Wednesday, July 4, 2012

Central banks and influencing interbank lending rates

In his Telegraph column, Andrew Lilico suggests that there is a role for central banks to influence interbank lending rates by offering their opinion as to the soundness of each bank.

Regular readers know that just like governments, central banks should never express their opinion about the soundness or lack there of of any bank.

Saying a bank is sound is making a representation about that bank as an investment.  A representation that carries with it a moral hazard and taxpayer liability.

Simply put, should the central bank's opinion about the soundness of the bank be wrong, the taxpayers are on the hook for bailing out the investors who relied on this opinion in making their investment.

While central banks set the general level of interest rates, they should not opine about the spread the market charges above this rate.  Presumably, the market is charging a larger spread to compensate for what it perceives as the risk of the investment.  That is how capitalism works.

Keep in mind, under the FDR Framework, the role of government is to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner to make a fully informed investment decisions.

For banks, this means that banks should be required to provide ultra transparency and disclose on and on-going basis their current asset, liability and off-balance sheet exposure details.  With this information, market participants can assess the risk of each bank and appropriately price their exposure.

A central bank and the fractional reserve banks under its jurisdiction form a symbiotic system.  A key role of the central bank is to provide liquidity at times of crisis to central banks, if they are worthy recipients of such last-resort lending.  Prudential regulation should properly be conceived as the way the central bank checks and communicates whether banks are indeed worthy.  
In a liquidity crisis, a central bank such as the Bank of England might quite properly tell banks whether it still regarded them, and other banks with which they deal, as sound.  There is nothing improper about that – such communication is an integral part of the role of the central bank.
Everything is wrong about the Bank of England making representations about how it feels about any bank.

Who is to say that the BoE's analysis of any bank is better than the markets' assessment?

All that happens from the BoE providing its opinion is that it creates moral hazard and puts the taxpayer in the position of having to bail out any investor who relied on the BoE's opinion.
Take this as an example.  The Bank of England, if it found that one of the banks – let us call it B Bank – were finding it harder to borrow money than the rest, might have a chat with B Bank to see why.
The BoE already knows that the market prices the risk of different banks differently.  Not much of a conversation to ask a bank why the market considers it so risky
It might reassure senior officials in B Bank that it still regarded B Bank as sound.  It might even tell those officials that it would have a chat with other banks to reassure them as well.  It might also feel that other banks were sufficiently sound that it would be prepared to provide last resort lending to them.  
The upshot of B Bank being sound and other banks being able to obtain cash from the Bank of England if necessary might be that other banks should feel able to lend money to B Bank at interbank rates not wildly dissimilar to the rates those other banks lend to each other. 
A clear case of the BoE saying that the credit spread the market thinks is appropriate for the risk of B Bank is wrong and that it is willing to put the taxpayers money behind the idea the idea the credit spread is wrong.
A perfectly natural way to convey this, perfectly proper, intention by the central bank to reassure other banks about B Bank might be to say that the Bank of England saw no particular reason why B Bank should always be borrowing at the most expensive rate.
To restrain this perfectly natural impulse of central bankers to put the taxpayers money at risk, banks need to be required to provide ultra transparency.  With this information, the market will deliver its assessment of each banks risk and the central bank will not feel the need to offer up its opinion.  

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