Smith Faculty Opinion Article

April 21, 2008

By Dr. Peter Morici, Professor of International Business
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 Peter Morici

Bank of England Announces New Special Liquidity Scheme
Like Federal Reserve Moves, Too Little to Resolve Credit Crisis

The Bank of England (BOE) has announced a £50 billion lending facility that will permit British banks and building societies to borrow against mortgage-backed and other securities for terms up to one year, and renewable by the BOE for up to three years.

The market for mortgage-backed securities and other collateralized debt obligations (CDOs) has essentially closed, making the extension of new mortgages and credit by banks to worthy homebuyers and businesses in the United States and Britain very difficult. Unfortunately, like similar special lending facilities created by the Federal Reserve in recent months, this BOE move is not likely to appreciably open up lending and avoid a recession.

Over the last two decades, banks have moved from a “deposits into loans model” to a “loans into bonds model.” The shift is a good thing, because it eliminates the kind of risks banks bear when they borrow short and lend long, which mightily contributed to the Savings and Loan Crisis. Properly done, the loans to bonds model permits banks to greatly expand their lending capacity.

However, in recent years, banks have created increasingly complex and difficult to understand securities. Banks sold, bought and resold securities, and engaged in credit-default swaps that did not lay off risk in the manner advertised. Insurance companies, pension funds and fixed income investors, having been stuck with risky securities, are no longer willing to finance bank loans in this manner. Banks can no longer sell CDOs to these investors.

These practices did permit banks to earn outsized profits on transactions fees and pay executives much better than in comparable non-financial firms. However, it is simply impossible to borrow at 5 percent and lend at 7—the essence of traditional banking—and skim off the kinds of profits and executive bonuses bankers now expect and still provide for loan servicing, insurance and the other costs involved in lending and securitization. Unfortunately, bankers are not much interested in returning to traditional lending practices and are looking to other lines of business within their larger financial services firms for opportunities that may permit continued outsized incomes.

Central banks, by taking mortgage backed securities and other CDOs off the books of banks, may temporarily relieve liquidity pressures, but such measures do not resolve fundamental structural problems in the structure of contemporary financial conglomerates.

The Bank of England and Federal Reserve would do better to bring banks and fixed income investors together to define the kinds of simple mortgage- and other loaned-backed securities that insurance companies, pension funds and the like would accept, and condition access to the discount window on banks making and securitizing loans in such a rebuilt market for collateralized debt obligations.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.                                                          ►More Faculty Opinion Articles