The recent liquidity crisis was the first significant test of the Bank of England’s new framework for money market operations introduced in May 2006. The result must be judged a failure, not because of the enforced bail-out of Northern Rock, which may have been unavoidable, but rather because two of the stated objectives of the framework were not met: first, to achieve a flat money market yield curve consistent with the official Bank rate out to the next MPC decision date; secondly, to ensure efficient liquidity distribution even in stressed market conditions.

Of course, other central banks have also struggled to maintain functioning money markets, but the Bank’s critics argue that it has underperformed its peers in several respects. The first charge relates to the speed of its response. Market rates globally began to rise sharply on 9 August. The ECB conducted to an emergency operation to add short-term funds on the same day, with the Federal Reserve following on 10 August. On 17 August, the Fed reduced the penalty rate charged for borrowing from its discount window from one percentage point above the Fed funds target rate to 50 basis points, while extending the term of such borrowing. The ECB followed up on 22 August with a further special operation to supply three-month funds at an auction-determined interest rate. The Bank’s first action outside its normal operating framework was on 5 September, when it announced a possible short-term operation a week later if market conditions remained stressed. The actual supply of funds on 13 September occurred over a month after the crisis had broken.

The second criticism relates to the Bank’s insistence on charging a penalty rate of (at least) one percentage point above Bank rate on any lending outside its normal short-term repo operations. This condition applied to funds accessed via its discount window (the standing lending facility) as well as the operations to supply three-month funds announced on 19 September. As noted, the Fed reduced the penalty charged for discount window borrowing to 50 basis points, while the ECB conducted additional three-month operations at auction-determined rates (average rates in these auctions were 52 - 61 b.p. above the ECB’s official repo rate). The Bank’s hardline approach appears to be in contradiction to its own documentation on money market operations (the “Red Book”), which states that a cut in the standing lending facility rate relative to Bank rate is one of the Bank’s instruments for relieving stressed market conditions (paragraph 22 on page 8).

Thirdly, and perhaps most seriously, banks’ ability to access emergency funds from the Bank may have been constrained by much stricter collateral requirements than employed by the ECB and Fed. Under normal circumstances the Bank restricts eligible collateral to securities issued by the UK and other European governments and supranational bodies with a credit rating of Aa3 or higher. British banks hold few such securities. By contrast, the ECB allows private as well as public sector assets to be used, including mortgages, with a lower rating threshold of A. The Fed’s definition is similarly broad, though without a specified credit rating minimum. (The Bank loosened collateral requirements for the auctions to supply three-month funds announced on 19 September, but continues to use the stricter definition in its normal operations.)

The Bank’s defenders deflect such criticisms by arguing that alternative actions or procedures would probably have made little difference given the extent of dislocation in global markets. They claim that the lack of any intervention by the Bank until early September reflected distinctive features of the UK system, in particular banks’ ability to choose their target level of reserves balances at the Bank once a month, with the Bank then supplying these reserves at a non-penal rate. On this view, it made sense to delay additional action until the start of the new reserves maintenance period on 6 September, when banks would be able to access additional funds.

In reality, market dislocation was never likely to be relieved simply by banks requesting higher reserves targets. Once targets are set, banks are required to maintain actual reserves within 1% of the specified amount on average over the maintenance period; deviations incur penalties. In other words, the additional reserves supplied on 6 September did not meet banks’ demand for a cushion to meet unforeseen liquidity demands. This was provided only on 13 September, when the Bank widened the permitted deviation of reserves from targets to 37.5%. Such action could have been taken much earlier and indeed is mentioned as a second instrument for relieving stressed conditions in the “Red Book”.

Another claim is that the more timely actions of the ECB and Fed had little effect. It is true that term premiums in money market rates in the Eurozone and US remained unusually high, but they were consistently lower than those in the UK over the month to mid September.

Finally, the fall in term rates in recent weeks, including relative to Eurozone and US rates, is cited as evidence that the Bank has regained control of markets. Some commentators even suggest that banks’ unwillingness to bid for funds at the three-month auctions supports the Bank’s earlier inaction. Such claims neglect the liquidity impact of the Bank’s enforced lending to Northern Rock, which succeeded where its operational actions had failed in breaking the logjam in markets. Term rates began to decline significantly on 14 September – the day the Bank announced its lender-of-last-resort support. In effect, Northern Rock’s shareholders paid the penalty rate demanded by the Bank to supply the banking system as a whole with greater liquidity. Without Northern Rock, market rates would almost certainly have been higher and banks would probably have borrowed funds in the three-month operations.

At a minimum, the Bank faces charges of tardiness and a failure to use the full range of instruments available for relieving stressed market conditions according to its own “Red Book” framework. However, changes to the framework itself also appear to be necessary in light of recent events, in particular a widening of the definition of eligible collateral and the addition of term auctions as an instrument for maintaining functioning markets.