Back in February of this year I wrote an article on a new type of unconventional monetary policy by the Bank of England. It was not something that the media reported widely or well. Indeed many places seemed to ignore it completely. This was slightly confusing to me as the original version of Quantitative Easing had been reported almost ad infinitum in the media and the press. It was potentially a significant change in the monetary policy that the Bank of England was operating in my view and as I shall discuss later likely to be a good change. However for some time the policy has remained dormant and barely used. On Tuesday this changed somewhat and the Bank of England began to operate its new system. In my opinion these reasons for this change were intertwined but from the same route. The first is that market volatility and a decline in appetite for taking risks meant that the Bank of England was keen to begin implementing its new tool and the second was that for the same reason market players were willing to accept the terms offered by the Bank.
What happened on February 4th 2010?
The Chancellor Alastair Darling wrote to the Bank of England and gave it the following instructions and authorisation.The letter authorised the Bank of England to spend up to £50 billion on asset purchases. However these would now be private sector assets as opposed to the public sector ones that the Bank of England’s Quantitative Easing programme had mostly ended up purchasing. It will buy commercial paper,corporate bonds and secured commercial bonds with the money and it will be financed by the issue of Treasury Bills. So just to make it clear whilst the Bank of England will no longer buy government bonds it will continue to buy corporate bonds under this programme.
How is this different from Quantitative Easing?
1. It will be paid for by the issue of Treasury Bills and not the Bank of England creating money.
2. It will purchase private sector assets as described above.
Implications of such a policy
I wrote on this subject on the 5th February and my views on it still hold
Actually on a first reading this policy looks preferable to the Quantitative Easing policy which had previously been pursued. This is more in line with the way the US Federal Reserve has operated and as I wrote yesterday it has had more success than we have had with unconventional monetary operations so far. So hopefully companies will find it easier and cheaper to finance long-term borrowings. This does seem to have been the American experience. Also borrowing the money and not simply creating it is a better more transparent system as I never liked the idea of circulating money between the Bank of England and the Treasury.We should have done more of this and less of QE. If we had our economy would be in better shape now.For the curious the average rate paid on 3 month Treasury Bills in January was 0.49% according to the Bank of England.
The only drawback is that some of these private-sector markets are quite small in the UK so it may take a while to spend the money and have an impact. So far the Bank of England has only spent some £479 million on Commercial Paper and £1,484 million on Corporate Bonds. It bought £2.11 million yesterday so at that rate it would take quite some time to spend £50 billion!
After welcoming the policy I went on to point out that there was one potential flaw in it.
Having had time to think a little more about this policy it still looks a good idea to me. One flaw that does come to mind is the adage for banks ” be careful of borrowing short and loaning long”. In principle this can apply to nations too and in borrowing on a rolling 3 month timescale and loaning to bonds which have much longer lifespans e.g 5 years,10 years this is exactly what we are doing.
What has happened since February?
Well until Tuesday the truth is not much. I speculated at the time that there appeared to be some friction between the Bank of England and the UK Treasury. You see the announcement of this was released on the HM Treasury website in the evening and not with the normal monthly Bank of England monetary policy announcement,which had been earlier that day. It certainly was not good policy procedure in my view and smacked of political opportunism and possible disagreements between the Chancellor and the Treasury. I got the feeling that maybe the Bank of England was not very keen on this policy and tried to put it on the back-burner for some reason.
The change on Tuesday 25th May
The Bank of England bought £88 million of Corporate Bonds, just to give a comparison it only bought some £12 million in the whole of the previous week. This is quite an acceleration because up until that time it had only bought £109 million of Corporate Bonds using this system according to its website. So perhaps we are seeing a change.
What good might this policy do?
1. The clearest link is that such purchases by the Bank of England should reduce interest rates in the corporate bond markets should help companies to borrow more cheaply. This has clear potential benefits for the UK economy.
2. The second issue is that of volume. You see the UK has one of the smaller Corporate Bond sectors in comparison with its Gross Domestic Product of the developed world. As a ratio of our GDP the UK stands at 0.16 which compares with an average of 0.53 and for example the United States on 1.30, Italy on 0.60,France on 0.57, Germany on 0.36 and Japan on 0.38. These figures are from 2008 and are from the World Bank Financial Sector Dataset.
