The Bank of England has just updated the Sterling Monetary Framework “Red Book”, adding explicit language about providing liquidity support to CCPs. This new liquidity backstop makes sense, but its easy to see how the idea would be criticized as creating a new kind of moral hazard. Here are the pros and cons.
First, by the way of background, last October, Bank of England governor Mark Carney announced in a speech “we are open for business”. He said:
“…Our facilities are not ornamental. They are there to be used by banks to access money and high-quality collateral. We are offering money and collateral for longer terms. The range of assets we will accept in exchange will be wider, extending to raw loans and, in fact, any asset of which we are capable of assessing the risks. And using our facilities will be cheaper. In some cases the fees are being more than halved…”
“…First, should the Bank of England allow non-banks to have access to our regular facilities? After all, our responsibilities for financial stability run much wider than the banking sector. Institutions that play a central role in markets, like broker-dealers, are obvious first candidates. We will also consider the case for opening them to other participants including financial market infrastructures. If the scope of access to central bank facilities increases, the scope of regulation can be expected to expand in a proportionate manner…”
Carney followed through on that promise when the Bank of England just announced they are
“…widening access to its Sterling Monetary Framework (SMF) to accept broker-dealers and central counterparties (CCP)….”
“…both broker-dealers and CCPs are exposed to liquidity risk. As the supplier of the economy’s most liquid asset, central bank money, the Bank is able to be a ‘back-stop’ provider of liquidity, and can therefore provide liquidity insurance to the financial system…Specifically, from today, those broker-dealers deemed critical to the stability of the UK financial system (designated investment firms) and CCPs that operate in UK markets and are either authorised under EMIR or recognised by ESMA, are eligible to apply for participation in the SMF, including the Discount Window Facility…”
With UK CCPs able to borrow against highly liquid high-quality sovereign debt as well as supranational, mortgage and corporate bonds, the Bank is providing an explicit liquidity backstop. The discount window facility will be available for five-day terms and, instead of receiving Gilts that can then be monetized (as is the typical procedure), CCPs will be able to directly borrow cash.
One can only imagine the response to an explicit announcement like this in the US. “A back door bail out of the banks” would probably be the headline. It seems like UK thinking is more evolved — focused on liquidity crises. They don’t ignore TBTF or moral hazard. But the Bank of England still publically practices the lessons of Walter Bagehot who, in his 1873 book Lombard Street: A Description of the Money Market advocated central banks to embrace their role as lender of last resort.
While US CCPs are typically deemed SIFIs, it is hard to find a current US regulator detailing access to the Fed’s discount window facility in the same way that the UK’s Carney has. Lender of last resort access is not an excuse for lax risk control, but LOLR is an important part of the mix. The suggestions put forward by JP Morgan in their September 2014 paper “What is the Resolution Plan for CCPs?” strengthen the risk absorption capacity of CCPs and hopefully avoid ultimately tapping taxpayers – but central bank support (and regulation) that supports liquidity makes for better sleep at night.
So if you had to choose between a CCP that had explicit central bank liquidity support at the end of the risk waterfall and one that won’t risk the political fallout, which would you pick?