The new master of Threadneedle, governor Mark Carney, announced Thursday of last week that the Bank of England was “open for business”.
The winding down of the Funding for Lending Scheme was one trigger for firing this missive. FLS offers potentially unlimited, cheap (25bps) long-term funding to banks and building societies that increase their net loans to the real sector. In view of its impending end, Carney announced that henceforth the BoE would accept an extraordinarily wide range of collateral at its monthly auction in exchange for continued funding; in effect, permanent facilities to ensure that banks never again felt short of the liquidity their treasurers’ hearts might desire.
| Finn Poschmann is vice-president, research, at the CD Howe Institute |
Access would not be limited to banks; broker-dealers are the first candidates for enhanced access, then others, “including financial market infrastructures,” such as central clearing parties for OTC derivatives will be able to join. In other words, the entire shadow banking system may have permanent access to loans on “everything which in common times is good banking security” – something Walter Bagehot thought might be a useful feature for a central bank to have, at least in times of crisis. Evidently a permanent state of crisis is on us. Continuous liquidity access for the shadow banking system is a superb route to that system’s expansion, and for collateral to go forth and multiply. On this, Carney is clear: he is happy if the banking sector multiplies to many times its current size between now and 2050. And he is absolutely correct to be unafraid of a large shadow sector: its activities are fundamental to financial intermediation, yield transformation and the diversification of risk among those who are willing and able to bear it, for a price. The shadows are not to be feared, they are to be loved.
And yet.
And yet, there are the matters of context and human nature.
Begin with the beginning – or rather the eventual end of the FLS. The scheme is broad-based on its surface. But while banks’ and building societies’ access is general, the programmes’ success is measured by increased mortgage lending, mortgage rates that fall relative to some counterfactual, and increased lending to small businesses.
This focus lends FLS a topology akin to the US Federal Reserve Board’s quantitative programmes, including its monthly purchases of the entire flow of residential mortgage-backed securities. On many scores, QE is a US success: if a crisis had been caused by the burst balloon of a housing market, best to patch it as well as you can and reflate. Previously deflated housing prices now bubble merrily, and Wall Street bankers are being laid off by the thousands, owing to a shortage of refis or foreclosures to settle.
And monetarists, to be sure, like broad quantitative measures. What they caution against, as have the dissenters among the Fed’s open market committee, is targeting specific sectors or asset classes. Selective measures cannot fail but to distort asset prices, misdirect resources, or cause sectoral or regional bubbles – say, in housing.
Which brings us back to FLS. It is a deliberately distortive policy measure; the kind economists do not normally favour much. What they recognize, however, is that a policy might reasonably introduce a distortive measure to offset some other market distortion or malfunction, or a distortion introduced by some other policy. As with Australia’s history of pest management policy: if you have got cane beetles, you need cane toads. Or, if money is easy and housing prices are bubbly, you tighten mortgage insurance regulation, as in Canada, to force risk into private sector hands. Which, at this point, seems to be working better than the cane toads.
In the UK, however, the FLS complements easy money and commensurately high inflation – while expectations tick up – and complements the mind-numbing Help to Buy scheme. The latter pickled programme offers homebuyers and traders interest-free home-equity loans to 20% of housing value, as well as mortgage insurance assistance aimed at boosting the market share of high loan-to-value ratio mortgages. To an outsider’s jaundiced eye it's as daft as a bag of hammers. This is policy poured from Alice's 'Drink me' bottle.
It is in this context, rich in market distortions, asymmetric information, moral hazard, uncertainty, politics and elections that one must consider the Bank of England’s openness for business.
In his address, Carney hit the right regulatory notes. Capital regulation should be countercyclical. Haircuts, margining and collateral requirements should be tuned to risks. Other emanations from the Financial Stability Board – such as the likely chimeric and certainly distant cross-border wind-up protocols for large multinational, 'systemically important' financial institutions – are, well, also wishful. As a Reuter’s writer put it: “The governor showed a touching – and possibly alarming – trust in the new recovery and resolution regimes." Nonetheless, such steps fall in the should-do category.
What should be, however, is a different thing from what is likely to be. Countercyclical measures, if in place and successful, will lead to unobservables: balloons that did not burst, like dogs that did not bark. We will wonder why we need them. Lenders, borrowers, derivatives traders and their regulators, meanwhile, will face similar information sets, and their risk assessments will be similar. And a politician will always find a potential and worthy homeowner who is just shy of a down-payment, or, as Franklin Raines, then head of Fannie Mae, put it in 1999: "Fannie Mae has expanded home ownership for millions of families in the 1990s by reducing down payment requirements... Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called sub-prime market."
It is not at all clear that the stability board appreciates the inevitability of such outcomes. Speaking on October 12, Paul Tucker, deputy governor of financial stability, declared too-big-too-fail solvable and nearly solved. Meanwhile, the governor proposes to hardwire backing for trillions of dollars of derivatives trade novation into the central bank.
For all that, Carney is absolutely correct not to fear a large banking sector, even a large shadow sector. What is to be feared is the unintended, the inevitable and currently unforeseeable outcome. They will turn out to be the same thing.
Finn Poschmann is vice-president, research, at the C.D. Howe Institute in Toronto.