How did the central banks find themselves holding the torch that keeps the shadow banks in existence? Leon Wansleben throws some light.

You are likely to read this piece at a time when numerous other articles return to the collapse of Lehman Brothers as the most iconic, single most consequential event of “the worst banking crisis the world has ever witnessed”1.But in autumn 2008, more or less coinciding with Lehman’s fall, another, less publicised, similarly consequential event took place: the Bank of England decided that it would turn its ad-hoc support for distressed financial institutions and failing markets into permanent policy.2

After a year of reluctance and internal conflict following the failure of Northern Rock, governor of the Bank of England, Mervyn King, and colleagues had come around to endorse a new version of the bank’s role as lender of last resort – that is, as the ultimate provider of liquidity for the banking sector in times of market turmoil.

I return to this decision because it marks an important step in re-defining the relationships between central banking and financial markets, not just for a situation like Lehman’s fall and all that followed, but for decades to come.

Through its commitment for permanent liquidity support, the central bank would become ever more closely intertwined with finance. Federal Reserve rate cuts in the 1990s under its then chairman, Alan Greenspan, were made to shore up liquidity in times of crisis. Those interventions spawned the infamous “Greenspan puts” – options that shielded investors from their risk taking strategies – which have now become acknowledged, permanent feature of public policy.

“What is most astonishing is how the monetary policy makers collectively managed to neglect potential consequences and policy implications of what they had just observed.”

There exist two prominent interpretations of the Bank of England’s move.  According to one of those views, while King took long to realise the need for massive central bank interventions, ultimately, he understood what a central bank ought to do; lend freely and against the cycle of disappearing liquidity in the markets. Only in that way could a systemic breakdown be prevented and public interest be saved. Most experts and monetary officials endorse this interpretation.

But critical scholars and political theorists offer a different account. For them, the Bank of England’s new support operations represent a seismic shift in the very locus of sovereignty in Western polities. Financial markets only have to call a crisis for the state to suspend democratic procedures and to invest billions of dollars, pounds, or euros for the sake of saving financial markets and individual banks. We have moved, with little protest, from shadow banking to shadow politics.

What actually happened between 2007 and 2008 at the Bank of England? What were the concrete decisions that policy makers took? These questions have been largely ignored in academic and public debate, and if discussed at all, only for the US context. But answering them will at least give some preliminary evidence for engagement with the bigger question of how relations between finance and the state shifted in the context of 2007-8. ​
For that purpose, I will draw on different historical sources that were published recently by the Bank of England. In 2015, it released the minutes of its Court of Director meetings held between 2007 and 20093; and together with the published minutes from the central bank’s then exclusive executive decision-making body, the Monetary Policy Committee (MPC), we can use this evidence to reconstruct what happened during the critical period preceding the decision in autumn 2008.4 All subsequent quotes are taken from these documents.

This evidence shows it took considerable time for the authorities to recognise that a crisis was happening at all. There had been warning signals in financial markets well before autumn 2007. In February that year, HSBC had suffered considerable losses from its US subprime mortgage exposure and in July 2007, with the troubles of Bear Sterns and warnings from the Federal Reserve Bank in Washington, King and colleagues arguably possessed enough information to detect a looming crash. Indeed, the MPC itself had already pointed to the “risk of a sharp reversal in asset prices” in January and continued to observe “downside news in the United States” (April) and “concerns about the US subprime mortgage markets” in its subsequent meetings until August 2007. But the dots only became gradually connected with the MPC’s gathering on 12 September.

“The blame here thus falls on a neglect for financial markets before the crisis that resulted from academic economic training and a technocratic blindness towards financial market risks.”

In the background, King was dealing with the liquidity squeeze faced by Northern Rock. The British mortgage lender was unable to obtain wholesale funding from other financial institutions and would close its doors within the subsequent ten days. The MPC members were not informed about these policy discussions in the Tripartite Committee – the government’s forum for discussing financial emergencies – but they still noted “considerable disruption in financial markets” and identified further “deterioration in the US housing market”. Most importantly, in September, the policy makers first drew a crucial connection between problems in US housing and a liquidity crisis faced by the global financial system. They remarked: “the extra demand for short-term liquidity, and uncertainties about who had large exposures to US sub-prime mortgages, meant that banks had, as a general matter, become reluctant to lend to each other at maturities beyond a few days in most currencies, including Sterling”. Here, then, the central bankers provided a first sketch of how the later collapse of financial markets would actually unfold; drops in asset prices would lead to an overall contraction in the market liquidity that was essential for maintaining inflated balance sheets in “shadow” as well as “official” banks.

