Tuesday, September 04, 2007
Has the Bank lost control of rates?
Posted by David Smith at 12:45 PM
Category: Thoughts and responses

Bank rate is steady at 5.75%, where it will surely remain on Thursday, but three-month interbank rate has risen to a nine-year high of nearly 6.8%. The credit crisis has effectively tightened monetary policy, both in terms of the price of money and its availability. What should the Bank do? The last time money market conditions were like this, in the autumn of 1998, it cut interest rates aggressively. We can be sure this will the main topic of discussion at the monetary policy committee's meeting this week.


If the BoE want to assist with the interbank problem, their first action would be to inject liquidity via their open market operations, as the Fed and ECB have done. Only if this didn't work would they then resort to cutting base rates. So far they have not done the first, so I can't see why they would do the second.

Posted by: Minh at September 4, 2007 02:30 PM

With the libor coming out today at 6.7975 and the BofE discount window at 6.75, why do financial institutes not borrow from the bank over night and lend to those institutes in need of margins over night at libor or above, like Barclays for example who seem to have difficulty getting any funding at the moment?

But more importantly why would an instutute like Barclays need to go to the cash market rather than borrow directly from the BofE?

I do not understand how or why the libor can be above the BofE discount rate, surely the BofE are goign to take action this week, at least lowering their discount/penal rate if not their main interest rate?

Interesting times indeed...

Posted by: James Trouble at September 4, 2007 05:13 PM

James - I think there is still a stigma attached to using BoE as lender of last resort, and probably rightly so.

The reason banks don't perform the arbitrage you've suggested is that if the bank they lend to doesn't repay the money, they still have to pay it back to the BoE. They are clearly not happy to lend to each other at the moment for 3 month terms, whatever the rate of interest on offer.

Like I said about the BoE taking action, so far they haven't attempted to use their open market operations to bring the LIBOR rates down, so they are obviously happy to let the situation stay as it is. If they had tried and failed, that might be different.

Posted by: Minh at September 4, 2007 07:05 PM

My understanding is that the Bank believes it can influence the overnight rate by providing liquidity but that it has limited traction when it comes to the three-month interbank rate. If so, as you say, it may be better not to have tried than to have tried and failed.

Posted by: David Smith at September 4, 2007 08:24 PM

It seems fairly obvious to me. The MPC's job is to keep inflation at target two years out. If it believes volatility in inter-bank rates threatens that objective, it will alter policy. And only then.

Posted by: Sell Everything at September 4, 2007 08:52 PM

That's a bit too obvious I think - the Bank also has a wider responsibility for financial stability. This is its own description:

"One of the Bank's two core purposes is to maintain the stability of the financial system. The Bank has to make sure the overall system is safe and secure and that threats to financial stability are detected and reduced. By monitoring and analysing the behaviour of participants in the financial system and the wider financial and economic environment, the Bank aims to identify potential vulnerabilities and risks, with a view to making the system stronger. The Bank's role includes oversight of payment systems - a crucial part of the financial system, which facilitate transactions between individuals, businesses and financial institutions."

Posted by: David Smith at September 4, 2007 10:28 PM

'Sell Everything', that's not the banks primary purpose though is it? It's first role is to keep the financial systems running smoothly, to act as lender of last resort.

If the bank refuse to act and this credit crunch spirals out of control, the BofE will have been the only central bank to have not done anything. They will lose all credibility, and history will show they are responsible for the biggest financial meltdown in living memory.

Why woudl they not act? Because of a breif blip up in inflation to slightly above the target rate? Small fluctuations in inflation at this point in time are totally irrelevent to what is going on. The risk of inaction is financial melt down, is that a risk worth taking? Sorry David, it's not too often I disagree with you, but the risk of inaction is catastrophy, the risk of action is what?

