In early 2008 the liquidity aspect, though, did not go away; and eventually on 21 April – just over a month after a deputation of senior bankers had pleaded with King to inject further extra liquidity into the market (with one complaining to the press that the Bank had ‘a much tighter definition of the collateral that it will accept’ than other central banks), which in turn was just a few days after the collapse of the American investment bank Bear Stearns – the Bank announced its Special Liquidity Scheme (SLS). ‘The Bank,’ reported the Financial Times, ‘will offer to acquire asset-backed securities from banks in exchange for Treasury bills,’ with the Bank expecting to swap £50 billion of assets in the first couple of months. ‘Bank of England’s Clever Swap Shop’ ran the headline to the paper’s editorial, which joined in the generally warm response (albeit some critics wishing it had come significantly earlier) but reflected that the SLS was not necessarily the answer:
A moment of truth is arriving in the credit squeeze: a clear empirical test of whether it is a problem of bank liquidity or bank solvency is about to begin. The Bank of England’s new Special Liquidity Scheme is a cleverly designed and welcome move to ease liquidity troubles. It should lower the three-month interbank lending rate. But if the real fear is solvency – that too many bad loans were made at too low an interest rate – it will not make mortgages cheaper or release wholesale funding for the banks.
Indeed, King himself at the press conference announcing the scheme made much the same point: its purpose was ‘to take the liquidity issue off the table in a decisive way’; but it was ‘not available for failing institutions’ and would not, he insisted, address the solvency of banks.19
What would? By mid-March, increasingly frustrated by the G7’s quasi-dysfunctional meetings, King was talking about the US, the UK, Switzerland and perhaps Japan coming together to attempt a simultaneous recapitalisation of all major banks; while later that spring he sent a handwritten letter to the prime minister, Gordon Brown, urging recapitalisation of the British banks. At this point, undoubtedly, the governor was well ahead of the curve, having arguably been somewhat behind it during the early months of the crisis. Yet of course in practical political terms it required something truly alarming to happen – with Bear Stearns being not quite enough – for externally imposed recapitalisation to be a serious runner. And anyway, perhaps all would be well without it. ‘The most likely outcome,’ predicted the Bank’s April 2008 FSR (published shortly after the SLS announcement), ‘is that market conditions improve in the period ahead,’ though not denying that ‘tail risks’ to financial stability remained; and some four years later, looking back in his Today lecture, King reflected that ‘we tried, but should have tried harder, to persuade everyone of the need to recapitalise the banks sooner and by more’, adding that ‘we should have preached that the lessons of history were being forgotten – because banking crises have happened before’.
Over the summer of 2008, noises off were seldom reassuring. During the preceding month, noted the minutes of NedCo’s meeting on 11 June, ‘monoline insurers had been downgraded which had implications for some of the largest financial firms; Lehman’s had been the subject of rumour and speculation over a few days, which fortunately had been so far contained; and in the UK, Bradford and Bingley served as a reminder that the situation remained fragile’. Altogether: ‘Although there was still some sense that the worst had passed, it was liable to remain a bumpy ride and, depending on the scale of the bumps, the destination might be changed.’20 Further ominous news followed: later in June, 5 per cent of the rights issue made by Royal Bank of Scotland (RBS) being left with the underwriters and Lehman Brothers reporting a serious second-quarter loss; in July, the announcement by the US Treasury of a rescue plan for Fannie Mae and Freddie Mac; and in early September a complete bail-out for both those huge mortgage-providing institutions.
Domestically, the principal issue was whether, against gathering economic as well as financial storm clouds, the MPC was unduly prioritising the countering of inflation at the expense of the countering of recession. ‘I would gradually expect the events of the last few months to have an impact in reducing the growth rate of consumer spending,’ King told the Treasury Committee at the end of April. ‘Remember, this is something that I have been expecting, and, indeed, perhaps hoping for, for some time, a rebalancing of the economy, and I think we would expect over the next two years that there would be some rebalancing of the economy. But that would also be accompanied by a slowing of growth, so the economy would grow below its long-run average for a couple of years. But that is not a disaster in itself, we were growing above the long-run average for a number of years before that …’ In mid-June, in his Mansion House speech, the governor specifically addressed those commentators and others wanting monetary policy to be significantly eased:
Target growth not inflation is the cry. I could not disagree more. This is precisely the situation in which the framework of inflation targeting is so necessary. Without it, what should be a short-lived, albeit sharp, rise in inflation, could become sustained. Without a clear guide to the objective of monetary policy, and a credible commitment to meeting it, any rise in inflation might become a self-fulfilling and generalised increase in prices and wages. And surely the lesson of the past 50 years is that, when inflation becomes embedded, the cost of getting it back down again is a prolonged period of sluggish output and high unemployment. Price stability – returning inflation to the target – is a precondition for sustained growth, not an alternative.
