Returning to normality

The Bank of England faces a number of issues in returning to more normal financial operations

 

As the UK’s gradual return to something more like normality continues, in every sphere of national life the same questions are being asked:  how much can we go back to how things were, and what has changed irrevocably?

On the one hand there are those who are urgent to recreate life almost exactly as it was in 2019, with all the freedoms and lack of concern that we only realise now in retrospect that we then enjoyed without a second thought.  Others though are more cautious and still need much convincing and reassuring before they are willing to resume their full place in society – agoraphobia, or a fear of crowds, looks like being a much more common affliction post Covid than it was before.

The truth will of course be somewhere between these two extremes.  In time even the most cautious will rediscover their ability to live life to the full;  as we have observed before, to be afraid to live because we are afraid to die is neither a natural approach nor in the end a sustainable one.  But life post-pandemic will be different, and some of the experiences and lessons of the last 12 months will remain – working from home will not cease to exist, city centres will change and adapt, and a greater awareness of hygiene in public places and the way in which respiratory diseases are spread will not be forgotten immediately.

Central banking faces exactly the same two questions – how much can we go back to how things were, and what has changed irrevocably – as everyone else, with the exception that central banks are seeking to return to normality after not just one but two near-death experiences.  Even before the pandemic, the fight against the financial collapse of a dozen years ago had left central banks with grossly extended balance sheets and interest rates near zero, and the tsunami of fiscal spending in the last year, much of it facilitated by central bank bond buying, has merely exacerbated their balance sheet problem and compounded the risks of premature interest rate rises.

But ultimately, central banks will want to return to being a more normal part of the financial system, in other words neither the funder of first resort for the government bond market nor the supplier of almost unlimited funds at almost non-existent rates for the banking system.  And when they do, the Bank of England for one may find that life is not as simple as they might have hoped.

This is because alongside the two big changes we have mentioned – the size of the Bank’s balance sheet and the level of UK official interest rates – the Bank has over the last dozen years or so made a host of other changes to the way it operates, ranging from its interaction with markets and other market participants, to the way bankers’ reserves (the money the commercial banks leave on deposit at the Bank of England) are handled and remunerated, to the composition and embedded mismatches in maturity, credit quality and much else of their extended balance sheet.

Most of these changes have been quite technical, and in terms of the wider government accounts they have – so far – proved relatively neutral in their financial consequences[1].  But there is one common theme to all of these changes which is far from technical or without wider consequences, which is that we do not really know how they will respond to a normalisation of monetary policy, and if and when interest rates move higher, they may end up costing a lot of public money.

It is one thing to observe that, in the current abnormal circumstances, the Bank’s changes have both individually and cumulatively come at little or no cost.  It is quite another to be sure that this would remain the case if interest rates, for example, were to return to their more long term levels of 3-5%.  And in a few cases, we can say positively that the changes the Bank has made, while largely costless when they were introduced, will be much more costly under any “normal” interest rate regime.

The decision to start paying interest to the commercial banks on their reserves at the Bank, for example – to quote just one example of changes that the Bank has made – has so far proved both beneficial and relatively costless.  It was designed to ease the operation of the financial system, in which it has succeeded, and with interest rates at 0.1%, it has cost very little either in monetary terms or in political capital.

Fast forward to a situation where interest rates are at more normal levels, and as the Holtham paper observes, this technical change in the way the Bank operates the reserves system suddenly turns into a transfer from the Bank to the commercial banks of perhaps as much as £40 billion a year.  It is not clear that a subsidy for the banks from public funds of this order of magnitude is either optimal financially or sustainable politically – but unless the Bank actively changes the regime it has established, that is what will happen unless interest rates stay permanently abnormally low.

A second example is the Bank’s balance sheet.  Traditionally the Bank has run a very conservative balance sheet, with most of its assets short term and most of its liabilities non‑interest‑bearing.  Such a balance sheet is largely immune to both a rise in interest rates and a steepening of the yield curve (ie, longer rates rising relative to short rates).  But as a consequence of buying a lot of government bonds and financing this by creating interest‑bearing reserves, the Bank’s balance sheet is mismatched and overweight long‑duration assets – exactly the sort of portfolio which is at risk of heavy capital losses when interest rates rise.

There are those that will argue that the Bank’s financial position is not material:  as the central bank it cannot go bankrupt, and in a real sense the bankers’ reserves are anyway not actually a liability that can be cashed.  Since a bank cannot withdraw its reserves (for what would it get in exchange? More reserves? Bank notes?), one could even argue that bankers’ reserves are more like an equity stake – an asset that has value and can be traded, certainly, but one that can never be redeemed[2].

We think this is too simplistic, and that even if the Bank is not at risk of bankruptcy, its financial exposures do nevertheless contain two real risks.  The first we will call the Weak Risk:  that the bank will be constrained from doing the right thing because of the financial and presentational consequences.  And the second we will call the Strong Risk:  that they will be encouraged and incentivised to do the wrong thing.  An example of the first might be a decision to delay a rise in interest rates, an example of the second might be to try to manipulate term rates, perhaps flattening the yield curve to avoid losses due to their maturity mismatch.  The first risks poor monetary policy, and the second leads to financial repression;  neither are routes the Bank will want to go down.

What should guide the Bank as it looks to make sure its financial management, and the way it operates the financial system, is future-proof and will survive a return to normality?  We offer the following Golden Rules, and suggest that the Bank’s management of the financial system should not:
– obscure or overcomplicate the operation of policy
– distort markets
– encourage unnatural behaviour from others
– treat different market participants differently

Over the last dozen years, different aspects of the Bank’s market operations, while introduced for a variety of entirely understandable reasons and with at the time very beneficial results, have broken some or all of the above four rules.  With the emergency receding, these changes, however necessary and beneficial at the time, now need to be reassessed.  As the Bank, like the rest of us, looks forward to and starts to get ready for a return to normality, it has much to do to make sure that it is fully in the right shape for what that more normal life will bring.

 

[1]              For those interested in exploring the details, we can strongly recommend a recent paper issued by the Policy Reform Group, “Monetary policy and the value of Public Debt”, by Gerald Holtham and published in February 2021.  The paper explains the issues extremely clearly, and sets out the Bank’s financial dilemma very well.  See https://www.policyreformgroup.org/our-work/monetary-policy-and-the-value-of-public-debt

[2]              An insight of the Holtham paper that we very much agree with.  Bankers’ reserves should be seen as the commercial banks’ contribution to making the banking system work, not as a loan to the central bank.