Friday, January 27, 2012

Bank of England and HM Treasury agree on covert operations to save banks

HM Treasury and the Bank of England have agreed on a Memorandum of Understanding under which the BoE will conduct covert operations if requested to do so by the Treasury.

Clearly, the areas of the UK government that supervise the financial system believe that the invisible hand works best when there are secrets.

This directly contradicts Econ 101 where students are taught that a necessary requirement for the invisible hand to work properly is that buyers know what they are buying.  How could a buyer of a bank's securities have all the useful, relevant information so that they could assess the riskiness of the bank and know what they are buying if the bank is part of a covert operation?

With ultra transparency, market participants can assess the risk of each bank.  As a result, market participants will demand a higher rate of return from the riskier banks.

Some banks will see this increase in their funding costs and respond by lowering their risks.

Other banks will ignore the increase in their funding costs and increase their risks.  As these banks increase their risk, an interesting thing happens to the ownership of their securities.  Each owner decreases the amount of exposure towards that level that the owner can afford to lose if the bank goes under.  

I think of this as simple asset allocation towards low risk securities and away from high risk securities.  Market participants see failure as a real possibility and adjust their exposure accordingly.  This is the essence of market discipline -- something banks have not been exposed to for decades.

If in fact a bank subsequently fails, there is no pressure on regulators to bail it out as the issue of contagion has already been addressed (investors are only exposed to what they can afford to lose).

Hence, there is no need for a secret operation and this includes when the central bank acts as a lender of last resort.  Please note how the long term refinancing operation undertaken by the ECB has completely eliminated any stigma from borrowing from any central bank.

How is the market better off for the government misrepresenting the financial condition of a bank and conducting covert programs?  It isn't.

The reason the interbank loan market in Europe is frozen like a rock is that no one knows which banks are solvent and which are not.  All the secret government programs have done nothing to answer this question.

If you want to maintain an inherently unstable financial system with regulators contributing directly to financial instability, you don't have disclosure and you allow governments to conduct secret bailouts.

Where the Chancellor directs the Bank to conduct a support operation, either to the financial system as a whole or to one or more individual firms, the Bank will act as the Treasury’s agent. 
The Bank will set up a Special Purpose Vehicle (SPV), separate from the Bank’s balance sheet, to effect the support operation. 
The Bank and the Vehicle will be indemnified by the Treasury. 
Where the Treasury has determined that the operation needs to be carried out covertly, the Bank will execute the operation in a way which best ensures that the existence of the operation does not become public.

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