The Bank must reassure Britain it has not lost its grip on policy
First published in the Telegraph on 15 August 2010
What would you guess is the world’s most highly-geared financial institution?
One of the lessons of the financial crisis – now gratifyingly drummed into most of us – is that if a bank tries to support a leviathan balance sheet atop a tiny sliver of safe cash (shareholders’ capital) its prospects are bleak.
Take Lehman Brothers – in 2008, at its very zenith (nadir might be a more appropriate word) it had just over $30 in assets for every dollar of shareholder equity. Northern Rock’s leverage ratio, before it exploded, was more than £50 for every pound of common equity. The two banks had become rather like inverted pyramids – massive bundles of borrowed money supported on a fragile base of real money.
So what if I told you there was an institution out there whose balance sheet dwarfed these numbers? As far as I know, it is the most leveraged institution in the world today and, far from crumbling in the crisis, has never been more powerful.
Step forward the Bank of England. The Old Lady of Threadneedle Street has managed, somehow, to balance a whopping £250bn of assets on a mere £4.2bn of capital. It adds up to a leverage ratio of some 60 times. In fact, if you’re being a real stickler for rules and, as is being done to private banks today, only count the £15m of shareholder equity (owned by the Treasury), the gearing ratio would be a disturbing 16,666 times – surely a historical record.
It might in a weird way be reassuring if the Federal Reserve was in a similar league but, while the US central bank’s leverage ratio is still eye-watering at almost 40 times ($2.27 trillion of assets on top of $56.9bn capital), it is nowhere near the Bank’s.
Now, to some extent I’m being disingenuous. Central banks are not directly comparable with private financial institutions. For one thing, the assets that have swelled these balance sheets to unwonted levels are not the proceeds of a desperate investment binge but the by-product of the asset purchase schemes both of the central banks have run over the past couple of years.
With further interest rate cuts no longer an option, both have instead spent billions buying up assets in an effort to boost the economy and unfreeze markets. This was an integral part of quantitative easing – their mechanism for pumping cash into the economy.
And just as their enormous balance sheets cannot be compared with Lehman or Northern Rock, neither can their share capital, since – like all central banks – both the Fed and the Bank of England have the benefit of the explicit support of their Government if they were to face a solvency crisis of their own.
But the fact remains that central banks can go, and do go, bust: the Reserve Bank of Zimbabwe and the National Bank of Tajikistan can attest to this, having faced precisely this fate in recent years.
Granted, this is a phenomenon usually reserved for developing countries, since they often borrow in a foreign currency and so lose control of their financial fate. But the spectre of possible failure is real all the same. And when a central bank has to be bailed out by its Treasury, things get really nasty.
In the Bank’s case, this threat helps explain why it handled the crisis the way it did. While both the Bank and the Fed bought up assets when they ran out of interest rates to cut, they did so in very different ways. The Fed spent the vast majority of its cash on securities – mortgage-backed instruments, commercial debt, short and long term, and put only a bit of its cash in US Treasuries. The Bank of England, on the other hand, spent almost all of its £200bn quantitative easing scheme on government bonds.
This sparked conspiracy theories that the Bank is intent on monetising the Government’s ballooning deficit and, while one can rule nothing out in the future, the Bank’s more immediate worry was that if it chose anything more risky than government bonds, it would face the prospect of losing money, and, if the worst came to the worst, suffering insolvency. Moreover, gilts were easy to buy, and buying them meant avoiding accusations of favouritism, depending on which commercial assets it chose to buy.
It is a lesson worth remembering, given the events of the past week.
First, the Fed announced that it will re-invest proceeds of the assets it bought over the past couple of years in government debt. Then the Bank cut its forecast and its Governor, Mervyn King, said that more asset purchases remain a real option. In short, both indicated that should their economies weaken, they stand ready to pump more cash into the system.
In and of itself, this ought not to have come as a surprise. Having ignored arcane money statistics over the past decade, the central bankers are suddenly extremely sensitive to the fact that the data is now pointing towards a double-dip recession. US economic growth is starting to slow, and, while Britain recorded a stonking quarter’s expansion of 1.1pc between April and June, the housing market looks to be turning.
However, the question remains: how much more can they afford to hold on their balance sheets before the entire edifice comes crumbling down? The answer depends almost entirely on credibility. Lehman and Northern Rock collapsed because their investors and depositors concluded that the banks could no longer pay their cash back. Technically speaking, the Fed and the Bank cannot run out of money, since they can always print extra cash if in need. However, this ignores the fact that they can only print cash with the co-operation of the Treasury. In other words, every fresh bout of money-printing erodes their independence, and hence their credibility.
Which is why the Bank and Fed must think very carefully before proceeding with more quantitative easing.
This is not to say it is not necessary – as King indicated this week, the Government itself simply does not have any more room to spend money and stimulate the economy. If a soft-landing is to be engineered, it is for the Bank to do.
But a second wave of money-printing and asset-buying would be far more tricky than the first. After all, we are already in murky territory.
The success of quantitative easing depends on the central bank convincing the public that it is steadfastly independent, while doing something which is inherently not: buying the very debt pumped out by its employers in the Treasury.
So far, the Bank has managed to get away with buying a full year’s worth of gilts while maintaining a patina of independence (King’s vociferous attacks on the previous Government’s handling of the public finances were not mere grandstanding). Whether it can continue to tread this tightrope is a moot question, and its grip becomes all the more shaky if it buys even more government debt.
The Bank’s position is rather more perilous than the Fed’s – in part because it has potentially a far greater opportunity to monetise the deficit, holding as it does so many government bonds; in part because it has been independent only since 1997. But both central banks need to understand that as their balance sheets become more and more bloated, it will become more and more difficult to convince the public they are not losing their grip on economic policymaking.