Monday, August 11, 2014

Mel Kelly — Bank of England to help the City circumvent regulations

When Mark Carney announced last year the Bank Of England “is open for business”, at the time, he claimed it was only to be for banks who were properly and tightly regulated. But with the world distracted by the opening match of the world cup finals, it went largely unreported that George Osborne and Mark Carney also announced in their Mansion House speeches that they intend to rip up Bank Of England lending rules to allow the BofE to start lending to “shadow banks”. 
Shadow banks are not banks at all, but a term coined by economist Paul Culley in 2007 for financial institutions such as investment banks and brokers who lend and invest. If shadow banks investments go wrong their lenders, i.e. banks, consumers and investors, go bust as shadow banks have no back up security from central banks to bail them out because unlike traditional banks they are largely unregulated and have no depositors. 
During the financial crisis, about $400bn worth shadow banking investments shrank to zero within weeks, causing huge losses for lenders and investors, and as Lara Kodres, the Assistant Director of the IMF’s Monetary and Capital Market’s explained in June 2013, “Shadow Banking, in fact, symbolizes one of the many failings of the financial system leading up to the global crisis”.
What could go wrong?

openDemocracy
Bank of England to help the City circumvent regulations
Mel Kelly

5 comments:

Ryan Harris said...

The BoE is in a tight spot on this one. The financial industry plays a very large role in providing jobs and employment to the UK but had grown disproportionately large for the size of the country, with financial debt exceeding 200% of GDP. If they "do the right thing" and carry along and, act as if the finance industry doesn't need a backstop, the industry would certainly in the future collapse as unbacked-banks always do. With a backstop, there is the risk of moral hazard. But perhaps, they've decided that the public has more of an interest than not in the City of London's primary industry. Who decides what is in the public interest? Parliament, I would think.

Tom Hickey said...

Given the politically explosive impact the bailouts following the previous crisis, a more explosive reaction can be expected to the next, which will likely be even bigger.

NeilW said...

I don't see what the argument is here.

The Bank of England has long stopped treating reserve accounts as 'special'. Their ideology is that the central bank and the government are just 'one of the boys' and that the financial market will sort it all out.

All they do is provide short term liquidity services in return for valuable collateral. Why shouldn't that be available to all and sundry?

It keeps the price of assets up and stops things ever being liquidated in a fire sale - which they believe maintains the 'wealth effect' on which all hope for a viable economy is hung.

That's the attitude - because they don't believe that debt is anything other than a transfer between a patient and impatient person.

We used to have clearing banks and building societies in the UK - the building societies were 'shadow banks', clearing via the clearing banks.

And what that meant is that the clearing banks could say 'no' to a shadow firm and force them to contract.

So we have here a difference in philosophy.

Ryan Harris said...

They believe that the only reason the collateral has value is because the central bank is propping up the markets. In their view, without the central bank, all collateral is basically suspect and worthless, I guess. Seems a bit pessimistic.

The system needs fresh reserves from time to time to keep the credit pyramid from collapsing no matter how stringent the risk management.

More of a political argument hiding underneath about the public purpose and fairness of banking, risk management and government's role.

Tom Hickey said...

It's a matter of lending against collateral, in that the purpose of most credit is to liquify collateral at some risk premium. If credit standards are too low for the risk or the risk premium is too low, then the lending is dodgy and liable to become non-performing.

When this begins to happen systemically, then short term liquidity dies up for lenders that are suspect of being in trouble. That puts some firms into a liquidity crunch without a back up system. If systemic risk in endemic, that provokes a liquidity lock-up, which was the source of panics prior to the institution of central banking.

So central banking is huge step forward, as Neil observes, but there is also moral hazard in that some firms will rely on the central bank propping up the system and make loans they would not make otherwise. This can promote systemic risk as all firms compete and so the good are drawn into the game of "musical chairs," as Chuck Prince put it, along with the bad.

If the central bank is to be the lender of last resort, which involves some moral hazard, then there must be regs in place to prevent gaming the system to increase profits through imprudent risk taking and risk management. Banks have stricter regs than shadow banking, so lending is more expensive for them. This drives questionable lending to shadow banks and creates systemic risk.

The cb obviously has an interest in preventing systemic risk from threatening the entire system, so there is a good rationale for acting as the lender of last resort to shadow banks, too.

But that puts regulated banks at a disadvantage competitively and it also makes the financial system more dodgy than it would be otherwise.

So just extending the backup facility of the cb without addressing this is asking for trouble down the line. As we have seen, in the end of financial cycle it is not just a matter of the cb providing liquidity, since solvency enters the picture when imprudent loans go bad en masse due to moral hazard and gaming the system.

It remains to be seen how the BoE intends to address this. They surely are aware of it, and if they are not, regulated bankers will be letting them know, since they will be at a disadvantage.

Or maybe TPTB have concluded that just neoliberal capitalism and the government has to step in periodically and bail out the financial system and major firms to prevent a meltdown. But I doubt the voting public would stand for that on any kind of a regular basis. Maybe once every eighty years or so is OK though.

Economists who believe that money is a neutral veil fail to understand that credit is the life blood of the capitalist economy in that money creation operates through credit and credit largely finances investment, which they wrongly think is paramount.

Without a well-functioning credit system, which means the banking system and financial sector, modern capitalism is impossible without the government creating enough money to fund the system, and capitalists see that as socialism. But they also see regulation as socialism.