LONDON, Dec 1 (Reuters Breakingviews) – Walter Bagehot’s 1873 book “Lombard Street” is a bible for financial policymakers. The English businessman and journalist argued that central banks should stem financial panics by lending freely, at high interest rates, to solid firms with good collateral. He meant this lender-of-last-resort policy to apply broadly – “to this man and that man, whenever the security is good”.
Over the past 150 years this principle has applied mostly to propping up banks. That is no longer tenable, in part because of reforms to bank regulation that shifted activity from traditional lenders to financial market players. These days, the institutions in need of urgent liquidity are just as likely to be pension funds, insurers or hedge funds. Following financial market freak-outs at the start of the Covid-19 pandemic in March 2020 and in UK government bond markets two years later the Bank of England, along with its international counterparts, is pondering how to update Bagehot’s dictum. The British central bank’s initial ideas make sense, but only solve part of the problem.
DEALER’S CHOICE
The BoE’s Executive Director for Markets Andrew Hauser outlined the plans in a September speech. He wants to introduce a new tool that would offer collateralised loans to pension funds and insurers in a crisis, so that they do not have to dump UK government bonds to raise cash. Hauser’s initial thoughts broadly follow Bagehot: fire sales of assets can quickly become self-fulfilling as prices fall. The central bank can short-circuit the panic by opening the credit taps. The BoE’s “baseline assumption” is that it would only offer liquidity to institutions that were resilient before the market turmoil struck, and that it would do so at interest rates high enough to be unattractive in normal times.
The tool is necessary because of the way regulators responded to the 2008 financial crisis. Authorities boosted lenders’ capital requirements and stopped them from placing bets with their own money. As a result, financial assets moved from banks’ balance sheets to investment funds and other market vehicles. Meanwhile, banks scaled back their trading arms.
The share of U.S. Treasury securities owned by American dealers, which are typically big banks, fell from 10% in 2008 to 3% in 2019, according to one study, while the chunk held by hedge funds and open-ended mutual funds increased to 21%. The upshot is that financial markets have outgrown lenders’ ability to intermediate them, leaving them prone to sudden liquidity shocks.
The crisis that struck the market for UK government bonds in October 2022 is a case in point. Investment vehicles used by pension funds sold UK gilts to meet margin calls, pushing up long-term yields by an unprecedented 1.3 percentage points in a few days. Similarly, back in March 2020, leveraged hedge funds and others sold U.S. Treasury bonds to raise cash, almost breaking the world’s most important financial market.
In both cases, banks were unwilling and unable to mop up the extra supply even at distressed prices, meaning the Federal Reserve and Bank of England had to launch asset purchases to restore calm. Armed with a broader Bagehot-style tool for non-banks, things might have been different. The central banks could have lent to solvent but cash-strapped market players directly, stopping the fire-sale before it started.
SHADOW REALM
There are a few problems. First is moral hazard. In return for access to liquidity, banks submit to extensive regulation which in theory ensures that the central bank only lends to sound institutions. For market-based players, the regulatory picture is patchier. This is why Hauser’s proposed tool will initially just cover insurers and pension funds. The former are supervised by the BoE, enabling an implicit bargain like the one it has with banks. The latter group is overseen by the Pensions Regulator, which responded to the gilt market crisis by setting out guidelines on minimum cash buffers.
No such framework exists for hedge funds, which accounted for 29% of sales of UK gilts in the March 2020 “dash for cash” and amplified the U.S. Treasury market breakdown by dumping securities worth around $90 billion. It is hard to imagine regulators imposing bank-like leverage restrictions on big firms like Citadel and Millennium Management. Besides, the 10 biggest U.S. hedge funds only account for about one-third of total assets, according to the Financial Stability Board.
Geography is another problem. The BoE’s new tool could work well for insurers or pension funds based in the City of London, but not necessarily for far-flung investors. This could be an even bigger problem for the U.S. Federal Reserve if it ever wants to mimic Hauser’s thinking, for example by opening its standing repo facility to a broader range of non-banks: a vast quantity of U.S. Treasuries are in the hands of non-Americans.
A key cause of the March 2020 turmoil, for example, was the fact that foreign investors, including official bodies like central banks, liquidated U.S. government bonds to get their hands on dollars. The Fed has a liquidity backstop tool for other monetary authorities, known as FIMA, which in theory could act as a sort of cross-border Bagehot to stop that from happening again. But it was barely used. The backstop’s international nature also makes it hard to police moral hazard.
WALTER RIGHT
Academics, think tanks and other international bodies have floated various workarounds for these and other issues. One is to charge non-banks like hedge funds an upfront fee in return for future access to emergency loans. Another is to crack down more directly on market players’ leverage, or at least enforce greater disclosure so that authorities can understand any problems more quickly. In an ideal world, major central banks would agree common regulatory standards for non-banks, like the Basel rules that govern traditional lenders. But that possibility seems remote for now.
The basic difficulty with applying Bagehot’s dictum today is that the financial world is much bigger and more sprawling. The 1866 collapse of Overend, Gurney & Company, which prompted the Victorian economist’s celebrated book, took place on Lombard Street, around the corner from the BoE’s headquarters. Today, the epicenter of a financial problem could sit on the other side of the world. Central banks are only just starting to grapple with what it means to be a lender of last resort in that context.
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CONTEXT NEWS
The Bank of England is starting work on its first facility to lend to insurers and pension funds to help avoid a repeat of the 2022 gilt market turmoil, Andrew Hauser, the BoE’s executive director for markets, said on Sept. 28.
Editing by Peter Thal Larsen, Streisand Neto and Thomas Shum
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