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Last chance saloon?

• Robert Peston
• 12 Dec 07, 05:17 PM

It is difficult to know whether to feel elated or alarmed by today’s coordinated attempt by the world’s great central banks to bring down money market interest rates.

The good news is that they are working overtime to ward off the prospect of possible recession.

But their action is without precedent – which therefore demonstrates that the stakes are high.

What concerns them, as I wrote this morning, is that the rates which banks charge each other for funds, which ultimately determines what we all pay for credit, are refusing to fall much – even though the US Federal Reserve and the Bank of England have been cutting their policy rates.

This has become a particularly acute problem in the sterling money markets.

Broadly the five central banks are doing three important things.

• They are acting in concert – which demonstrates that they regard the risks and challenges as common ones.

• They are pumping money in slightly different ways into the parts of their domestic money markets that are perceived to need the additional funds, reflecting structural differences in their banking markets.

• Also, both the Bank of England and the Federal Reserve are broadening the range of collateral they will take for loans provided in normal money market auctions, without the imposition of any interest rate penalty.

The last point is really important.

It at last removes stigma from banks which need additional three month money from the Bank of England, but lack the highest quality collateral to obtain it.

With any luck it will reduce the propensity of banks to hoard their cash – which has been driving up interest rates. If they can count on central banks to lend to them, then they too may be prepared to start lending to each other again.

And that should bring down the rates we all pay.

What’s the risk?

Well if it doesn’t work, the authority and credibility of the central banks will have been undermined – and we’ll all be struggling to see how a serious global slowdown can be averted.

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Sterling drought

• Robert Peston
• 12 Dec 07, 08:19 AM

Interest rates charged by banks to each other, or money market interest rates, have barely come down at all since last week’s cut by the Bank of England in its policy rate.

The gap between the benchmark rates – the BBA Libors – and the Bank of England’s base rate has widened very considerably.

Thus, as of yesterday, three month Libor – which is crucial to the pricing of mortgages – was 6.63 per cent, much more than 1 percentage point greater than reduced base rate of 5.5 per cent.

And the price of one month Libor was 6.74 per cent.

The Bank of England tells me that it doesn’t target these so-called term rates with its base rate.

But what should alarm it is that the overnight Libor rate at 5.7 per cent is still way out of whack with the base rate.

It’s symptomatic of what the chief executives of the banks describe to me as a structural shortage of sterling – for which they blame the Bank of England and the way it pumps liquidity into the banking system.

The Bank of England says they are just wrong about this, that they simply don’t understand its system for supporting the markets.

There is a very basic contradiction here, which I have been struggling to reconcile with the facts.

For example, Mervyn King, the Governor, told me when I interviewed him a few weeks ago that the Bank of England had pumped just as much liquidity into the sterling market in proportion to the market’s size as the European Central Bank and the Fed had done.

And the Bank continues to make this point.

But the uncomfortable fact for the Bank of England is that the gap between sterling money-market rates and its base rate is considerably wider than the gap between the equivalent euro interbank rates and the ECB’s policy rate.

That is evidence of conditions in the sterling markets being considerably worse than those in the euro ones.

And, to be clear, this matters to all of us.

It means there is a risk that Britons will pay considerably more for credit than the Bank of England would like us to do, in the context of its mandate to keep inflation low.

So what is going on?

Well, this may sound absurd but even our biggest banks have become very frightened of the Bank of England – and our smallest ones live in terror of it.

Their concern is not primarily the amount of liquidity pumped into the system by the Bank of England in its planned operations, although they would like the Bank to accept a wider range of collateral for the funds it provides, along the lines of what the ECB does.

But their fears are really about the attitude of the Bank of England as and when one of them is forced to borrow a bit more than they’ve agreed to do or expected to do.

They think that the Bank itself views any request for funds under its standby facility as a sign of management incompetence by the requesting bank.

Although the names of banks drawing on the facility are not published, the banks fear leaks.

In the summer, for example, Barclays drew on the facility and promptly saw its name splashed all over the media. The implication was that there was something seriously awry at Barclays, which was not the case but wreaked considerable reputational damage on it.

The consequence is that the standby facility – whose point is to provide comfort in a time of crisis such as the one we’re living through now – has been used much less since the onset of the credit crunch than in the normal market conditions that preceded it.

Which is crazy.

Similarly, no bank dared to draw on the special three-month facility put in place by the Bank of England after the Northern Rock debacle, because again the banks thought that to do so would be seen as a sign of weakness.

Think “Northern Rock” and you’ll understand their neurosis about requesting funds at the punitive rate which the Bank demanded for this three-month money.

The consequence is that all banks are accumulating cash as if the bomb were about to drop, to avoid even the faintest risk that they might have to do an Oliver Twist and ask the Bank of England for a bit more than their agreed portion.

It may be that the banks deserve their plight, that they should feel humiliated and ashamed for the way they underpriced risk in the bubble conditions of the preceding few years.

And there is no doubt that the Bank of England during the summer felt it was wholly appropriate to punish them for their imprudence.

But I find it difficult to believe that remains the attitude of Mervyn King.

To be fair, there is a comparable problem in the US money markets - but the Federal Reserve appears close to reforming the way it provides liquidity, in an attempt to lessen the the stigma for banks of requesting incremental funds.

Right now, if Mervyn King is punishing the banks, he is also punishing all of us - in the sense that we all depend on the banking system to price money efficiently, and that’s not happening right now.

There needs to be a new entente between the Bank of England and the banks, to sort this out.

And the sooner the better.

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