Monday, 17 September 2007

All Hail The King

Here is the edifice that houses the Lutine Bell in Lloyds of London. Traditionally the bell was sounded to signal bad (or good) news in the insurance market.

Talking of bad news, two Bloomberg reporters seem to have it in for Mervyn King:

Two days after King, 59, told lawmakers on Sept. 12 that central banks should avoid giving the impression they will help lenders that made bad decisions, the Bank of England provided emergency funds to Northern Rock Plc in the biggest bailout of a British bank in three decades.

Subsequently the Bank has been forced to guarantee all of Northern Rock's depositors (as opposed to 100% of the first £2000 then 90% of the rest up to a maximum of £33,000* under the UK's Financial Services Compensation Scheme).

``It's a crisis of confidence, and the bank is confused,'' said Patrick Minford, an economics professor at Cardiff University who advised former Prime Minister Margaret Thatcher. ``They want to be hands-off, but in this situation they can't be. I don't think this has done King any good.''

Minford was Thatcher's economist, a recognised hardliner and currently out of political favour. Perhaps he isn't the most disinterested observer of the situation?

Bloomberg continues:

King's credibility is in question for his refusal to emulate other central banks and take early action to help cash-strapped lenders. With Northern Rock's failure, he is finding himself subject to the same charge of excessive caution being leveled at U.S. Federal Reserve Chairman Ben S. Bernanke, whose office adjoined King's at the Massachusetts Institute of Technology in the 1980s.

Horror of horrors, two intellectuals. Your money cannot possibly be safe with anyone who went to M.I.T.

King held back until markets forced his hand. Last week he said that too much help ``encourages excessive risk-taking, and sows the seeds of a future financial crisis.''

And he was right to do so. The only criticism of King I would offer is that he failed to engineer a takeover of Northern Rock by Lloyds or HSBC earlier in the week, something that would have represented the typical dirigiste approach of the Bank to a crisis (cf. ING's purchase of Barings). But someone will come along sooner or later with an open pocket, and meanwhile King is rightly signalling to the market that institutions must bear the consequences of their own liquidity risk management decisions.

*One might argue having only a 90% guarantee introduces an incentive which encourages bank runs: no one wants to lose 10% of a chunky amount of money. Perhaps now we are actually seeing bank runs again HM Treasury, the Bank and FSA might like to redesign the scheme?

Update. Willem Buiter and Anne Sibert writing in the FT are wrong about liquidity premiums:

The Bank is not blameless in the Northern Rock debacle, however. A bail-out might not have been needed if the Bank had a more sensible collateral policy for its open-market operations and discount-window borrowing. The ECB accepts private securities rated at least A-; the Bank should too.

This risks the Japanese problem of excess liquidity and a lack of liquidity premiums causing falling returns on illiquid assets, deflation, and a reluctance to invest. The Bank absolutely should not accept dodgy collateral at the window in ordinary conditions. It should widen the definition of eligible collateral when necessary to manage the three month swap spread but not otherwise.

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