FOR the past fifteen months, the Bank of England (BoE) has been backpedalling. Instead of coasting, the UK economy has stalled. The government’s bold and sensible plans for budget deficit reduction are broadly on track for the next few months, but will not remain so unless the central bank shapes up to the challenge of restoring the flow of credit to the private sector. Neither the 0.5 per cent Bank Rate nor the resumption of gilt purchases addresses the fundamental problem: a broken wholesale funds market. The BoE’s strategy of rapidly weaning UK banks off emergency liquidity support has proved a disaster for the domestic economy. Moreover, it has exposed UK banks to additional stresses in the face of a Eurozone banking contraction. The eagerness of the politicians to “fix the system” as a bulwark against any future banking crisis has had the diametrically opposite effect. A reintroduction of the Special Liquidity Scheme is urgently required.
The UK banking system entered the global credit crisis with a massive shortfall of domestic customer deposits relative to domestic customer loans, known as the customer funding gap. This gap, which grew to £800bn by the end of 2008, was filled for many years by short-term bank borrowing from the international wholesale funds market. The US subprime crisis erupted in August 2007, triggering severe funding problems for UK banks, especially Northern Rock. Over the next 18 months, the central bank launched a barrage of measures intended to stave off the crisis, including a cut in Bank Rate from 5.75 per cent in December 2007 to 0.5 per cent in March 2009, where it remains today.
Arguably the most significant intervention was the Special Liquidity Scheme (SLS), launched in April 2008, which accumulated £287bn of securities – mostly residential mortgage securities and covered bonds – against which the BoE lent £185bn of Treasury bills. As recently as June this year, the central bank boasted that strong debt issuance, deposit growth and loan shrinkage had allowed UK banks to “reduce official sector liquidity support more quickly than planned.” The strict timetable for the return of SLS funds forced banks to make their replacement top priority. This has superseded the various initiatives and incentives designed to promote bank lending to the private sector, whether as home loans or commercial loans.
Despite the repetition of the very same threat that plunged Northern Rock into darkness four years ago, the BoE is adamant it will close the SLS by January 2012. UK banks have been preparing for this, holding back from net new customer lending and reining in their unused credit facilities by 11 per cent or £31bn since September 2010. This has robbed low interest rates of their expansionary vigour and denied to the UK economy even the temporary phase of rapid economic recovery that normally follows a slump.
The BoE has adopted the position that the structural liquidity support for the banks should be temporary while the compression of interest rates, extending across the government yield curve, should continue for a considerable period. This combination is wrong-headed and counterproductive. As Professor Ronald McKinnon of Stanford University has recently pointed out in the US context, the continuation of near-zero short-term interest rates poses a credit constraint on the banking system. Low interest rates only stimulate faster credit growth when interbank rates are comfortably above zero. Banks with good opportunities for lending to individuals and small and medium-sized enterprises (SME) typically do so through the extension of credit facilities. These credit lines, like an overdraft facility, can be drawn down when the borrower requires them. For the bank, this creates uncertainty over its net cash position. An illiquid bank would be in trouble if its customers decided to use up their credit lines in a synchronised fashion, as can happen in a soft economic patch.
If banks had ready access to wholesale funds through the interbank market then it would allay their fears of illiquidity. They could cover unexpected shortfalls by borrowing from banks with excess reserves without needing to offer collateral. However, with the interbank rate barely above 1 per cent, strong banks are unwilling to part with surplus reserves for a derisory yield. Weaker banks cannot readily bid for funds at an interest rate well above the interbank rate without signalling that they might be in trouble. The BoE’s new contingency liquidity facility is welcome, but carries the stigma of the discount window and doesn’t address the structural problem.
The solution is to reverse the BoE’s position: to reinstate the SLS for an extended period, and to begin to reconnect Bank Rate to the market interest rate structure. Bear in mind, average interest rate on bank and building society accounts with notice periods at end-November was 1.78 per cent. The logical response to the Eurozone threat to UK wholesale market funding is to strengthen substitute liquidity facilities for UK banks, not to suppress interest rates.
Peter Warburton is director of Economic Perspectives and a member of the IEA’s shadow Monetary Policy Committee.