Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation. This blog is currently suspended.

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Tue, 25 Sep 2007

Bank of England U-Turn

Last week, I blogged admiringly about the Bank of England paper on inter bank liquidity and moral hazard and it was embarassing to find the Bank do a U-turn within days of that paper. Mervyn King faced a hostile Treasury Committee and the transcripts of this oral testimony are quite disturbing.

King stated that he wants to carry out lender of last resort operations covertly and wants disclosure laws to be changed to make this possible. To my mind, this is totally unacceptable. The disclosure requirements of modern securities market are sacrosanct and central banks must simply learn to live with them.

The transcripts also show that King had difficulty providing a convincing explanation for his U-turn on moral hazard:

Q2 Chairman: ... In that letter of 12 September you told us that providing extra liquidity at longer maturities - in your words - undermines the efficient pricing of risk by providing ex post insurance for risky behaviour and that you would conduct such operations only if there were strong grounds for believing that the absence of ex post insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in the future. However, yesterday you conducted such operations. What has changed in the past seven days?

Mr King: ... the balance of judgment between how far you extend liquidity against a wider range of collateral on the one hand and being concerned to limit the moral hazard on the other, to limit the ex post insurance, is a judgment that we are making almost daily in the febrile circumstances of the time. The operation yesterday was carefully designed and judged. It does not give ex post insurance, it is limited in size, it is limited in amount to each individual bank, and that provides a strict limit on the extent to which there is some ex post insurance, so we have balanced the concerns about moral hazard against the concerns that arose at the beginning of this week about the strains on the banking system more generally.

Q18 Chairman: When you talk about everybody knows their own job, Governor, I have to ask you this question because it has been in the public press: are you your own man? Were you lent on in this situation? Is that why you did the U-turn in the past seven days?

Mr King: No, I can assure you that the operation we carried out was designed in the Bank. Of course in these circumstances I want to discuss it with Callum McCarthy and the Chancellor. It would be very odd if they were to have woken up and found we had done this and they did not know anything about it, so of course we discussed it, but I give you my personal assurance that I would never do anything unless I thought it was the right thing to do. The independence of a central bank is not just about legislation; it is about having people in the central bank who will do what is right for the country in their job and not do what people ask them to do, whether it is the banks or whether it is politicians.

Q46 Mr Fallon: Governor, you have spoken on moral hazard and you have written us an eloquent essay on moral hazard, but is not the criticism that you have passed the theory but when it came to dealing with Northern Rock and when it came to dealing with three-month funding actually you failed the practical?

Mr King: No, I do not think that is true at all. I am happy to explain a bit later if you like why I think moral hazard is such an important issue. Can I just answer this point. I have tried to set out a sequence of events in which Northern Rock required ultimately a lender of last resort, the way in which we would have preferred to do it was not open to us, and at that point we did it in an overt way. I do not think it was at all obvious what impact that would have. It might or might not have led to people wanting to take their money out. In the event it did and once that run had started people were not behaving illogically by joining it and at that point the only solution was the Government guarantee. I think this is a very clear chain of events.

Q86 Peter Viggers: How severely do you think the principle of moral hazard has been compromised since you wrote us your rigorous and lucid letter?

Mr King: I hope that it has not and I do not believe that it has but, as I said, this is a balancing judgment. When I listened to the banks I do not believe that they felt that offering them an ability to bid for liquidity at a 100 basis point premium over bank rate was something that they regarded as entirely generous, so I think there is still a fair chunk of restriction against moral hazard in what we have done.

Posted at 21:32 on Tue, 25 Sep 2007     View/Post Comments (1)     permanent link

Thu, 13 Sep 2007

Bank of England analysis of turbulence in inter bank liquidity

The paper that the Bank of England submitted yesterday to the Treasury Committee of parliament is an unusually lucid analysis of the recent turbulence in inter bank liquidity; surprisingly, it reads more like a thoughtful blog than a ponderous official pronouncement. This certainly cements Mervyn King’s reputation as the foremost academic among central bankers. Ben Bernanke is of course not far behind – his speech day before yesterday on global imbalances was also very insightful.

King’s paper contains a careful analysis of what has happened since the beginning of August:

In summary, the turmoil in financial markets since the beginning of August stems from a reluctance by investors to purchase financial instruments backed by loans. Liquidity in asset­backed markets has dried up and a process of re­intermediation has begun, in which banks move some way back towards their traditional role taking deposits and lending them. That process is likely to be temporary but it may not be smooth. During that process, demand for liquidity by the banking system has increased, leading to a substantial rise in inter­bank rates.

