Weaning the banks off the Old Lady’s teat

There is a warm sense of security that comes from suckling liquidity from the teat of the central bank rather than foraging for capital and earnings in a harsh world full of threats and predators.  Nonetheless, there comes a time when a good mother pushes away her importunate young and forces them to fend for themselves subject to her stern guidance and supervision.

Central banks have been suckling their broods of commercial banks since the credit crunch first exploded on the scene in August 2007.  Now there are signs that the Bank of England and European Central Bank, at least, are keen to push their broods toward self-sufficiency, even at the risk that not all survive independently.

The Old Lady of Threadneedle Street has announced that she really, really means it when she says that the Special Liquidity Scheme introduced to enable banks to draw her gilts against mortgage-backed collateral will be closed down 20th October.  The SLS was opened as a “one-off operation with a finite life” and was never intended to do more than bridge the liquidity gap created by the collapse of the mortgage-back securities market while banks adjusted their business models to changed market conditions.

The banks, led by UBS, are throwing temper tantrums, stamping their little feet, screaming in the financial press, but so far the Old Lady is holding firm.  Mervyn King said last month:

 “The SLS was introduced as a measure to deal with a legacy problem of liquidity of the stock of assets which banks owned last year when the crisis hit. So that window will close in October. The longer-term issue of tightening of credit conditions is much wider. That is to do with the health of the capital position of the banking system, and it’s very important not to confuse the two”.

Mr King’s determination to husband what remains of the Old Lady’s resources may have something to do with profligate abuse of them when opened to her brood.  What started out as a scheme to extend up to £50 billion (a bit less than $100 billion) in liquidity to shore up the UK credit markets during a surprise credit dislocation may have been drawn for as much as £200 billion in total as crunch turned to constriction.  The Bank will only publish the true scale in October after the SLS closes.  The SLS has been hungrily drained by banks keen to swap whatever unmarketable dross remained on their books for good central bank gilts.

The abuse has been made plain in numbers reported by the BIS.

Banks issued a record £45bn in mortgage-backed bonds in the three months to the end of June – more even than at the very height of the housing boom in 2006 – according to figures from the Bank for International Settlements. . . . . The Quarterly Review added: “Most of the UK issuance followed the Bank of England‘s announcement in April 2008 of a Special Liquidity Scheme (SLS) that enables UK banks to swap illiquid assets such as mortgage-backed securities against UK Treasury bills.”

This record mortgage-backed issuance comes at a time when new mortgage lending in the UK has contracted very sharply, down 71 percent year on year for the month of July.  That indicates a cynical abuse of the Old Lady’s generosity.  Rather than be left with dry dugs dangling to her waist, the Old Lady would prefer to wean the banks while she retains ample bosom and sufficient other assets to shore up her public stature.

Over at the European Central Bank, a rule change this week will increase haircuts (discounts to stated market value) for collateral provided under that liquidity scheme from next February.  The ECB has made available over EUR 367 billion (a bit less than $700 billion) under very liberal terms.

According the Financial Times:

The changes, which take effect from February 1, include increases in the average “haircuts” applied to asset-backed securities. A haircut is the amount deducted from the market value of a product when judging its value as collateral. In future, a blanket 12 per cent haircut will apply, replacing a previous sliding scale of between 2 per cent and 18 per cent. There will be penalties for asset-backed securities valued using models and for unsecured bank bonds.

Restrictions already in place on banks using assets they themselves had formed were extended to stop banks using assets from issues to which they had offered currency hedges or liquidity support above a certain level.

Analysts at Barclays Capital said the extra haircuts would mean banks might have to post an additional €25bn-€45bn of securities for collateral purposes. “That could cost €375m to €450m annually to banks … Not in­significant, but probably bearable,” said Laurent Fransolet, analyst at Barcap.

The normally politic Yves Mersch made explicit reference in his remarks to “dangers of gaming the system”.

Nonetheless, with house purchases falling to new lows and credit getting progressively tighter, the Labour government and the Council of Mortgage Lenders are wild to have another source of cheap liquidity if the Old Lady denies them.  A new scheme for taxpayer-subsidised mortgage finance is in the offing.  It is clearly bad public policy to have the government subsidise further borrowing for the housing sector after such a destructive bubble, but the scale of vested interest and the unpopularity of the Labour incumbents as the house prices fall make a new scheme a certainty all the same.

Rather like a mother who loves her young no matter how ill-bred, destructive and abusive they are to their peers or the community, the Old Lady of Threadneedle Street is unlikely to mind very much if British banks prosper by depredations on the politicians, taxpayers, market counterparties, corporate treasurers, hedge funds and others so long as they are out of the house.  Having proved they have no sense of gratitude or duty to the Old Lady that preserved them in time of need, the others who will become their new targets can expect even less consideration.

14 Responses to "Weaning the banks off the Old Lady’s teat"

  1. Alessandro   September 5, 2008 at 5:47 am

    First!(sorry I couldn’t resist!)

  2. London Banker   September 5, 2008 at 6:00 am

    @ AlessandroWho better? I had to chuckle typing in the keyword for this post: WeaniHow appropriate to this wunch of bankers! (Wunch is the accepted collective noun for bankers in London.)

