Mervyn turns a tidy profit

It was, said one MP, “a shocking cover-up.” Another was “outraged”; a third complained about “how many jobs you could support with all this money.” The broadsheets prominently covered the scandal. The cause of the distress? The announcement on 24th November that, in autumn 2008, the Bank of England provided emergency liquidity assistance (ELA) to the Royal Bank of Scotland (RBS) and Halifax Bank of Scotland (HBOS). These “secret loans” totalled about £60bn and were repaid by RBS in December 2008 and HBOS in January 2009.

Those acquainted with the workings of London’s wholesale money markets were unsurprised by the announcement. It was widely known that the Bank of England had provided significant liquidity to banks that were unable to fund themselves, until things got better. And it wasn’t especially hard to guess the likely recipients of the Bank’s help. At most, for the insiders, the Bank had filled in the details.



The idea behind ELA is that a central bank provides temporary breathing space by funding a struggling bank’s operations, allowing it to fix up its balance sheet. This funding is secured by the bank pledging collateral back to the central bank, the value of which exceeds the amount of the loan. Following the Northern Rock débâcle, when support for the ailing bank was unveiled by the BBC in a blaze of publicity, laws were changed to allow for ELA provision without public disclosure. This allowed the central bank to be a secret “lender of last resort,” keeping the borrower’s temporary distress under wraps. It is a perfectly sensible system, and clearly one that worked well in this case.

ELA is neither a subsidy, nor a bailout, nor a public investment. By being made to put up collateral to the Bank of England (of around 1.65 times the value of the loan), both RBS and HBOS actually saw their balance sheets weaken further. Both banks had to pay a big fee to the Bank as well.

The idea that central banks should lend to solvent but illiquid banks, but do so at a penalty rate, is as old as Lombard Street (1873), Walter Bagehot’s classic account of the London money markets. Bagehot’s principle is as valid today: solvent banks should not be allowed to fail without some opportunity to refinance themselves, but they should pay a high price for it.

The Bank of England has, so far, been coy about how much it has made on these transactions, but they were undoubtedly profitable. Given a couple of reasonable assumptions—that the Bank charged a margin of around 2 per cent and that the average size of the loans was just under half the peak size of the loans—I would estimate the Bank of England’s pre-tax profit at £130m. And amid gloom about the public finances it is worth noting that the Bank’s profit in the financial year 2008-09 went up sharply too: from £197m to £995m.

How? Largely from the money it earned helping cash-starved banks. Note 29 of their annual accounts tells us all we need to know: that the Bank’s “retained earnings” grew by £664m in 2008-09, thanks to post-tax surpluses from what are known as “indemnified operations,” of which £573m came from the operation of the special liquidity scheme. That suggests a post-tax figure from ELA of £91m, which would fit with my pre-tax profit estimate above.

So, when chancellor Alistair Darling told the House of Commons on 25th November that “there has been no cost to the taxpayer” as a consequence of the Bank’s liquidity support for RBS and HBOS, he was understating his case. These “secret loans” turned a profit for the public. They have been well understood by those who make a living in the wholesale markets (those who lend to other banks), while also being fully in keeping with venerable principles of central banking.

So why the fuss? It is worth noting that the MPs quoted are not obscure backbenchers. They were, in order quoted: Vince Cable, shadow chancellor for the Liberal Democrats; Michael Fallon, senior Conservative member on the treasury select committee; and John McFall, Labour chair of the same committee. In other words, politicians whom one might have expected to have understood something of the activities of central banks.

The big surprise here is not that the Bank of England lent money to illiquid but viable banks. It isn’t even that, having learned some hard lessons from the collapse of Northern Rock, the Bank of England decided to keep these loans a secret, at least until the long-term financial positions of each bank become more stable. No, the big surprise is that, more than two years into a major financial crisis, our leading politicians are still unable to discuss technical matters relating to banks with any degree of assurance. They appear not to understand what our central bank is doing when it intervenes to support banks in trouble; nor to grasp the difference between illiquidity and insolvency—nor the distinction between operating capital and balance sheet asset valuations.

And worse, our financial journalists, who are supposed to explain such matters to the public, appear to be as ill-informed as the politicians. Rather than challenging their empty outrage, they simply echo it.