King then argues (a) that monetary policy should continue to be fixated on inflation targeting and (b) the provision of liquidity in the automatic window at penal rates against high quality collateral is sufficient for the smooth functioning of the payment system.

The concluding part of the paper is sharp and brutal:

So, third, is there a case for the provision of additional central bank liquidity against a wider range of collateral and over longer periods in order to reduce market interest rates at longer maturities? This is the most difficult issue facing central banks at present and requires a balancing act between two different considerations. On the one hand, the provision of greater short­term liquidity against illiquid collateral might ease the process of taking the assets of vehicles back onto bank balance sheets and so reduce term market interest rates. But, on the other hand, the provision of such liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behaviour. That encourages excessive risk­taking, and sows the seeds of a future financial crisis. So central banks cannot sensibly entertain such operations merely to restore the status quo ante. Rather, there must be strong grounds for believing that the absence of ex post insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in the future. In this event, such operations would seek to ensure that the financial system continues to function effectively.

As we move along a difficult adjustment path there are three reasons for being careful about where to tread. First, the hoarding of liquidity is a finite process ... [T]he banking system as a whole is strong enough to withstand the impact of taking onto the balance sheet the assets of conduits and other vehicles.

Second, the private sector will gradually re­establish valuations of most asset backed securities, thus allowing liquidity in those markets to build up ...

Third, the moral hazard inherent in the provision of ex post insurance to institutions that have engaged in risky or reckless lending is no abstract concept. The risks of the potential maturity transformation undertaken by off­balance sheet vehicles were not fully priced. The increase in maturity transformation implied by a change in the effective liquidity in the markets for asset­backed securities was identified as a risk by a wide range of official publications, including the Bank of England’s Financial Stability Report, over several years. If central banks underwrite any maturity transformation that threatens to damage the economy as a whole, it encourages the view that as long as a bank takes the same sort of risks that other banks are taking then it is more likely that their liquidity problems will be insured ex post by the central bank. The provision of large liquidity facilities penalises those financial institutions that sat out the dance, encourages herd behaviour and increases the intensity of future crises.

In addition, central banks, in their traditional lender of last resort (LOLR) role, can lend “against good collateral at a penalty rate” to an individual bank facing temporary liquidity problems, but that is otherwise regarded as solvent ... LOLR operations remain in the armoury of all central banks ...

...Injections of liquidity in normal money market operations against high quality collateral are unlikely by themselves to bring down the LIBOR spreads that reflect a need for banks collectively to finance the expansion of their balance sheets. To do that, general injections of liquidity against a wider range of collateral would be necessary. But unless they were made available at an appropriate penalty rate, they would encourage in future the very risk­taking that has led us to where we are ...

The key objectives remain, first, the continuous pursuit of the inflation target to maintain economic stability and, second, ensuring that the financial system continues to function effectively, including the proper pricing of risk. If risk continues to be under­priced, the next period of turmoil will be on an even bigger scale. The current turmoil, which has at its heart the earlier under­pricing of risk, has disturbed the unusual serenity of recent years, but, managed properly, it should not threaten our long­run economic stability.

Posted at 08:05 on Thu, 13 Sep 2007     View/Post Comments (0)     permanent link

Sat, 08 Sep 2007

Carry trades and hedging

Stephen Jen and Luca Bindelli argue in a post at the Morgan Stanley Global Economic Forum that currency hedging produces much of the effects that are commonly attributed to carry trades. Jen and Luca Bindelli are absolutely right in arguing that:

However, to replicate the carry trade effect, Jen and Bindelli need to make the further assumption that the hedge ratio depends on the cost of hedging as measured by interest rate differentials. I would argue that the part of the hedge that depends on interest rate differentials is a speculative position masquerading as a hedge. In Black’s universal hedging model (“Equilibrium Exchange Rate Hedging”, Journal of Finance, 45(3), 899-907) the hedge ratio is a constant across all currency pairs and the primary reason for the hedge ratio to differ from unity is Siegel’s paradox. Even if one employs more general models, it is difficult to see a role for interest rate differentials in determining the optimal hedge ratio if one assumes that the forward rates are equilibrium rates.

The assumption that forward rates are incorrect and therefore (via interest rate parity) that interest rate differentials are irrational, is a speculative position which is the core of the carry trade phenomenon. It is difficult to regard this as hedging.

Posted at 12:18 on Sat, 08 Sep 2007     View/Post Comments (0)     permanent link