Finance counsels

Global regulators should force banks to hold assets such as government bonds as a buffer after the financial crisis exposed a “shocking” lack of liquidity at some U.K. lenders, Bank of England official Paul Tucker said.

“Regulators should define the ‘liquidity buffer’ to comprise high quality securities that can reliably be traded or exchanged in liquid markets, including in stressed circumstances,” Tucker, the bank’s deputy governor for financial stability, said today in Tokyo. “In practice, that would mean focusing on government bonds in many economies.”

Prime Minister Gordon Brown has committed billions of pounds to saving Britain’s financial system as the global turmoil plunged the U.K. into a recession. His government has nationalized banks from Northern Rock Plc in 2007 to Dunfermline Building Society this year, and bought stakes in larger lenders including Royal Bank of Scotland Group Plc.

“It has been shocking over the past year or so to discover how many medium-sized banks and building societies did not hold government bonds or other very high quality assets; or if they did, how many did not have a regular presence in the gilt repo market,” Tucker said. “Turning up in the core secured-funding markets for the first time for years is an absolute giveaway of distress. All that has to change.”

The liquidity squeeze created a “vicious spiral” where the credit famine fed the recession and in the process impaired the quality of banks’ loan books, Tucker said. “It would have been better if, somehow, we could have preserved the liquidity of the markets.”

Market Maker

Tucker raised the question of how central banks should operate as a “market maker of last resort” to preserve liquidity at times of stress bad credit payday advance. He said the Bank of England is already acting as a market maker when it buys commercial paper and corporate bonds through its asset purchase facility.

“To the extent that such measures work, liquidity risk for intermediaries, and so for traders and investors, is reduced; and thus, the spread in corporate bond yields should decline too,” he said. “There is some evidence that that has occurred since we introduced the facility in March, although it is impossible to control for the more general improvement in global corporate bond markets.”

A policy for providing capital of last resort should have costs finally accrue to the banking system, not the taxpayer, he said. He suggested it may be financed with a requirement for banks to take out private capital insurance, or for them to issue hybrid bonds convertible to equity in times of stress.

Hybrid Bonds

Hybrid bonds rank after loans and senior bonds for repayment, and typically contain options allowing borrowers to defer interest payments.

Tucker also said that the Bank of England plans to expand its list of collateral eligible in its liquidity insurance facilities.

“In doing so, the bank recognizes that its decisions will have a bearing on the development of markets,” he said. The bank will also take into account of “structural and cyclical changes” in financial conditions when it determines haircuts on liquidity insurance, he said.

Tucker spoke at the Bank of Japan 2009 International Conference in Tokyo.

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Filed under: economics by Guru