold watches’ and plenty of broken ones
The PFAS rule is not a pipe dream. Some central banks have already moved in that direction. For example, the Bank of England has for some while encouraged banks to preposition collateral as a way of obtaining liquidity insurance. In the spring of 2015, the value of collateral pre-positioned with the Bank was £469bn and the average haircut was 33pc. Together with reserves at the Bank of £317bn, the effective liquid assets of the banking system were £632bn, compared with £1,820bn of total deposits. There was still a substantial degree of alchemy, but around one third of deposits were backed by “effective” liquid assets.
Alchemy can be squeezed out of the system by pressing from the two ends – by raising the required amount of equity and keeping central bank balance sheets, and hence bank reserves, at broadly their present level. That would allow the PFAS rule to complete the job. Far from being a radical and unrealistic objective, the elimination of alchemy could be achieved by building on actions that were taken during the crisis and the adoption of the PFAS rule. The idea is new, the means of implementation isn’t. There is a natural path from today’s “extraordinary” measures to a permanent solution to alchemy.
The threat to the global economy is the imbalance of spending to saving
The world of Bretton Woods passed away a long while ago, and with it the effectiveness of the post-war institutions that defined it – the International Monetary Fund, the World Bank and the Organisation for Economic Cooperation and development (OECD).
The veto power of the US in the IMF, and the distribution of voting rights more generally, undermines the legitimacy of the Bretton Woods institutions in a world where economic and political power is moving in new directions. It is not easy for any multilateral institution to adapt to major changes in the assumptions that underlay its creation. The continuing refusal of the US Congress [until two months ago] to agree to relatively minor changes to the governance of the IMF threatens to condemn the latter to a declining role.
The stance of the IMF in the Asian crisis, its role as part of the so-called troika in the European crisis, and its reputation in Latin America mean that it is in danger of becoming ineffective.
A key role of the IMF is to speak truth to power, not the other way round as it came close to doing in Asia in the 1990s and in Europe more recently. Misguided attempts to suppress national sovereignty in the management of an integrated world economy will threaten democracy and the legitimacy of the world order. Yet, acting lone, countries may not be able to achieve a desirable return to full employment. There are too many countries in the world today for an attempt to renew the visionary ideals of the Bretton Woods conference to be feasible.
For a short time in 2008–9, countries did work together, culminating in the G20 summit in London in the spring of 2009. But since then, leadership from major countries, the international financial institutions and bodies such as the G7 and G20 has been sorely lacking. They provide more employment for security staff and journalists than they add value to our understanding of the world economy, as a glance at their regular communiqués reveals. Talking shops can be useful, but only if the talk is good.
As time goes by, parallels between the inter-war period and the present become disturbingly more apparent. The decade before 2007, when the financial crisis began, seems in retrospect to have more in common with the 1920s than we realised. Both were periods when growth was satisfactory, but not exceptional, when the financial sector expanded, and when commentators were beginning to talk about “a new paradigm”. After 2008, the parallels with the 1930s also began to grow. The collapse of the gold standard mirrors more recent problems with fixed exchange rates. The attempt to keep the euro together produced austerity on a scale not seen since the Great Depression, and led to the rise of extreme political parties across Europe. Enlightened self-interest to find a way back to the path of strong growth is the only hope.
The attempt to keep the euro together produced austerity on a scale not seen since the Great Depression
The aim should be fourfold: to reinvigorate the IMF and reinforce its legitimacy by reforms to its voting system, including an end to a veto by any one country; to put in place a permanent system of swap agreements among central banks, under which they can quickly lend to each other in whichever currencies are needed to meet short-term shortages of liquidity; to accept floating exchange rates; and to agree on a timetable for rebalancing of major economies, and a return to normal real interest rates, with the IMF as the custodian of the process.
The leadership of the IMF must raise its game. The two main threats to the world economy today are the continuing disequilibrium between spending and saving, both within and between major economies, and a return to a multi-polar world with similarities to the unstable position before the First World War.
Whether the next crisis will be another collapse of our economic and financial system, or whether it will take the form of political or even military conflict, is impossible to say. Neither is inevitable. But only a new world order could prevent such an outcome. We must hope that the pressure of events will drive statesmen.
Extracted from The End of Alchemy (Little, Brown £25) © Mervyn King 2016. To order your copy for £19.99 with free p&p call 0844 871 1514 or visit books.telegraph.co.uk