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.