What harm will it do to cut the discount/penal rate to make sure that this credit crunch does not bring down one of the institutions? If they are wrong, what is the down side? They put the rate back up. Perhaps they will lose some 'respect', but I don't see economists looking unfavourably at The Fed's decision to reduce their discount rate, even though the US libor is now even higher than before they cut their rate.

It's a mess, and as has been said about Merv and his team before, it's about time they put their foot on the ball.

Worse case scenario in my opinion is they release a no change rate policy, and no statement. I think there'll be carnage in the front end of the curve in this scenario and they won't want to risk that...

Minh, you say there is a stigma attached to borrowing from the central bank, but this is business here, the libor is now much more expensive than the central bank offers. Surely stigma doesn't come into profit/loss situations? And if you are saying that nobody is prepared to lend to Barclays at the libor rate, because of the risk they will not pay it back, are any of us safe having our money in these institutions? And besides, as the libor is above the BofE base rate, surely if one lends money to these banks like Barclays at libor, with money one has borrowed overnight from the BofE, and Barclays can not pay it back, then the BofE then has to lend barclays the money at the dicount window, as lender of last resprt to prevent financial meltdown of the system?

do you follow my thinking? It just seems a bizaar situation, and I don't buy into the "stigma" thing, especially concidering the Barclays top chap has been in the press virtually begging th bank to help them out.

Interesting times...

Posted by: James Trouble at September 4, 2007 10:56 PM

We'll see how today pans out. But James, I think you're aiming at the wrong target. I haven't been arguing against a rate cut if this situation deteriorates, merely reporting the Bank's apparent unwillingness to go down that road.

Posted by: David Smith at September 5, 2007 10:03 AM

Thanks for the reply David, I was responding to your comment "it may be better not to have tried than to have tried and failed".

My point is that if they wait till the financial melt down has already started it may be too late and their inaction would go down in history as one of the main causes of the impending disaster while the other central banks did their best to restore normailty.

The bank is playing a dangerous game in my opinion, that is getting more and more dangerous everyday they sit on the sidelines. I see libor has gotten another wack today, looks like it's coming out higher yet again, although it's getting a bit irrelevent now as there is little business being done there. It could be a percentage point higher or lower, I still don't think anyone is lending anyone else money at the moment, because of the risk of meltdown...

I'm surprised by the rampant stocks in the face of such risks...

As you say, should be interesting...

Posted by: James Trouble at September 5, 2007 10:50 AM

BofE just announced they are basically doing nothing. Short sterling reacting very badly to this news. I'd be intersted to know your views on their action David? Short sterling is falling out of bed by the looks of it...

Posted by: James Trouble at September 5, 2007 11:17 AM

That is a bit of a surprise - see Alex Brummer in today's Daily Mail for the view that something significant was about to happen. I guess from a monetary policy perspective the Bank is taking comfort from the strong CIPS data. It must also be more confident about financial stability than some market participants.

Posted by: David Smith at September 5, 2007 11:29 AM

Yes, a surprise alright! Saw those comments in the daily mail, or rather heard about them, I don't normally read daily mail ;-D

I thought the bank were goign to take action the other way. Interestingly, I was told that the bank are denying they had a meeting today with the top chiefs of the high street banks, but I've heard form a source that that is not the case, and obvously it is very unusual to be meeting with bank chiefs during their rate setting meeting.

As you say, the bank are obviously very confident in the financial system, and/or they are prepared to send the econmy into a recession to avoid the moral hazard of bailing out some of the banks.

Maybe in the long run they will be proved right, but I'd hate to be in their shoes if the equities fall 25%+ lead by a high street bank going under. I personally wouldnt' think that's a risk worth taking...

Looks like equities are slipping away on the back of this news. Have we seen the highs?

