Emergency support for a collapsing system

The Bank of England's balance sheet is normally a picture of tranquility. Not anymore, the underlying aggregates are jumping around like stock prices. It is all because of the credit crisis. The BoE has been using its assets to prop up the UK banking system.

Most of the action is on the assets side:


(click on the chart for a sharper image)

The green line represents other assets. This is where we find the northern rock bail-out. This contains the emergency liquidity offered to NRK from September onwards.

The blue line captures longer term reverse repos. Presumably, this captures the recent additional long term liquidity support offered by the Bank of England to ailing banks.

What did the commercial banks get in return for this rubbish? We get a very strong hint from the sudden movements in short term market operations repos - the pink line. This item has fallen dramatically since the credit crisis began.

Short term market operation repos comprises of high quality government debt. In normal circumstances, the BoE takes on these repos in return for cash. When the commercial banks want notes and coins, it comes to the BoE and offers this paper in return for cash.

In contrast, the liabilities side of the balance sheet is much calmer.


(click on the chart for a sharper image)

High powered money - notes and coins - has remained largely unchanged, and if anything, it has been declining in recent weeks. This only goes to show that the Bank of England hasn't used cash to bail out the banks.

Reserve balances, which contains commercial bank deposits, has shown a little more volatility since August. This suggests that the banks have been hoarding cash, and to the extent possible, they have been trying to keep it in the bank of England. However, in the grand scheme of things, this cash hoarding has had only a minor effect on the overall balance sheet of the bank.

Other liabilities - the green line - has also increased slightly since August. This item contains the Bank of England's capital. Since it is rising, it suggests that the BoE is retaining profits. Some of these retained earnings could be coming from the NRK operations. It could also be the cash that the BoE is not transferring profits to the government and stocking up for larger anticipated losses down the road.

So, the Bank of England has followed the example of its American cousin - the Federal Reserve. It has used its balance sheet, in particular its assets, to support the banking system. It has swapped its low risk high quality assets and in return taken on weaker assets onto its balance sheet. So far, it has avoided pumping cash directly into the banking system.

However, this asset based bailout has its limits. The BoE can transfer rubbish onto its balance sheet only to the extent that it has good assets to give to the commercial banks. However, the BoE almost ran out of high quality short term repos over the new year.

It has recovered some of these assets in recent weeks, largely through NRK repaying some of its loans. Nevertheless, the BoE's ability to bailout the banking system by swapping its assets is very limited. In future, it might need to print cash to prop up the UK banking system.