So there are two potential gains here. The encouragement provided by the Bank of England being a backstop may help and develop the Corporate Bond market. This in itself is a good objective but of course currently with bank lending still constrained and limited is particularly important as we try to recover from the follow-on effects of the credit crunch. As banks are rumoured not be lending to each other in the inter-bank market they are unlikely to be rushing to lend to commercial borrowers!
This policy is in my view superior to the original Quantitative Easing policy of the Bank of England. Rather than purchasing our own debt and hoping for good effects from it (which in my view have headed more towards asset price bubbles and inflation) we purchase corporate debt and make it cheaper for companies to borrow. There may be a follow-on effect of increasing the size of the corporate bond and commercial paper markets. Both are good objectives and I have been surprised that the Bank of England has not followed this policy with more enthusiasm. Perhaps of course it might embarrass the £200 billion they spent on Quantitative Easing!
Also the letter from the Chancellor did have in my view one other side effect. As regular readers will know I think that there was and indeed is not much left of the concept of Bank of England independence and this put another nail in its coffin.
Spanish banking sector developments
After discussing and analysing the Spanish banking sector and indeed her economy on Monday there have been some further developments. There has been some criticism of Spain’s financial position by the International Monetary Fund and even rumours of another downgrade. Anyway the Bank of Spain has produced some potential reforms.
1. In future all non performing loans will be fully provisioned for within a year rather than the current timetable of up to 6 years.
2.The Bank of Spain will change its position that all non performing loans have to be covered 100% and will allow for offsetting from the value of the asset. This might seem a reduction but is an improvement as you see the 100% provisioning rule has led Spanish banks to make all sorts of financial contortions to avoid having to provision because the current rate is so penal.
3. There will be increased provisions on acquired assets. The amount of provisions on recovered or acquired real estate assets will rise to 30% if these assets are held for more than 2 years.
Of these the third is the most significant as Nomura has produced some research which indicates that the cajas or savings banks have not provisioned to this level. Further it has looked at the level of real estate assets compared with the cajas equity and seven of them have more real estate assets than equity with three estimated as having twice as much. Of these Cajasur (which I discussed in detail on Monday) was way out in front at 411% so it is probably for best that it is in the hands of the Bank of Spain.
On slightly different tack as Nomura feel that the Spanish banks have a better level of provisioning for non performing loans BBVA has struggled to renew 1 billion Euros of commercial paper funding in US markets. With the current problems in inter-bank markets this may make it more dependent on funding from the European Central Bank (ECB). It is not entirely reassuring that the main users of ECB funding have been the Greek banks…
I believe that strains in the Spanish banking system and beginning to show and the cajas or savings banks in particular are showing more and more signs of the strain. It is not clear to me that the policy of mergers really solves things as a bad debt is not fixed by it and a relatively good caja is weakened in the process. The policy strikes me as something of a gamble on good fortune.
I was asked recently to give an opinion about Santander which has expanded its operations in the UK over the course of the credit crunch and my thoughts remain as they were on the 5th February.
When we went into crisis it appeared that the Spanish banking system had operated under a superior regulatory regime when compared with ours and was accordingly in better health. So from an apparent position of strength Santander (a Spanish bank) was able to buy Abbey, Alliance and Leicester and some of Bradford and Bingley making it a major player in UK banking. It published what on the face of them were solid figures this week. But with the severe problems in its domestic economy I cannot help but have the feeling that there must be underlying strains there. The unemployment rate in Spain and the housing crisis must be hurting the Spanish banking sector.
Now I do not want to ratchet up fears at a nervous time ….. Also Santander has a prudent reputation. However if the distress in Spain rises and it does hit problems then there are clear implications for the UK. Should we have allowed it to expand so much in the UK? I had the feeling at the time that as the only buyer in our crisis we were letting Santander over expand in the UK.
I wish to emphasise that I have nothing against Spain or Spanish banks making investments in the UK. In many respects I welcome this, but I feel that we let Santander expand too much here particularly considering that it was obvious even then that the Spanish property market was very over-extended which had in the end to hurt her banking sector. I feel that our authorities were so desperate for a short-term “saviour” they closed their eyes to potential and indeed the likely long-term implications of this.
Update 11.35 am
Spain has passed her austerity budget through her Parliament but according to Reuters the vote was 169-168 so literally by the skin of its teeth. This indicates that there are a lot of objections to this package in Spain and I suspect this story will run and run.