But what is most astonishing is how the monetary policy makers collectively managed to neglect potential consequences and policy implications of what they had just observed. In that same September meeting, “Committee members noted that eventually market participants should be able to re-evaluate the risks involved, re-price the relevant securities and probably re-assess the price of credit more generally, discriminating better between different assets. The adjustment process should be temporary”. The focus remained squarely on inflation risks, and since these had apparently receded with an expected economic cool-down, the committee decided to stay put.

This attitude resonates with how King reportedly behaved in the Tripartite Committee discussions that were concerned with “The Run on the Rock”.5 As has been widely criticised, King played a critical role in Northern Rock’s failure because he regarded its problems as consequences of imprudent banking and wanted to avoid “moral hazard” – a situation in which other bankers could count on future public bail-outs and would thus exploit their limited downside risks as with the Greenspan put options seen in the US.

King apparently stuck to this position even after The Run on the Rock. This led to conflicts inside the Bank of England within the months to come. According to retrospective accounts, some executive members believed the central bank ought to re-activate and re-design its lender-of-last-resort facilities, but King initially proved resistant to such a move.

Only gradually did the Bank of England change its policies towards a more proactive engagement with liquidity problems and with its role as lender of last resort. One crucial step was taken in December 2007 when the bank announced that it would offer additional funding at three-month maturity in exchange for an expanded range of “collateral” – meaning the assets used in “secured” borrowing from the central bank. And in April 2008, the bank then introduced a “Special Liquidity Scheme” that would enable banks and shadow banks to exchange their unmarketable collateral, especially securitised mortgages, against UK Treasury bills (which count as safe assets that can always be used to borrow from central and commercial banks).6

But the true turnaround happened in October 2008 when the Bank of England fundamentally restated the role of its market operations. The central bank stated the purpose of these operations in terms of two key objectives:  to implement monetary policy by controlling the interest rate and to “reduce the costs of disruptions to the liquidity and payment services provided by commercial banks”. This required the bank to ensure that “the day-to-day needs of the banking system for…liquidity” were met, “in normal and stressed conditions”.7

Key officials, in particular deputy governor, Paul Tucker, had convinced King that, to perform these tasks, the bank should formalise different facilities for the provision of liquidity to a wide range of financial institutions, in exchange for various sorts of assets, especially securities backed by residential mortgages and covered bonds.8

The explicit intention was to have these facilities as permanent armoury for the central bank.

Clearly this account is not the full story of what was going on in the Bank of England in the months between September 2007 and October 2008. And it might be seen in a favourable light that former officials did not disclose their internal conflicts after the events. But the cited sources at least provide some clear evidence that, within a short period, the Bank of England’s role as lender of last resort was not only re-activated but also fundamentally remade, and with this redesign, the bank explicated a new relationship between its policies and the financial system.

Of the two interpretations of these developments referred to earlier, the one endorsed by most experts, monetary officials, but also by some political scientists and sociologists is that the crisis actually represents a period of policy learning and paradigm change inside central banks. Ad-hoc bureaucratic learning had become necessary because of the ways in which central banking had been conceived before 2007. Willem Buiter summarises the problems associated with central banking at the eve of the crisis:

“The Monetary Policy Committee of the Bank of England which I was privileged to be a ‘founding’ external member of… had quite a strong representation of academic economists and other professional economists with serious technical training and backgrounds. This turned out to be a severe handicap when the central bank had to switch gears and change from being an inflation-targeting central bank under conditions of orderly financial markets to a financial stability-oriented central bank under conditions of widespread market and funding illiquidity.”9

The blame here thus falls on a neglect for financial markets before the crisis that resulted from academic economic training and a technocratic blindness towards financial market risks. King is particularly charged with this neglect. He was the one to replace markets people working for the bank with PhDs from MIT and he told his staff to focus on the problems of the “real economy” rather than lunching with finance-professionals from the City. The importance of lender of last resort – a central bank’s first and arguably most foundational policy role – had been forgotten as a result. A MPC member who participated in the policy discussions up until 2008 draws this link:
“That role of the Bank of England as the head boy of the City was, even though it had already been sharply reduced in 1997, shrunk even further in the period up to 2007, which is one significant reason why the bank didn’t see the crisis coming and reacted so ineptly when it did. [King] forgot that the role of the central bank is to be the lender of last resort.”10

“King, in that story, is not a macroeconomics-dupe but the tragic hero.”

Only under the pressure of events, and with some intellectual and practical guidance from New York’s regional Fed, did the Bbank overcome its lender of last resort neglect. Tucker, among others, reportedly played a prominent role in turning British central banking culture around.
This argument implies that, what the Bank did in October 2008 was exactly what it ought to do – re-define and expand its financial stability and policy role. That is because liquidity insurance of the kind now offered by the bank is “a public good, indeed a global public good”.11 The way forward is pointed by Tucker – lending of last resort should be articulated as a public policy task just as monetary policy had been 20 years ago.12

For critical scholars and theorists, however, these technocratic developments just touch the surface of deeper structural shifts that have been unfolding since the 1970s – and which require a re-perspectivisation of what “public” financial policy actually means. This process gained pace with financial globalisation, continued with expanding power for “independent” central banks, and accelerated though the various bail-outs and liquidity injections decided during the crisis of 2007-8 – undemocratic decisions that amounted to a redistribution from bottom to top, without any accountability for those, who had created the mess.