  3. Guest   September 5, 2008 at 7:08 am

    LB and Alessandro, et al.Is it not clear that there is no logic to that which are the reactions to the dilemma at hand? The solutions apparent are clearly either a result of ‘lets’ do lunch’ stuff or telephone (old school’ stuff solutions. There is no integrity and no physics.So what’s new?Bottom line Gentlemen: There is nobody at the helm that experientially and intellectually, ‘see’s’ the ‘big picture’ and is ready to assume full responsibility for civilization direction, today and for tomorrow.Yesterday, we had Captains of Ships who commanded from a deserved position of respect; today our captains of industry demand respect; And, they suck!PeterJB

  4. Alessandro   September 5, 2008 at 7:10 am

    London Banker,good ol’ Snake-oil politics is charging.I’m quite surprised that the European central banks are showing a relatively better crisis-handling performance than most other CBs and politicos.

  5. Alessandro   September 5, 2008 at 7:16 am

    PeterJB: “There is nobody at the helm that experientially and intellectually, ‘see’s’ the ‘big picture’ and is ready to assume full responsibility for civilization direction, today and for tomorrow.”Being sadly used to Italian politics, I’m long accustomed to this very notion. I have to admit that during this crisis I learned, with great surprise, that most of the rest of the world has politicos as bad as the Italian ones. My hope of civilization progress are weaning.

  6. Medic   September 5, 2008 at 8:17 am

    LB;Yet another wonderful addition to this site. I must admit, in all this gloom, you have made me smile – even this morning after the employment numbers came out!I am in hopes that your CB can control the IB’s and push them away, sending a message and leading by example.Here’s to hoping that an Obama administration removes all the Bush appointees at the Fed – may the bastards never find fruitful employment again!

  7. Quintum   September 5, 2008 at 8:34 am

    while the banks may be the preferred children of the old lady, the people should be her collective family.the problem that might arise is when the spoiled brats will put a gun at the rest of the family’s heads, for favors of the mother.and I think that the spoiled brats will have no scruples in pulling the trigger…@medic. I’m not American and although I sympathize with Obama, IMHO you cannot rule out that he might be just another puppet in the lobbyists’ hands. a change of ruling parties is usually just an additional cost in the corporate budgets, not an insurmountable hurdle in their business plans…

  8. lili   September 5, 2008 at 11:11 am

    100 BILLIONS dollars instead of 100 millions (sixth paragraph)always great to read you LB :)lili

  9. London Banker   September 5, 2008 at 11:17 am

    @ liliGood catch. Many thanks! And thanks for giving me another happy opportunity to type “Weani” this morning. It still makes me smile.

  10. lili   September 5, 2008 at 11:24 am

    If you’re there, LB :)What do you make of Bill-Gross-like (and minsky style) analysis insisting on the necessity of opening up treasuries (at least US Treasury) balance sheets to prevent asset prices to fall to badly ?I understand your concerns about helping banks in doing a business that caused us the mess… but isn’t just NECESSARY to induce a government PORTFOLIO effetc to avoid a big debt deflation ?mmh i’m going to type Weani again :)lili

  11. jo6pac   September 5, 2008 at 10:39 pm

    Being sadly used to Italian politics, I’m long accustomed to this very notion. I have to admit that during this crisis I learned, with great surprise, that most of the rest of the world has politicos as bad as the Italian ones. My hope of civilization progress are weaning.Written by Alessandro on 2008-09-05 07:16:21I hope we all make it alive.jo6pac

  12. artichoke   September 6, 2008 at 12:51 pm

    What about the broker-dealers? If they failed, no depositors would be hurt. Your article discusses only commercial banks.In the USA at least the broker-dealers are major beneficiaries of the Fed’s largesse. Are they being suckled in the UK too? If so, are they immune from this new tough love too?

  13. Alessandro   September 6, 2008 at 5:57 pm

    London Banker,I asked you already, but I’d really appreciate “deep” answer: “Why exactly do we need a central bank?”.Gold as money has its own problems, but now that we are reaching the first real big crisis of central banking, should we ask ourselves if was it worth?I’m slowly making my mind up that no matter how bright and loyal a central banker is, he as too much power and we know a working alternative.As I said, I’d vote for you on any election you’d be running, but I’d probably chose the gold standard over the fiat London Banker Sterling should I chose the monetary system of my country.

  14. London Banker   September 7, 2008 at 12:04 pm

    @ AlessandroI am gratified by your faith in me, but as I was involved in shaping many misguided policies during my tenure as a central banker, a more objective framework for validating public policies is required. Sadly, in the real world we inhabit, the central banks exist and are powerful and seem determined to resist scrutiny. Any constraints on their conduct are easily shredded as soon as they whisper “systemic risk” and declare the need for urgent intervention with secrecy.Being a realist rather than an academic, I am searching for ways to constrain abuse of their powers and make them more fully accountable for the economic impacts of their policies. I can’t say that I’ve found any really workable yet.I’m a bit tired today (lots to do around the house), but will think on the “deep” answer and try to write about it another [email protected] artichokeThere is no special regime for insolvency of broker dealers in Britain, and the law remains ambiguous on some points. We are looking at this in the context of modernising laws here, but it is still in the early stages and not addressed in the legislation to be laid this fall.