OMO changes must temper money-market woe: King

The primary objective of the Bank's revised system, which it is set to reveal "in due course", was "to implement monetary policy by keeping interest rates on overnight borrowing in the money markets in line with bank rate," King told the Treasury Select Committee, an influential group of UK lawmakers, adding that "our framework must deliver this in normal and stressed conditions alike."

The Bank's new system for open market operations, introduced in May 2006, has failed to keep bank rate close to the overnight London Interbank Offered Rate, the most widely-used measure of money-market spreads, since the credit crunch began last August. The spread between bank rate and the sterling overnight interbank average rate, the measure used by the Bank, averaged 20 basis points in the final five months of 2007. The spread averaged five basis points for the first five months of last year.

Emphasising the weight he places on moral hazard, King said that while there were circumstances in which it was necessary for banks to be able to access funding from the central bank to prevent a major shock to the financial system, any such funding required a balancing act. "Although [central bank funding] can remove fragility in the financial system, it can also encourage excessive risk-taking in the future," he said.

King also said it was necessary that open-market operations tackled issues of liquidity, not solvency. "They should not insulate banks from the risk of losses on the loans they have made and the risk to the public sector from these operations should be minimised."

Special Liquidity Scheme

The Special Liquidity Scheme, through which the Bank is expected to swap £50 billion-worth ($98.6 billion) of government bonds in exchange for collateral such as AAA-rated mortgage-backed securities, conformed to each of his principles for operations: "The financial sector is reducing the size of balance sheets by cutting back on lending and raising new capital. That is not a process we can, or should try to, stop. By ensuring that banks can access liquidity, the new Special Liquidity Scheme will support confidence during this period of readjustment," the governor said.

Revisions to the Bank's operations "will build on the lessons we learn from the Scheme," he added.

Click here to read King's comments in full