If lender-of-last-resort operations are justified with “public interests”, so the argument continues, this can only mean that the very locus of “sovereignty”13 in capitalist democracy has shifted to finance itself. For what lending of last resort boils down is a commitment by monetary authorities to invest unlimited amounts of public resources for the sake of saving a system whose true beneficiaries remain unnamed. Seen in this light, the emergency measures during the crisis were not that different, in their structural meaning, from the deregulatory and complacent policies observed before 2007.

The difference is only that, before the crisis, support for financialisation was implicit and somehow coupled to a democratically sanctioned model of welfare based on private credit;14 while during and after the crisis, central bankers have more selectively and explicitly committed themselves to the dominant market actors. King, in that story, is not a macroeconomics-dupe but the tragic hero. He showed hesitance to give in to the dominant interests at work but, trapped in his economics mind-set, could only express his unease by referring to moral hazard. But technocrats more attuned to their age completed the task. They moved the Bank of England to a position, from where it would become further removed from democratic politics and could fully commit itself to its ever more intimate ties with finance.15

What should we make out of these different interpretations? Let me here use the above-mentioned evidence to dig a little deeper at what changed in the Bank of England’s relations to finance. The central bank’s consultative paper on market operations from autumn 2008 vindicates the idea that, during the crisis, some necessary policy learning had indeed taken place. This is for two reasons. First, the consultative paper was more or less signed on the very day that Lehman went bust. As we know that failure not only triggered a widespread money market breakdown, but also a credit crunch.

“While checking a commercial bank’s annual reports for capital buffers could be easily delegated to a regulatory agency, such delegation would fail due to the continuously changing liquidity position of the banking system.”

Credit crunches are very consequential because they cut off access to sources for investment, operative capital, and private credit for the economy as a whole. Morgan Ricks writes that “fragility of the short-term funding markets was a central problem – perhaps the central problem – for financial stability”.16 If this is true, central banks’ widespread liquidity support was inevitable and existential to avoiding further deterioration. So whatever role Tucker or others played in changing King’s mind, we should be thankful to them.

The paper from autumn 2008 reflects learning in another respect: with this public statement, the Bank of England ultimately gave up its previous position that conducting financial regulation was for others, not for a central bank. In the course of the crisis, the bank had come to realise that, while checking a commercial bank’s annual reports for capital buffers could be easily delegated to a regulatory agency, such delegation would fail due to the continuously changing liquidity position of the banking system, which is influenced by global money market developments and the policies of the central bank itself. In fact, only a central bank possesses the market expertise and financial resources to design and enforce regulations in this critical domain. Moreover, in combining the promise for last-resort lending with demands for prudential liquidity provisions by banks, can the central bank hope to be addressing King’s moral hazard concerns. Institutions that want liquidity insurance need to accept the central bank’s regulatory interventions in exchange, because “the overall social cost of…liquidity risks…can be greater than the costs for the individual banks themselves”.17 In his post-crisis book, King reiterates this argument for tying the lender-of-last-resort promise to liquidity regulation:

“If bank ‘bailouts’ were seen not as crisis interventions to save institutions in trouble, but as the payout from an insurance policy into which the banks had been contributing regularly in normal times, then perhaps much of the understandable anger that accompanied the rescues of 2008 would have been tempered.”18

But it is precisely because of evident asymmetries in the relation between private gains and “socialised” support – between industry resistance against more profound changes in banking and widespread reliance on central bank support – that we need to engage with the cited, more radical critiques. To put it bluntly, technocrats in central banks have been unable or unwilling to rebalance the constraints imposed on financial institutions with the privileges that are granted to them.

The permanent liquidity support promised by the Bank of England has thereby led to even more moral hazard. As a result, the bank is ever more implicated in the consolidation of those financial market structures that had led to rising inequality and financial fragility in the run-up to the crisis of 2007-8.

Why does this imbalance between weak liquidity regulation and liberalised lending of last resort persist? Worrying insights come from economic history research on the post-war period.

During that period, financial crises were largely avoided and the inequality-production endemic to finance was tamed. As John Turner and William Allen suggest, this was achieved as an unintended consequence of “financial repression” – a repression that was exercised because the government needed to finance a massive post-war debt and because the central bank could successfully achieve compliance using a latent threat: should the City fail to comply with onerous liquidity regulations, a Labour government might simply decide to nationalise the banks.19

“The problem of regulating shadow banking remains – precisely because this globalised part of the financial system relies on regulatory loopholes.”

