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Carney liquidity rules are an ingenious revolution

The new flexible liquidity rules will prove key to realizing Bank of England governor Mark Carney’s bold ambition to further entrench London’s status as a global financial hub while addressing the challenge of rising interest rates and a collateral shortage.

When Mark Carney was appointed chairman of the Financial Stability Board (FSB) in November 2011, his top priority was to end the notion of banks being too big to fail.

Now ensconced as governor of the Bank of England (BoE) since the summer, he appears to have no intention of reining in the size of the country’s financial institutions.

In his first speech on financial sector regulation last month, Carney struck a strong pro-finance note at odds with his predecessor Mervyn King, who warned of the dangers of moral hazard. Carney said: “It is not for the Bank of England to decide how big the financial sector should be.”

Carney is backing the banking industry by extending more liquidity to struggling financial institutions, an approach that will bring it more into line with the European Central Bank and the US Federal Reserve.

That includes amending the bank’s indexed long-term repo auction, a standard monthly facility, so that it will be cheaper to access and offered against a broader range of collateral. The central bank will also turn its extended collateral term repo, a temporary facility aimed at calming volatile markets, into a permanent arrangement.

In addition, Carney said he will consider extending this liquidity beyond traditional lenders and into the shadow-banking sector, provided it meets certain criteria.

The speech marks a sea-change in the BoE’s response to the 2008 financial crisis and shows that while Carney still advocates a safe banking system, he no longer links it to the overall size of a financial institution. In fact he said he envisaged the sector growing to almost nine times GDP by 2050, compared with the current level of four times.

Carney’s proposals are designed to be used in the medium term as and when the central bank ends its funding for lending scheme and tapers its quantitative-easing programme. Until that point, the bank believes those schemes provide all the liquidity and collateral the UK system needs.

Carney’s liquidity move has come because he believes the banking system is stronger and so should be supported through an economic recovery. The higher cost of liquidity has been seen when the Fed first talked of tapering its bond-buying programme in May – talk that led to a sharp sell-off in credit that exposed the low level of inventories held by banks willing to buy fixed income assets.

Collateral management has become even more crucial for banks since the introduction of centralized clearing for the OTC derivatives market, requiring banks to post collateral with clearing houses. Industry figures have warned of a collateral crunch as banks try to lay their hands on collateral of a sufficient quality – such as cash and US treasuries.

Banks could use the greater liquidity provided by the BoE as collateral for other counterparties, rather than for lending to the economy.

Carney’s old-school approach to boosting capital and liquidity differs from continental European banks, which are reducing their balance sheets by cutting lending to achieve a similar end.

One banking expert says: “In the UK, however, there is the opposite concern – the help-to-buy scheme, which allows banks to lend on a levered basis is coming too early in the recovery and risks forming an asset bubble. High household leverage, in turn, could constrain the Bank of England from raising interest rates.”

By contrast, the new liquidity rules will help offset the negative of impact of a higher policy rate.

On Carney’s plan to grow the size of the banking system, the expert says: “The UK banking system is already at seven times GDP, including the operations of foreign banks, and the 3.5 times is only for domestic assets. That’s among the highest in the world.”

By opening up liquidity to non-traditional lenders, Carney, in a sense, is taking an approach that is consistent with his FSB days, when he vowed to bring greater regulation to shadow banking.

The way companies finance themselves is undergoing a secular shift from bank lending to funding through capital markets, while other forms of finance, such as liquidity provided by insurance and pension funds, are also a powerful source that can be harnessed.

However, market sources say, in the short term, the changes will have little effect as global rules at Basel require that banks keep higher liquidity levels.

The banking expert says: “Long term, it is positive that the banking system has more liquidity, but in the near term the increase in [Basel] liquidity rules could have a negative impact on lending.

“There’s more eligible collateral, but liquidity ratios are higher – on a net basis, banks still need more liquidity and they will take advantage where they can.”

The expert added that changing the rules to allow lower-quality collateral still means banks will have to hold more liquid instruments, as the riskier collateral is discounted more. There is also inevitably a concern that, by swapping lower-quality collateral in exchange for higher-quality liquidity, systemic risk will build up.

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