Monday, 10 November 2008

The strange disappearance of the interbank market

Does anyone remember that repulsive line from the early years of new labour - "joined up government"? There might be a need for the Bank of England to consider whether it is operating "joined up monetary policy." Some recent innovations in policy look a tadge contradictory.

Consider the great economic problem of the day - the interbank market. We are told that banks don't want to borrow to each other. It is all too risky, with banks not knowing whether there are other NRKs and B&Bs lurking on the high street.

On the face of it, it seems true. A quick look at the consolidated accounts of the UK banks will show that the volume of interbank lending has fallen dramatically since August 2007. However, if you sit back and ponder on this problem, it becomes a lot more murky.

Think for a moment about supply and demand. If the price of something goes up and the quantity traded goes down, this means that supply has fallen. In the case of the interbank market, the price is the LIBOR interest rate, and the quantity traded is the volume of interbank loans, which is the spare cash that banks are holding on a short term basis.

This raises an interesting question - where did the supply of loans to the interbank market go. In other words, where are UK banks holding their spare cash? Are they sticking it some offshore account abroad. Are they holding the cash in the bank vaults. Where did the interbank market go.

The answer is a shocker. Banks are sticking their spare cash into the Bank of England. Yes, the Bank of England isn't just a central bank, it is a bank to the commercial banks.

On the balance sheet of the Bank of England, there is something called Reserve Balances. These are short term commercial bank deposits. Since the credit crisis, banks have parked their cash there rather than lend to each other.

So, we have the crazy situation of banks complaining about tight liquidity, the Bank of England lending huge amounts of cash to beleagured banks, while at the same time, taking huge deposits of cash from the banking system.

Here is simple idea, why doesn't the Bank of England stop taking deposits from commercial banks and see what happens. Perhaps the banks might take a chance and start lending to each other.

14 comments:

Nick von Mises said...

They won't. Japan. Deflation. History repeats.

Mitch said...

But that would be common sense and that's not allowed.

Anonymous said...

"
So, we have the crazy situation of banks complaining about tight liquidity, the Bank of England **borrowing** huge amounts of cash to beleagured banks, while at the same time, taking huge deposits of cash from the banking system"

you mean:

"
So, we have the crazy situation of banks complaining about tight liquidity, the Bank of England LENDING huge amounts of cash to beleagured banks, while at the same time, taking huge deposits of cash from the banking system"

Alice Cook said...

anonymus 17:28.

Yes, that is what I meant to write. I've corrected it now. Thanks for picking that mistake up for me.

Alice

mike said...

The question is whether it really is 'spare cash' they stick in the bank of England or whether it's to cover some expected shortfall/write-off/loss in the near future. I can't be sure but it sounds to me like the banks are expecting a lot more losses due to bad credit derivatives exposure.

Anonymous said...

AC: "The answer is a shocker. Banks are sticking their spare cash into the Bank of England. Yes, the Bank of England isn't just a central bank, it is a bank to the commercial banks."

This is only a shocker if we hadn't seen exactly the same behaivour in the US.

The sad think is, this was quite predictable (given the US experience) but all those high powered, high paid folk in the BoE, couldn't manage to do so.

By the way, it is only what happens when the state gets involved in any aspect of the economy, since no commercial organization can operate with such profligate abandon as the government - it never having to make a profit an' all - nothing else can compete, it smothers all economic activity.

Mark Wadsworth said...

I thought that you had already covered this topic. Ah, you did.

It all makes sense - banks are indifferent whether they borrow from another commercial bank or from the BoE. But banks are unwilling to lend to other banks. Ergo, BoE can take deposits from banks and lend them out to other banks.

I have absolutely no problem with this, provided BoE pays rather less than LIBOR on deposits and charges rather more on borrowing, making a nice margin for the taxpayer.

dearieme said...

"a tadge" - is this some sort of combination of a "tad" and a "todger"? If so, it is rather rude.

aSteve said...

Wonderful graph, Alice... but I really wish it went back further. While I might be teaching my proverbial grandmother to suck eggs, there is more to this than meets the eye.

