The big news for students of the unfolding economic story is surely Mervyn King’s appearance before the Treasury Committee.  As anyone reading the last Inflation Report* will gather, the Bank’s estimates for the economy has turned down. Today, specifically, he is worried that Europe’s weakness will impact on us.  Other signs are weak, like lower mortgage approvals. But as Simon Ward highlights (see earlier post today) the signs of cost-push inflation are present.  Mervyn’s job is not easy.

What puzzles me slightly is this:

The governor also repeated his insistence that the government’s three-year special liquidity scheme, which allowed banks to exchange hard-to-sell assets such as mortgage-backed bonds for more liquid gilts, will not be extended, and urged banks to find other sources of funding before the scheme starts to expire early next year.

Now, the Inflation report said:

it is likely that credit conditions will remain restrictive for some time and that the need to strengthen public and private sector finances will weigh on spending.

The Bank has a tool that helps credit conditions; it thinks the economy faces a risk of weakess; it doesn’t want to help a portion of the credit problem beyond a fixed date.  What does the Governor think this announcement of an impending end to such support will do to conditions today?

In my doggerel about QE, I quipped:

the Lady of Threadneedle Street's a curious kind of prude
Who'll debauch herself on public debt, but think it beastly crude
to grant her money favours in the world of private credit
Even though a loss is still a loss, not matter what risk bred it.

Clearly the prospect of unbearable loss is not what is putting the Bank off: if inflation expectations rocket, the Bank could take a £40bn bath on its gilts, and the Treasury indeminfies it.   So the nervousness about private credit must run deeper; a fear that it distorts the real economy.   I would argue that the greater distortion is coming from the unusually stressed and uncertain condition of banking, which means you only get credit if you’re big.  Remember, the NIESR likes credit easing too …. this is not just for commies.

UPDATE: Paul Tucker’s speech about, well, everything at first glance, looks like a must read.  I’m afraid. It touches on where it thinks the MPC has gone wrong in the past few months about inflation.

*I personally think it is a wonderful education, and worth printing out to ‘enjoy’ at leisure.  What is happening to me?

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6 thoughts on “If the Bank is worried, why is it closing down the Special Liquidity Scheme?

  1. Giles,
    Do you know the spread between ordinary and inflation linked gilts at the moment?
    Would that give us an idea of expectations for future inflation?
    BYW I’m still backing you over this Guido chappie.
    B

  2. You need to distinguish between liquidity needs of banks and their equity capital needs.

    EQUITY CAPITAL NEED
    When a bank adds a loan (say £100) it adds to its risk weighted capital (say £100 for simplicity). The FSA currently requires a banks tier 1 capital (essentially equity) to be around 10% of the risk weighted assets.
    So a making a loan of £100 requires the bank to have £10 of surplus equity (or raise it). Banks have some control over this in the long term and now have lots of capital, even to meet the FSAs excessive 1:10 requirement.

    LIQUIDITY
    When a bank makes a loan of £100 it needs an extra £100 of cash, £10 from surplus equity and £90 extra to be borrowed from new deposits or the wholesale money market. If confidence is lost in a bank it just will not have the liquidity regadless of how much capital it has. Banking can only work by agreeing to lend longer term (eg 25 year mortgages) than they can possibly borrow (no one places 25 year fixed deposits). This is why governments should always stand behind well capitalised banks with liquidity when they need it – otherwise banking will not take place. So the Bank of England should always be ready to provide liquidity when there is a liquidity crisis (but not an equit capital crisis).

    1. Yes, I agree; but isn’t liquidity likely to be a problem in the next few years? The funding gap; deposits growing slowly; a lot of them heading off into unit trusts and not banks; and so on.

      (damn, should have put some of these points in the paper)

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