15 June 2011

Bank of England’s and HM Treasury’s Maneuvers to Accommodate Financial Crisis

Central banks and regulators were not only unable to prevent the financial crisis. As we shall conclude from the following description of the Bank of England’s and HM Treasury’s maneuvers over the past few years, in at least some of the still top-rated countries the crisis has been accommodated temporarily using clever maneuvers rather than making real improvements. Significant risk exposures have been transferred from private sector to public sector and are extremely difficult if possible at all to track properly. What will come out of all this is yet to be seen – probably not today or tomorrow but some day in not too distant future. Note that all these unconventional measures are being presented to the public as (I’d say) something for “greater good”, to ensure monetary stability and contribute to the financial stability which both are necessary to the economy to function.

Let’s be specific after this rather lengthy introduction.

Bank of England basically ceased to function as it is supposed to do. It got overleveraged (as of 28 February 2010 it had GBP 246.7bn in assets, and GBP 4.2bn as capital and reserves, i.e. leverage of 55-60 times) and, in order to avoid taking too big risks into its balance sheet, is being indemnified by HM Treasury against any cumulative loss it may separately incur in connection with some of its facilities.

One of such facilities (and the very important one during the time of financial stress) is the Asset Purchase Facility (APF) operated by The Bank of England Asset Purchase Facility Fund Ltd. As of at the end of Q1 2011 the fund had purchased assets (mostly gilts from non-banks) in the outstanding amount of GBP 200bn. The curious things about this Asset Purchase Facility Fund are that:
* Despite of being a subsidiary company of Bank of England it is not consolidated into the Bank of England’s financial statements and this on the grounds that Bank of England has no economic interest in its activities (HM Treasury bears the risks). What an example for banks for getting things out of their balance sheets, by the way!
* HM Treasury in turn treats the fund as a derivative, the fair value of which is basically calculated as a difference between the purchase price of the assets and their fair value (market value).
* Purchases initiated under APF help to keep up the fair values of the assets, thus creating a strange feedback loop. During the crisis most of the asset purchases were financed by creating central bank reserves (i.e. by just crediting the accounts of the banks that acted as intermediaries and in turn credited the accounts of those non-banks from whom the assets were purchased – which means, by “printing money”).
* Asset Purchase Facility Fund Ltd is consolidated nowhere, i.e. those who are not reading carefully may easily miss it and get an impression that HM Treasury’s risk exposure is smaller than it actually is.

Another facility that by design should belong to Bank of England but the risks of which have been taken directly by HM Treasury is Bank of England’s Special Liquidity Scheme (SLS). In its latest annual report, HM Treasury estimates the potential liability of SLS to be GBP 165bn. What is notable is that under this facility banks could generate liquidity from their own illiquid assets via own asset securitisation, sometimes also referred to as zombie securitisation. Due to the subjective nature of valuing mortgage-backed and other securities that were accepted as collaterals, HM Treasury may well have left with a whole load of nothing (ok, I’m exaggerating, but not much). Thus, the above provided number of GBP 165m might be questioned.

To continue, HM Treasury appears to have been generous with its guarantees indeed. Providing a guarantee has been like replacing a need for capital or cash with something that has zero cost. Yet we know that there are risks related to guarantees.

Consider the following example. As we well know, government had to recapitalise some of the banks, most importantly Royal Bank of Scotland (RBS) where the government’s economic ownership had risen to 83.2 per cent by 31 March 2010. But, in order to improve RBS’s capital ratios (and possibly the capital ratios of the other banks) while avoiding injecting even more capital, Asset Protection Agency (APA) was founded and the Asset Protection Scheme (APS) invented. Under APS, HM Treasury has guaranteed significant part of RBS’s assets (probably the riskiest ones) and in this way enabled the bank to reduce its risk-weighted assets. As of 31 March 2011, the off-balance-sheet exposure arising from APS was close to GBP 150bn (after taking into account the RBS’s own responsibility).

Further, Credit Guarantee Scheme (CGS) and Asset-backed Securities Guarantee Scheme were put in place. Potential liabilities (HM Treasury’s estimate) in the amount of GBP 125bn were taken easily.

For putting all the numbers above into some perspective, note that tax payers’ equity in HM Treasury was approximately GBP 121bn as of 31 March 2010. The total revenue of UK’s government in 2010 was GBP 591bn (according to Eurostat). What about of an additional bill in the amount of let’s say GBP 500bn?

When summarising the above, accommodating the financial crisis is an illusion of Bank of England and HM Treasury:
* keeping part of their risk exposures quite out of sight (first of all, I’m referring to Asset Purchase Facility and Special Liquidity Scheme);
* creating demand and market for government’s debt securities by using various facilities and schemes, and by “printing” money; this demand has clearly been a demotivation for the government to improve its budget;
* issuing government guarantees while the cost of such guarantees is not yet (fully) included into the price of government’s debt (while top rating is still maintained).

In short, we see a self-reinforcing cycle which so far has enabled to accommodate or hide the inherent flaws in financial system and in government finances. But this cycle may easily turn vicious if excess money is to be removed from the economy. Alternative, of course, is inflation which is not what a central bank is ought to be targeting.

If not indicated otherwise, the article has been compiled based on the materials available on the websites of Her Majesty's Treasury, Bank of England and UK Debt Management Office as of 14 June 2011. Among others, the materials included:
* the latest publication of Bank of England’s annual report (financial year 2009/2010)
* the latest publication of HM Treasury’s accounts (HM Treasury Resource Accounts 2009-10)
* quarterly report of 2011 Q1 of The Bank of England Asset Purchase Facility Fund
* the “Red book” (updated in December 2010)

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