In 2006 the Bank of England underwent a radical shake up... the "Reform of Sterling Money Markets." Two things happened. First, the BoE went from "daily to weekly operations" (basically, banks only needed to settle-up once a week) and interest started to be paid on BoE reserves... I understand, at the base rate.

In 2007, when I researched this, I was worried that it represented an inflationary policy which I'd have to account for in any investment strategy. What I discovered I found very surprising. Prior to March 2006, according to a BoE paper, negligible (~£50m) reserve balances were held at the central bank. The reason for this was that the BoE didn't pay interest... so, REPOs were carefully managed to minimise the amount of "dead" money that didn't earn interest. The move to pay interest on reserve balances was justified because reserve balances were minuscule prior to the reform... and the fractional-reserve for banks was commonly on deposit with other commercial banks... rather than sitting with the BoE paying zero interest.

This observation rather up-ends how we should view BoE reserves... paying interest on BoE reserve accounts, I established (contrary to the BoE claims, and contrary to naive anticipation) was likely to prove deflationary. Where BoE reserve accounts are expanded, this deprives banks of income over-and-above the BoE base rate... and doesn't expand the money supply (as I'd initially thought it would) as every pound in the reserve at the BoE has to have been borrowed in the first place.

I've been expecting a substantial rise in BoE reserve account balances ever since I fathomed this 2006 reform. I strongly suspect that the upshot of this reform (intended to be neutral to inflation/deflation according to BoE papers) will be counter-intuitively deflationary.

It would be extremely interesting to establish the size of individual banks' reserve balances.

Anonymous said...

asteve, if I follow you correctly, then dramatically lowering the base rate is an incentive to the banks to deposit with other commercial banks, and a key policy goal would presumably be to reduce the BoE deposits.

aSteve said...

Hmmm... I didn't say that, anonymous, but that doesn't necessarily make it false...

The reform of sterling money markets mean that banks do not necessarily need to deposit with other banks in order to avoid a massive penalty. The reduced cost of central bank borrowing massively outweighs the other factors relating to a base rate cut, I think.

Nick von Mises said...

"paying interest on BoE reserve accounts, I established (contrary to the BoE claims, and contrary to naive anticipation) was likely to prove deflationary"

Agreed. It also changes incentives for the banks. There's no reason to lend out your money at risk when you can deposit it safely at the BoE and still get something back on it.

The more cash is parked at the BoE, the less that gets turned into commerical money through lending. It's also bad news for commercial paper and other working capital because the BoE will be hoovering up all the cash that could've gone there. That's deflationary too because companies are forced to contract.

I happen to think a deflation is desirable, so this is all good in my book

Anonymous said...

I also think deflation is desirable and I am in the sad situation of also thinking that a recession in the UK is desirable, for me. I have a choice, debt slave or take my chances.
I will take my chances, I have to now anyway.
I don't see that "The more cash is parked at the BoE, the less that gets turned into commerical money through lending" because the capital at the BoE is capital, not lending. The money the banks place at the BoE must be money they actually have, and given that they can still account for that as an asset they can still lend on the basis of the deposit. Whether they have it or the BoE has it is irrelevant, I assume this.
I think also that all of these various fiscal adventures are putting a very bright light on paper money, which I agree with personally, and I also think that as we go through this more and more people are losing trust. For example myself. Whether rightly or wrongly I believe that the outcome will be a deflationary recession. However, despite that, I think my main goal must be to obtain gold because I can't view the people in charge as anything other than incompetent.
I should admit that I have no money at this point just that I am very interested in all this stuff.

Nick von Mises said...

When a bank has to borrow overnight it goes into the interbank market to get the cash. The system means said bank doesn't need to call in the 9x loans it made on that cash.

When the bank goes to the interbank market and can't get the cash, because the potential lender has deposited it with the BoE, it needs to call in those loans and thus reduces the aggregate commercial money.

It's a weird system where the BoE is sucking in all these funds into its reserves then pushing them back out through it's lending facilities. The unintended consequence seems to be that commercial money is substituted by base money but contracting overall. Secondly because only the BoE is lending, certain types of lending aren't happening. Most worrying for the real economy is the working capital markets drying up, particularly commercial paper and letters of credit.

That's very deflationary.

Anyone expert on the precise money flows, please contribute.