Posted by: James Trouble at September 5, 2007 11:40 AM

The Bank isnt there to ensure 3m and 6m Libor rates dont get excessive. They will only make sure that o/n rates stay relatively close to Bank rate. Financial system stability is clearly still in tact in this case.
By their statement today they have just taken the guesswork out of the market by stating they will not step in to move longer maturity borrowing rates. Now at least the market participants know where they stand.
And there is no appetite to arbitrage between lending at 3m rates (6.80% today) and borrowing overnight at a worse case 6.75% off the BoE. Bank Treasury desks are in lock-down mode. They are not in a situation to lend to anyone, especially for 3m at the moment....Also, as most desks work on a mark-to-mkt and not an accruels P/L basis, if rates blew out to 7 - 8 % the paper losses would be huge.

Posted by: Simon at September 5, 2007 11:53 AM

James, there isn't a great deal the BoE can do to start banks lending to each other if none of them want to. The market needs some transparency regarding bad debt, not just being able to borrow at lower rates from the BoE.

What we are seeing at the moment is a lack of information leading to fear.

Posted by: Labarte at September 5, 2007 11:58 AM

Thanks Simon, but is the carnage in the front of the short sterling curve not a sign of lack of liquidity in the cash market? That's a clue to the instabilty, no? I'm not sure, I've never seen anythign like this before.

And as for market participants knowing where they stand, I'm nto sure that is the case. At least the bank has shown some of it's hand, do you not get the feeling they have more cards they are likely to play? The question is when and what are the cards...

Uncertainty has not faded in my opinion.

It does get more interesting though...

Posted by: James Trouble at September 5, 2007 12:06 PM

LaBarte, yes, I agree.

Posted by: James Trouble at September 5, 2007 12:08 PM

Agreed there is significant uncertainty. But that is what makes a market move. If everyone knew everything with utter certainty, prices would instantly move to the appropriate level and never move.
The Bank wants to signal that they will do as little as possible to save them from moral hazard problem. They bale out banks now, and they will be even more reckless in the future.
Let these money machines suffer some losses for a change. They can suck it up.
Fancy it gets worse before it gets better, but Armageddon isnt here yet.

Posted by: Simon at September 5, 2007 12:26 PM

Agreed Simon, they are more than happy to make money when thigns are good, let them lose when things are bad. Bull markets make genius out of idiots. But let's hope the problem is not as deep as I fear and a serious economic crash is not a risk we should be taking just to teach these idiots a lesson...

Posted by: James Trouble at September 5, 2007 12:29 PM

BoE is clearly behind market rates.With the sub-prime turmoil it has seen banks being squeezed out of cash and therefore interbank lending has come to a minimum, however what if it were that short term interest rates were higher?

Lower interest rates dont auger well for making huge investments in CDOs and other asset backed securities.The money making machine at the banks is creaking with all the volumes that have transpired until now, thereby exaceberating inflation and thats where the problem lies. Broad money was also indicative that all is not well .

I suppose IR have a long way to go and hope the MPC sees some light in this and in any case o/n lending is supposed to be higher, isnt it? The best bet would be to be watchful of unfolding events and then continue with the rate hiking trend.

Posted by: Hitesh Damani at September 5, 2007 01:24 PM

I don't think BofE are behind the curve as such, I really don't think they have any wish or need to raise rates anymore and they are not going to. The way the sterling has reacted shows how shocked the markets are to their attitude. They have a problem now, the markets are dictating interest rate policy, not the BofE.

I've got a feeling we will see the result of inaction, front month short sterling now 15 ticks down form today's highs, sat on the lows now.

BofE playing a game of russian roulette with the market in my opinion, they might win, and come out the other side looking cool, calm and collected. But if they're getting it wrong....Ouch.

Posted by: James Trouble at September 5, 2007 02:00 PM

ECB have just said they stand by ready to act if the turbulance continues tomorrow.

Seems BofE and ECB have different ideas about how to handle this situation...

Posted by: James Trouble at September 5, 2007 02:15 PM

Does the high LIBOR feed through to increases in retail standard variable rate mortages ?
If so, what is the time delay ?