These historical insights are worrying precisely because we live in a world that is radically different from that of the 1950s or 60s – even if some populists promise a return to good old times. One decision to undermine the post-war order was taken by the Bank of England itself, in response to the emergence of Eurodollar markets in London. Firms in these markets were left unregulated – they did not have to maintain liquidity buffers. A rationale behind this “hands-off” approach was that the Bank of England did not want to take institutional responsibility for offshore firms – it wanted to avoid a situation in which the British central bank would need to bail out the entire Eurodollar market, no matter where the firms in this market came from and what kinds of activities they were engaged in.

This decision made sense at the time but it has contributed to the predicament that we find ourselves in today. Those once excluded from lender-of-last-resort facilities – now called shadow banks – have become partially included in the central bank’s “liberalised” lending of last resort. Shadow banks turned out “systemically” too important to refuse liquidity support for them.20

The redesign of liquidity provisions in the wake the financial crisis thus undermined the distinction between “respectable” and “unrespectable” banking that had once underpinned the regulatory approach of the Bank of England.21

Again, liberalising the lender of last resort function was perhaps inevitable, given the threat of a complete breakdown in autumn 2008. But the problem of regulating elements of the shadow banking system remains – precisely because this globalised part of the finance relies on regulatory loopholes and so may rather move to unregulated jurisdictions than become fully included in a structure, in which constraints and privileges are rebalanced again.

We can surely live in a world in which Lehman Brothers no longer exists. But can we continue accepting a situation in which the Bank of England promises liquidity insurance to a shadow banking system that the same time undermines any serious attempt to reregulate the financial system? This question will remain with us for years and decades to come.

References:

1. Mervyn King, The End of Alchemy, New York, London: WW Norton paperback edition 2016, p. 1.
2. Bank of England, The Development of the Bank of England’s Market Operations, Consultative Paper October 2008.
3. See the Bank of England press releaseand Larry Elliott and Jill Treanor “The minutes that reveal how the Bank of England hand led the financial crisis“, The Guardian 7th January 2015
4. MPC minutes are accessible via the Bank’s website.
5. House of Commons Treasury Committee: The Run on the Rock. Fifth Report of Session 2007-08.
6. For an overview, see Sarah Breeden and Richard Whisker Collateral Risk Management at the Bank of England, Bank of England Quarterly Bulletin 02/2010 7. p. 95.  Market Operations 8. p. 4. Collateral risk Management, p. 94.
9. Willem Buiter, The unfortunate uselessness of most ‘state of the art’ academic monetary economics, Financial Times, 3rd March 2009.
10. Interview author with unnamed former member of MPC, April 2017.
11. Perry Mehrling, Why central banking should be re-imagined, BIS Papers No 79 2015, p. 114.  12. “What’s needed today is the injection of the kind of formality, analytical rigour and transparency that transformed the practice, and legitimacy, of monetary policy during the 1990s” In: Paul Tucker, The lender of last resort and modern central banking: principles and reconstruction, BIS Papers No 79 2015, p. 23.
13. This notion of sovereignty refers back to Carl Schmitt’s dictum that the sovereign in any political situation is that entity which can announce a “state of exception” – a situation in which the usual political procedures and constitutional checks are suspended for the sake of doing what arguably needs to be done. This is exactly what financial institutions are now able to do: They can call upon central banks to receive public support, and central banks can decide to spend billions of public money for the sake of saving banks, hedge funds, and markets as a whole. See Joseph Vogl, The Ascendancy of Finance, Polity Press, Cambridge 2017.
14. See Avner Offer The Market Turn: From Social Democracy to Market Liberalism. Discussion Papers in Economic and Social History. Number 149, December 2016.
15. Adam Tooze, The secret history of the banking crisis, Prospect Magazine, July 14, 2017.
16. Morgan Ricks, The Money Problem. Rethinking Financial Regulation. Chicago: The University of Chicago Press 2016, p. X.
17. Market Operations, p. 5.
18. End of Alchemy, p. XXVII-XXVIII.
19. William A. Allen, Monetary Policy and Financial Repression in Britain, 1951-59. Basingstoke, Palgrave 2014; John D. Turner, Banking in Crisis: the rise and fall of British banking stability, 1800 to the present. Cambridge, Cambridge University Press 2014
20. This term is from Morgan Ricks, The Money Problem, p. 193.
21. Anthony Hotson. Respectable Banking. The Search for Stability in London’s Money and Credit Markets since 1695. Cambridge: Cambridge.

Leon Wansleben

Leon joined the LSE in 2014 as an Assistant Professor. His main areas of interest include economic sociology (in particular the study of financial markets), the sociology of knowledge and …

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