Among the external critics was the Daily Telegraph’s Damian Reece, who in early July was prompted by grim manufacturing figures to assert that ‘it’s clear to me we’re headed for recession and as soon as that fact dawns on the MPC it should cut rates without delay’. The Bank, however, remained unmoved, with its Inflation Report in August not even mentioning the word ‘recession’ and arguing that although the risks ‘from a more pronounced slowdown in demand’ had become greater, nevertheless that was a lesser consideration than the ‘possible impact of elevated inflation on pay pressures and inflation expectations’. The MPC’s meeting on 5 September saw rates held at 5 per cent, and soon afterwards King uttered a striking pronouncement before the Treasury Committee: ‘I do not really know what will happen to unemployment. At least, the Almighty has not vouchsafed to me the path of unemployment data over the next year. He may have done to Danny, but he has not done to me.’
‘Danny’ (a reference to the legendary Spurs footballer of the 1960s) was David Blanchflower, a UK-born but US-based economist who had become an MPC external in June 2006 and, after a lengthy period of largely voting in vain for rate cuts, had gone public with his prediction that Britain was heading for mass unemployment. In September 2009, four months after leaving the MPC, Blanchflower wrote candidly in the New Statesman:
In my view, and as I have consistently argued over the past two years, the economy would have been in much better shape today had the MPC not kept interest rates so high, especially from the beginning of 2008. House prices had peaked by the end of 2007 and business and consumer confidence surveys had collapsed. By the second quarter of 2008, based on both output and employment, the UK economy had moved into recession. But my colleagues on the MPC did not join me in voting for rate cuts until October 2008.
So why did the Committee get it so wrong? From my perspective, it was hobbled by ‘group think’ – or the ‘tyranny of the consensus’. Mervyn King, with his hawkish views on rates, dominated the MPC. Short shrift was given to alternative, dovish views such as mine. I focused on the empirical data suggesting Britain was heading for recession; Mervyn and the rest of the Committee focused on their theoretical models and the (invisible) threat of inflation …21
To which, the defence would be that the inflationary threat was far from ‘invisible’ – approaching 5 per cent by the autumn – and that the all-important oil price was rising sharply. It was, as ever, a matter of judgement.
‘Presently there was
considerable nervousness around Lehman Brothers which would announce results today,’ Tucker told NedCo on 10 September 2008. ‘Whatever those results, it was thought that markets would remain tense. No matter what actions were taken by the authorities, market participants appeared to think that there was always one more significant institution to worry about.’ There was indeed, and the headline events of that unforgettable early autumn amounted to the biggest financial crisis since the 1930s, perhaps even earlier. Five days later, on 15 September, Lehmans filed for bankruptcy and Bank of America rescued Merrill Lynch; next day, the Fed announced a rescue plan for the world’s biggest insurer, AIG; on the 18th, it was announced that Lloyds was taking over the struggling Halifax Bank of Scotland (HBOS), while the Bank concluded a reciprocal swap agreement with the Fed, enabling the former to provide US dollar funding to RBS without either central bank taking an exchange rate risk; on the 28th, Fortis was rescued by the Benelux governments; next day, the mortgage lender Bradford and Bingley was nationalised; in early October, a $700 billion rescue bill for the American financial system passed into law; on the 7th, the Icelandic government rescued that country’s second-largest bank; next day, the UK government announced its rescue package for the UK banking system – involving an injection of up to £50 billion capital into UK banks, a doubling of the SLS to £200 billion, and a new credit-guarantee scheme of up to £250 billion – while at the same time the leading central banks undertook co-ordinated rate cuts; and five days later, on the 13th, the UK government’s specific capital injections were announced, amounting to a total of £37 billion into the beleaguered RBS as well as Lloyds and HBOS. Two days afterwards, on 15 October, the Bank’s executive team told NedCo that ‘the corner had been turned in relation to the banking system’, but that there now existed ‘a significant macroeconomic risk as the major economies entered recession’.22
This is not the place for a blow-by-blow account of those charged weeks, but it is clear in retrospect that the Bank made two overwhelmingly important contributions: predictably enough, one relating to capital, the other to liquidity, with both being pushed hard by King towards the end of September. On the liquidity front, mattering hugely in the short term while recapitalising arrangements were negotiated and took effect, the crux was not just the doubling of the SLS (for which the Bank, two days after the Lehmans shock, had extended the drawdown period), but the Bank’s wholly covert Emergency Liquidity Assistance (ELA), coming into operation at the start of October. In the event, RBS’s use of the facility peaked on 17 October with some £36.6 billion being borrowed, while HBOS’s peaked on 13 November with £34.5 billion; and though initially the Bank lent against bank collateral, soon it had no alternative – given the numbers – but to seek a government indemnity. As for capital, it was very much the governor who continued to take the lead, persuading government (Brown perhaps more receptive than Darling) and helping to face down the often unconvinced, resentful commercial bankers, who continued to insist it was essentially a liquidity problem. He spoke quite frankly at the end of September:
We have been dealing with the gravest financial crisis since 1914. We have been on the precipice. When we started this crisis there was a widespread view that banks were well capitalised. But now we realise that the problem was that assets sitting on their balance sheets which were supposed to be risk-free, carried a lot of risk. Perceptions of the value of those assets and the risks changed radically. What has become clear is that you cannot deal with this problem just by providing more liquidity to the banks. That just addresses the symptoms …
Importantly, during the four days or so of intensive international meetings – national leaders, finance ministers, central bankers et al – following the UK’s 8 October announcement, it was King’s doctrine about the paramount necessity of recapitalising the banking system that was spectacularly taken to heart; and at NedCo’s meeting on the 15th, sober satisfaction was expressed that, ‘in the wake of the UK plan’, there had been at those meetings ‘a real sense of urgency’.
