The results of the Bank of England’s auction today reveals that ideas that should work in theory may not work so well in practice. The auction was to make funds available at a penalty rate (1% above prevailing interbank rates). The mechanics are different, but intent is similar to the use of the discount window in the US.
The notion comes from 19th century economist Walter Bagehot, who argued in times of stress that central banks should lend against sound collateral at penalty rates. The idea has been roundly endorsed by Martin Wolf of the Financial Times as well as other economists.
The problem was that no one showed up. From Bloomberg:
U.K. commercial banks shunned the Bank of England’s three-month money auction after a drop in market interest rates enabled them to avoid the potential stigma of borrowing at a penalty rate.
Financial institutions made no bids for the 10 billion pounds ($20 billion) that the central bank offered to ease strains in the money market, the Bank of England said. The cash was made available at a minimum rate of 6.75 percent, 1 percentage point above the Bank of England’s benchmark….
The Bank of England said it still plans to go ahead with three further weekly sales of three-month cash. The next will take place on Oct. 2.
So why was this operation a bust? Some claim that it shows that the Bank of England is out of touch, but the roots are more complicated.
First let’s start with an overview. From the Financial Times:
Under the auction, banks were able to offer much lower quality collateral than normal for Bank of England cash, something that represented a U-turn for the central bank. It said it would continue with its plans for further auctions of three-month money at at least 1 percentage point above its official rate of 5.75 per cent to ensure a “safety valve” remained in the system.
A spokesman said: “The auction was designed as a safety valve in the light of concerns that arose about potential pressures in the banking system more generally as a result of Northern Rock”.
Interbank interest rates have fallen fast in the past week after the rescue of Northern Rock and the subsequent run on the bank. Three-month interbank Libor rates dropped to 6.32 per cent on Wednesday, well below the 6.75 per cent quoted rate on the day before the bank announced this facility last Wednesday.
While it’s tempting to depict the Bank of England as flat-footed, the problem is a bit more complicated. First, the immediate crisis has abated, so one could regard the lack of demand as a sign of success.
Second, however, is that there is considerable stigma attached to using these facilities, and rightly so. Any bank that had better funding options would use them. When the Fed lowered the discount rate, only a few banks stepped forward after some exhortation by the Fed, and for the most part it was a symbolic gesture by banks who did not need the money. That is a nice show of support but still does not solve the conundrum that bidding at this auction would be seen as a sign of distress.
In our modern day world of rapid flow of information, the move to use the Bank of England’s facility could lead to counterparties becoming even more chary of dealing with a weak institution, increasing funding pressure. Similarly, directors in the UK are personally liable if a company is deemed to be trading insolvent. One might argue that the need to go to the Bank’s auction shows that a company is on the brink and perhaps should be wound up.
John Kay in the Financial Times pointed out the dangers of this approach and suggested a fairly modest remedy of having failed banks put in the hands of an administrator. This is far tougher than the treatment they’d get in the US (troubled institutions can hold their creditors at bay by using Chapter 11, but for banks, the existence of Chapter 11 gives them a much longer window to arrange a sale).
The British government, planning to privatise water utilities, was forced to recognise that these could not be like other businesses. If a hairdresser, or a burger bar or even a car plant failed, the shop or factory would close. But if a privately owned water company failed, it would not be enough to post a notice on the reservoirs and sewage treatment works telling potential customers to contact the liquidator. Even if the flow of cash to the business ran dry, the taps must not.
So for water and some other utilities there is provision for a special administrator with the responsibility to ensure continued service. There are other commodities for which financial problems of the provider cannot be allowed to interrupt supply. It would be intolerable for a bankrupt care home to turn its residents in to the streets or for a failed hospital to abandon patients. An airport cannot tell aircraft not to land until its banking facilities have been renewed.
Ad hoc solutions to these problems are usually cobbled together in haste. A shotgun marriage is arranged with a solvent institution or a financial bail-out is organised. But these are not satisfactory solutions….These rescue schemes do not give enough protection to customers and give too much protection to managers and investors of the failing concern.
A hard budget constraint means you shut when you run out of cash; a soft budget constraint means that when you run out of cash you lobby for more. Bankruptcy is the hardest of budget constraints, although provisions such as Chapter 11 soften it – perhaps too much. Failing organisations argue for constraints to be softened. They are too big or too important to fail, like Chrysler or Alitalia. They are too complex to fail, like Eurotunnel, or too embarrassing to fail, like the Royal Opera House….
The concept of special administrator was designed to keep budget constraints hard. Weak organisations could not wield the threat of consequences for customers in order to extract money because financial failure would not imply a loss of service…
The priority of customer service should hold even at some cost to shareholders and creditors, who take that risk in return for the potential rewards of investing in essential public services.
Not by coincidence, the industries for which a special administration regime is appropriate are mostly subject to scrutiny by specialist regulatory agencies. That agency should have the responsibility to put a special administrator in place if needed. The existence of a supervisor is a good guide to the sectors where that need might arise: utilities, infrastructure, health and education – and financial institutions that deal directly with the public.
The notion that private companies can extract indiscriminate, industry- wide support from the public for the benefit of their investors by threatening that their weaker members will collapse is intolerable in any sector. And it is most intolerable when the sector is as profitable as financial services.