Posted by: Nick Thorne at September 6, 2007 12:17 PM

Yes, some variable and tracker rates are already rising, though there are better fixed rate deals around as a result of the drop in government bond yields. Here's a link to a piece the BBC did on this the other day:

Posted by: David Smith at September 6, 2007 05:42 PM

Does the lack of bank co-operation greatly effect the economy?
considering the huge profits they make every year and the consequences of what will happen if there is a collapse and the effect it would have to the average person.
at the end of the day most banks are plc compaines and are expected to make money or the shares will fall..and genrally that is what they are quite good at. so does the BofE really need to get involved?

Posted by: doser at September 6, 2007 10:39 PM

Doser, yes it does matter - a lot!

The banks are the oil in the machinery of our economy. They provide finance for businesses as well as individuals. Many of their market lending instruments are at interest rates linked to various flavours of Libor.

If your business over-draft or working capital loan is at 150 basis points over 3 month Libor, then your interest rate has just gone up 1% - even though the BOE has done nothing.

The base rate is, frankly, almost becoming an irrelevence. Apart from over-night bank transactions, nobody seems to be taking any notice of the base rate - the market is finding its own level.

Fundamentally, the fallout from the sub-prime mortgage debacle in the USA has meant the institutions directing our savings (pension funds, hedge funds, insurance companies) have lost their appetite for colateralised debt securities. The sale of CDS instruments by banks has been the conduit for huge amounts of international savings money and "carry trade" finance flowing into economies like the UK to fund private equity M&A and commercial property activity.

Without the savings institutions to sell the debt to, some banks are left with huge debts on their books that have left them seriously short of money to lend out to participants in the "real economy" such as businesses and individuals. Even if a bank does not have this problem, they are reluctant to lend money to another bank who may have.

However demand in the economy has not abated, so persistent high demand for new debt (working capital, mortgages) is combining with a low supply of money. High demand and falling supply = an increaese in price. The price of money is the interest rate. Therefore interest rates are being forced up and this will affect everybody.

Posted by: Matt at September 7, 2007 11:41 AM

Tragedy, commedy, or farce?

The Central Banks intentionally catalyse a massive credit boom, and actively promote, or at least turn a blind eye to, a property bubble on both sides of the atlantic.

The credit bubble pops alongside the US property bubble.

Then, out if the woodwork come people like Diamond, who was paid 22Million last year on the basis of his massive and overtly risky expoitation of the credit bubble, with pleas for bail outs.

This thread shows that many support this form of crony capitalism and would like to see the the bubble inflated at all costs.

Economies becomes wealthy due to capital formation and consequent productivity growth. Economies cannot grow forever on easy-credit supporting asset bubbles, supporting domestic consumption.

Why do so many supoort the perpetuation of of bubbleomics? We need corrections and crises. Where capital is grossly misallocated there needs to be consequence.

It's good to see the markets setting the rate, and not the Bank, which is far too closely involved with the government of the day.

If the bail outs suceed in re-inflating the bubble, it will only make the bang brighter later.

I've never seen such a display of wanton hipocrasy as that shown by the financial elites of late in their cries for intervention. Brtual free marketeers when the going is good, cry baby socialists when things turn ugly.

Posted by: T Gumbrell at September 7, 2007 01:16 PM

T Gumbrell - I couldn't agree more. I find the squealing from some quarters quite amusing.

No doubt Mr Trouble and Matt are CDO salesmen, credit traders or something similar and are absolutely gutted that their bonus will be slashed this year. Bob Diamond's comments earlier this week were a disgrace.

It seems to me that these people are suggesting banks react asymmetrically to asset prices. David - you suggested that the BoE's mandate was to ensure financial stability as well as price stability. But it seems to me that argument goes both ways. Yet central banks haven't raised rates over the last 3-4 years while financial markets have been in party mode, even though that might have tempered some of the financial excesses that have built up. They've raised rates because economies have been strong and inflation pressures have been building. So why should central banks throw money at the problem and slash rates now because asset prices have fallen? If it impairs the broader economy, fine, but only at that point.

