Independence, liquidity and a level playing field – yet another impossible trinity?

Jesper Berg warns it will likely be impossible to balance the demands of monetary policy independence, liquidity standards and achieving fairness for all banks

walter-bagehot-2Walter Bagehot urged the Bank of England to offer unlimited lending at high rates against good collateral

Bagehot's Lombard Street is still compulsory reading for central bankers because of its description of how a crisis evolves and what central bankers should do as lenders of last resort. However, since the financial crisis, central banks and regulators have become increasingly concerned about the potential moral hazard dimensions of Bagehot's advice. The Basel III agreement includes an attempt to deal with the issue, but it involves trade-offs that may prove to be a new 'impossible trinity'.

Bagehot describes how a panic in the money market should be addressed:

"The end is to stay the panic; and the advances should, if possible, stay the panic. And for this purpose there are two rules: First, that these loans should only be made at a very high rate of interest... Secondly, that at this rate these advances should be made on all good banking securities, and as largely as the public ask for them."

Today the prescription to lend at a high interest rate is often interpreted as an attempt to reduce the moral hazard problem. However, the real reason was that the Bank of England had limited means in its banking department which was the supposed lender (the issuing department operated more or less as a currency board and could therefore not print money without backing). Therefore, it was of paramount importance that the Bank of England appeared strong, but at the same time was cautious in using its resources.

Bagehot criticised the Bank of England board for being overly timid in terms of its willingness to commit to lending. Bagehot was almost Churchillian in characterising a board member's statement: "Very few persons perhaps could have managed to commit so many blunders in so few words." However, he was hopeful that the pressure from the public would, when the crisis struck, terrify the board into doing the right thing, as long as the right thing was well defined.

Given our understanding since the days of Bagehot of the inherent problems in the liquidity transformation of banking, it can seem like a puzzle that international work on supervisory standards over the years has focused so much on capital and so little on liquidity. The problem may have been that liquidity fell between the chairs of central bankers and supervisors.

The Basel III standards attempt to address the issue by introducing new liquidity standards. The liquidity coverage ratio (LCR) is the relevant standard for the purpose of this article. The LCR states that banks shall hold sufficient high-quality liquidity to cover a really bad crisis for 30 days, where what flows out disappears and little flows in. This should reduce the need for central banks to act as lenders of last resort and thereby address the moral hazard issue.

The individual bank is in control of its own balance sheet, but the banking system is not. The individual bank can improve its holdings of high-quality liquid assets by funding itself longer term or reducing its lending and in both cases using the liquidity to acquire high-quality liquid assets.

However, the balance sheet of the banking system as a whole is to a large extent influenced by the operations of the central bank. Thus, it is the central bank that controls the net position of the banking system towards the central bank. And government debt management policy determines the amount of government bonds outstanding. The banks can move the net position towards the central bank around among themselves and likewise government bonds, but they cannot influence the overall net position or the stock of government bonds.

Meanwhile, the central bank can, through its operating procedures, influence high-quality liquidity. Available high-quality liquidity will increase if the central bank conducts quantitative easing by buying assets that are not classified as high-quality liquidity. The central bank can also influence the availability by the collateral it accepts in its long-term lending operations. Banks that can use assets that are not classified as high-quality liquidity as collateral in central bank operations will be able to satisfy the LCR easier than banks that cannot borrow in central banks against such collateral. Thus, different monetary policy operating procedures seem inconsistent with a level playing field.

The aim of the Basel standards is to create a safer banking system and a level playing field for large international banks. It would seem that it is difficult to have both a level playing field, a liquidity standard and independence in implementing monetary policy operations. Maybe this is another impossible trinity in central banking. The political geometry of international central banking suggests that a level playing field would have a tough time in gaining the upper hand against liquidity standards and monetary policy operations. Bagehot would also likely have argued that a central bank should never give up its right to provide liquidity against collateral, and in fact should be committed to doing so.

Central Banking Viewpoint brings together experts from across the globe to offer timely analysis on a broad range of issues. You can sign up to the Viewpoint newsletter here.

The contributory editors are Jesper Berg, Hui Feng, Steve Hanke, Richard Heckinger, David Mayes, Kingsley Moghalu and Marc Uzan.

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