Six days later, the governor gave a well-publicised and very characteristic speech in Leeds. He began with some local flavour, recalling how as a boy, half a century earlier, he had been taken by his father to Headingley to see New Zealand bowled out for 67 by the English spinners; he took his listeners through the causes of the crisis; and he explained why the scale of support, from governments and central banks, had been ‘unprecedented’. King’s crucial passage focused on why ‘a major recapitalisation of the banking system was necessary, was the centrepiece of the UK plan (alongside a temporary guarantee of some wholesale funding instruments and provision of central bank liquidity), and was in turn followed by other European countries and the United States’:
Securitised mortgages – that is, collections of mortgages bundled together and sold as securities, including the now infamous US sub-prime mortgages – had been marketed during a period of rising house prices and low interest rates which had masked the riskiness of the underlying loans. By securitising mortgages on such a scale, banks transformed the liquidity of their lending book. They also financed it by short-term wholesale borrowing. But in the light of rising defaults and falling house prices – first in the United States and then elsewhere – investors reassessed the risks inherent in these securities. Perceived as riskier, their values fell and demand for securitisations dwindled. For the same reason, the value of banks’ mortgage books declined. Banks saw the value of their assets fall while their liabilities remained unchanged. The effect was magnified by the very high levels of borrowing relative to capital (or leverage) with which many banks were operating, and the fact that banks had purchased significant quantities of securitised and more complex financial instruments from each other. Not only were these assets difficult to value, but the distribution of losses across the financial system was uncertain. Banks’ share prices fell. Capital was squeezed.
Markets were sending a clear message to banks around the world: they did not have enough capital. At the Annual Meetings of the IMF and World Bank in Washington ten days ago, the message was reinforced by our colleagues from Japan, Sweden and Finland, who, with eloquence and not a little passion, reminded those present of their experience in dealing with a systemic banking failure in the 1990s. Recapitalise and do it now was the lesson. Recapitalisation requires a fiscal response, and that can be done only by governments.
Confidence in the banking system had eroded as the weakness of the capital position became more widely appreciated. But it took a crisis caused by the failure of Lehman Brothers to trigger the coordinated government plan to recapitalise the system. It would be a mistake, however, to think that had Lehman Brothers not failed, a crisis would have been averted. The underlying cause of inadequate capital would eventually have provoked a crisis of one kind or another somewhere else.
‘With the bank recapitalisation plan in place,’ the cricket-loving governor concluded, ‘we now face a long, slow haul to restore lending to the real economy, and hence growth of our economy, to more normal conditions. The past few weeks have been somewhat too exciting. The actions that were taken were not designed to save the banks as such, but to protect the rest of the economy from the banks. I hope banks will come to appreciate, just as the New Zealanders at Headingley in 1958, the Yorkshire virtues of patience and sound defence when batting on a sticky wicket.’23
The Bank received considerable plaudits for its role in the October measures, with King himself as the semi-acknowledged hero of the recapitalisation moment; but he himself was subsequently to express some regret. Would the UK, he was asked in May 2013 in his final press conference on the economy, be in a better position if that recapitalisation by government had been on a larger scale? ‘The answer to that is yes, and we did say so at the time,’ he replied. ‘Not publicly, but we did make it clear that a more radical recapitalisation was necessary.’ If that was a minority argument, given the political difficulties of tapping the taxpayer even more than was done, so too was the per
sistent criticism mounted by the economist Tim Congdon. ‘Is the Government’s rescue programme beast or beauty for Britain’s banks?’ he asked in The Times as early as 15 October, two days after the specific capital injections were announced. ‘The leap in share prices has been beautiful for short-term investors in the stock market. But a strong case can be made that the Government has been beastly to the banks, with dangerous long-term consequences for our financial sector.’ He went on to argue that ‘for all their faults Britain’s banks are not insolvent or unprofitable’; that the terms of the deal, with the UK banks being able to access capital only ‘if they handed over to the Government chunks of their equity’, meant that they would now ‘compete head-on with banks from other countries, where the governments are being more lenient’; that it ‘would have been better if the Bank of England had reacted to the recent troubles in the same way that it did, so brilliantly and effectively, in past crises’, which is to say ‘the support should have been pre-emptive and low-key, and it should have come as a traditional lender-of-last-resort loan’; and finally, that the consequence of hasty, ill-judged nationalisation was that Britain’s leadership in ‘international financial services’ was ‘now in extreme peril’. Congdon continued to beat his particular drum for at least the next seven years, culminating in a 2015 article in Standpoint in which he accused the October 2008 recapitalisation of ‘far from stimulating extra bank lending to the private sector’, but being instead ‘a vicious deflationary shock to the British economy, at just the wrong moment in the cycle’.24
Till Time's Last Sand Page 92