What has gotten into Mervyn King?

To describe Bank of England’s governor's criticism of ECB lending practice in terms of hostage to fortune would be extremely kind. Mervyn King has in fact scored an own goal when he criticised other central banks, notably the ECB, for encouraging moral hazard. In a written submission to the House of Commons Treasury Select Committee, he wrote that efforts by some central banks to provide markets with excess liquidity would sow “the seeds of a future crisis”. He made the classic moral hazard argument. It was clear that he criticised the ECB, and that he put himself in the good guys’ camp.

 

Unfortunately, the following next day, the Bank of England announced that it had bailed a UK bank. If you criticise someone over moral hazard, and then bail out a bank the next morning, no matter what the circumstances, it does not look good at first sight. In this particular case, it looks even worse at second sight.

 

Anyone who compares British, US and continental European central banks should understand that these institutions face very different banking systems, and different legal structures. The European bankings system is different. There are a lot of small banks, which have been by the liquidity squeeze without having engage in any unsafe lending practices. Furthermore, the ECB has only ever provided injections of liquidity into the overnight money markets, and lately into the three-months money market. The ECB did not bail out any specific banks. The money market operations were only made to ensure that these markets function in line with the ECB’s own policies. Failure to stabilise the money market would have been tantamount to a massive increase in interest rates. While the ECB’s policy stance was, at the time, bias towards further tightening, the ECB did not express this bias by allowing the money market to take off. The provision of liquidity in money markets, though the use of normal tender procedures, is a standard procedure for central banks in times of a liquidity squeeze. Of course, it does not solve the credit crisis. But it is not intended to.  It amounts to a temporary increase in the money supply, the kind of operation that can be easily reversed.

 

The only bail-outs we have seen in continental Europe are those by governments. The German government, through its Kreditanstalt fur Wiederaufbau, has bailed out IKB Deutsche Industriebank, which would gone bust otherwise. The ECB itself was not involved in this operation. This is fiscal policy, not monetary policy.

 

The Bank of England, by contrast, has actually bailed out a bank directly. Northern Rock is a mortgage lender, or building society as these companies are known in the UK. Northern Rock was given a loan at a penalty interest rate, against collateral. We have to understand that Northern Rock is not your neighbourhood savings and loan, but a fairly aggressive mortgage banks, famous for 130% mortgages (that is they lend you all the money to buy house, with enough money to spare to buy a car that you can park in front of it). If ever there was moral hazard, Northern Rock is the embodiment of moral hazard in the mortgage market. This is the kind of Ponzi player that has given rise to the credit market bubble in the first place.

 

Eurointelligence ECB Watch

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