Lets have a look at some recent data: CBI industrial orders - strongest in 10 years; manufacturing PMI - strongest in nearly 5 years; construction PMI strongest in its 10 year plus history; services PMI - still close to cyclical highs.

OK, so some of this data applies to the period before markets started to blow up. But still, does it look like the economy was on the verge of oblivion? No. So why should the Bank step in and cut rates now? Oh! Sorry, I forgot. That hedge fund manager who's spent 20 million decking out his pad in Kensington that cost another 20 million has lost a few quid and now he can't afford the Bentley he's been eyeing up.

This all has me really annoyed. Does it show??

Posted by: Sell Everything at September 7, 2007 05:31 PM

Sell Everything - Absolutely.

Your comments on assymetrical reaction are bang on. The UK has being growing above trend for months, inflationary pressures are building still, money and credit growth is abnormally high, the property asset price bubble has still not been pricked, so why should there even be a discussion about lowering rates?

The Bank didn't stop the asset and credit bubbles developing, so why should it help them stay inflated? It's remit is to fight inflation. It should not bail out the big boys when their bubbles pop.

Yes, it also has a remit to maintain the stabilty of the system. But surely the stabilty of the financial system would only be further prejudiced in the long term if the Bank weakens its stance. The creation of moral hazard is the biggest threat to the long term stability of our financial system, not some funds going bust, or even a bank if that's what's needed. Any bail-outs will have to be paid for further down the road as more excess and indulgence take root.

Posted by: T Gumbrell at September 7, 2007 05:59 PM

I think I need to put my Michael Winner voice on here and say: Calm down dear(s). If it is the case that all that is happening is that a few bankers and hedge fund investors are going to lose some money, fine. If the situation has created a wider economic risk, and effectively tightened monetary policy, then the game has changed. As the Bank said, it is a bit too early to make that judgment, but it won't be too long before we can.

Posted by: David Smith at September 7, 2007 06:17 PM

Dear David,
Responding to some of the comments above, I do not think all traders will necessarily see a drop in their bonus. Those who can correctly spot under(over)-valued assets should be able to trade accordingly and indeed be rewarded for this. It simply needs harder work during a financial crisis.
Many thanks

Posted by: Costas Milas at September 7, 2007 06:52 PM

Costas - Bonuses do not relate to hard work. Largely they relate to making short term bets with other peoples money. In the case of Hedge Funds it's pretty much heads I win, tails you lose. (Now that's the way to gamble!)

Of course, the whole point of 'hedging' has been shown up as a little bit of nonsense as far as many of these funds are concerned, with Goldman's aptly name 'Alpha' leading the pack of jokers.

In fact, when you think about it, the whole risk-reward structure (ie the bonus structure) is at the rotten centre of this patch of bad weather that is perhaps becoming a perfect storm.

Posted by: t gumbrell at September 7, 2007 11:55 PM

Sell Everything,
"No doubt Mr Trouble and Matt are CDO salesmen, credit traders"

Pardon? Apart from being neither I thought my note was totally neutral. Doser asked if "the lack of bank co-operation affected the economy" I simply replied that of course it does.

The banks are the veins and arteries connecting all the various sectors of our economy. Regardless of what you think of the vast profits they make and bonuses they pay out, if they suffer, we all suffer. Loans to companies in the "real economy" have suddenly got a lot more expensive. This is going to directly impact on investment and job creation.

Nowhere in my comment did I advocate any form of BOE interference, in fact I comment that I think it almost irrelevant at the moment. The problem is that the investing institutions are no longer buying the banks repackaged debts, which is leaving them short of cash to fund the "real" economy.

We may gloat over the banker in the Bentley who just had a car crash, but the rest of us in our Mondeos and Transits arel about to pile into the back of him!

Posted by: Matt at September 10, 2007 02:52 PM