Monday, 7 April 2008

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.


L B said...

Those charts have completely changed my perspective on the credit crisis. I thought that the Bank of England was printing money, and this would then push up inflation. I need to rethink this whole credit crunch thing.

Anonymous said...

So if I understand correctly then, the BofE have a total of around £12bn in high quality assets (gov't debt) To put this in context, total outstanding UK mortgage debt as of Feb 08 was £1.194(bn, or in other words the BofE only has enough to cover 1% of the risks, without resorting to extreme measures.


traderboy said...

l b, you should read Mish, he's US based but he's been saying for a long time how the central banks aren't actually printing. It's just the lazy and dumb shills in the MSM that think the central banks are actually pumping liquidity into the system.

Deflation is a comin'.

Anonymous said...

Yeah it was Mish who tipped me off towards the deflation angle, which was good seeing as I'd been listening to too much Schiff.

Of course, just because they aren't doesn't mean they won't. However the BoE won't let the UK become Zimbabwe. High inflation creates just as much problems as it solves, even for the government.

BTW, any of you read Fred Hirsch's 1977 book "Social Limits to Growth"? Really interesting discussion on how all the important high cost items (housing, medicine, education, services) are socially stratified so that whatever the GDP it's still the same sections of society that get the best and you can't grow your way out of it.

I'm thinking the 10-year credit bubble disturbed this natural order of things by allowing the reckless to borrow their way into outspending the affluent. Now it's resetting.


yellerKat said...

So what happened in June??? Yours, Ms Shellshocked of Whitehawk.

francois-guillaume said...

govt buys the bad assets in a separate entity, issues debt, which is taken as collateral at the BoE.
is that printing or not ?
in this case BOE asset quality is not impaired, its the govt one...
i dont see much difference but some people might.

Anonymous said...

Traderboy: "Mish, [..] saying for a long time how the central banks aren't actually printing."

Would someone help me here? What exactly are these 'assets' the Central banks are exchanging for the toxic - as I understand it worthless - financial instruments?

Then suppose a central bank buys something that is near worthless, for 10Bn, you have injected liquidity? Effectively printed money?

To my simple mind there must be a payback, if not now then in the future.

Anonymous said...

It's not injecting cash. Transactions are always ultimately settled in money, even if they are parked in credit first.

When a bank swaps MBS for GILTs it is swapping an asset it can't sell for one it can. However in order to sell it still needs to find someone who has money. If the BoE hasn't created more money then the sale just changes it's holder rather than inflates.

The idea seems to be that there's enough money to go round and the BoE is trying to get it to the banks most likely to collapse.

Like Alice said, it's reaching the point where the only two choices are collapse or printing. Interestingly BOTH may be net deflationary