Old Lady told to change her ways: The Bank of England's top-hatted approach to managing the money markets is under fierce attack, reports Peter Rodgers

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The Independent Online
AFTER coming under fire for its competence as a banking supervisor and its role in the events leading up to the exchange rate mechanism disaster, the Bank of England now finds guns trained on its money-market operations.

This is a touchy area, and amounts to striking an Old Lady when she is down. It is in the sterling money markets that the Bank does the Government's bidding on interest rates. They represent an area of expertise the Bank has developed into a fine art since the early 19th century.

But there is growing pressure in the City, in the wake of the problems of the pound and interest rates, for changes in the way the Bank of England manages the money markets. At their most radical, these ideas would involve wholesale reform of some of the City's oldest institutions.

Some criticisms get short shrift from the Bank. But others draw a tacit acknowledgement that changes may be necessary.

There are several quite distinct strands to the attack. At the most extreme, some senior people in the money markets are convinced that the Bank did not have good enough tools available to deal with the final days of the ERM crisis.

They ask why it could not get very short-term interest rates on money lent for a day or so up to the 500 per cent used by the Swedes in their currency crisis. This would have penalised speculators who were borrowing to take a punt in the markets, and taken the heat off the currency.

Astronomical money-market rates make sense if they can be achieved for a day or two without dragging up other key rates such as mortgages, which would damage the real economy.

Before exchange controls were removed in 1979, the Bank could get very-short-term sterling interest rates in the international markets well above 500 per cent to penalise speculators, without hitting mortgages immediately.

In those days, the domestic sterling markets could be isolated from international dealings in sterling. But officials say that without exchange controls, the comparison made with Sweden is 'incoherent'.

The Swedish policy led to a rise of 8 percentage points in three-month rates, which in Britain would immediately raise mortgages and base rates.

The Bank is convinced that its tactic of announcing a minimum lending rate - a highly unusual direct order to banks to increase base rates - was the best that could be done.

And it believes that if it had lifted overnight interest rates to Swedish levels it would have created a self-fulfilling collapse of sterling, because it would have been read by the markets as desperation.

In the event, at the peak of the crisis some unlucky banks paid an annual rate of 180 per cent to borrow money for repayment the following Monday, but few noticed. The highest figure to appear publicly on dealing screens was a less dramatic 40 per cent.

A second criticism is that at the peak of the crisis the money market mechanism broke down and the Bank had to bypass the heart of its own system, the specialist discount market. This is where interest rates are set, through the Bank's dealings in sterling bills of exchange.

The market is an intermediary between the authorities and the commercial banking system, and is quite unlike anything found in other large financial centres. It is operated by small banks called discount houses, which are proud of their 19th-century origins. Some executives still sport top hats when they walk round the City.

The Bank sees the discount market as a useful buffer against the clearing banks. It is easier to manipulate a small market than a large and aggressive one.

During the crisis the Bank's huge purchases of sterling to support the pound in the ERM drained funds out of the commercial banking system.

Normally, the Bank of England would funnel money back to the banks through the discount market, to make up the shortage. Without this assistance, clearing banks would default on their daily payments to customers.

However, the discount market stalled during the crisis because of the scale of the demands made on it. The Bank was forced to supply emergency funds directly to the clearers, through agreements to sell and repurchase securities. This direct dealing is a practice the Bank normally avoids like the plague.

The forced manoeuvre revived a longstanding argument about whether there is any point in having a separate discount market. Why does the Bank of England not follow its European and US counterparts and deal directly with commercial banks anyway?

But officials reject claims that the seizing up of the discount market during the ERM crisis represented a failure. They cite a number of precedents in the 1980s for supplying funds directly to the clearing banks when market conditions were distorted.

Normally, a large daily shortage of funds in the banking system can be very useful, because it forces banks to rely on the Bank of England for money, which makes it easy to keep a tight grip on interest rates.

The biggest influence on the shortage, which is often over pounds 1bn a day, is the flow of money from the private sector to government, through the borrowing programme, the size of which is out of the Bank's hands.

The Bank nevertheless acknowledges that the scale of shortages has become a problem. Clearing banks, banned from dealing directly with the Bank of England, often get round the deficiencies of the discount market by using the houses as a passive conduit in and out of the Bank. The houses rubber-stamp their transactions.

Once the after-effects of the ERM crisis have worked through, the Bank of England is to make a renewed effort to reduce the daily shortages to more manageable levels.

One experiment over the past year, to lengthen the maturity of the bills the Bank deals in, has backfired by sending confusing signals about interest rates. Now the Bank is looking at a long list of other manoeuvres.

It may, for example, manage the weekly sale of short-term Treasury bills more actively. Unusually, the clearing banks are allowed to sell these directly to the Bank, so it would take some pressure off the discount market.

Another option is to supply the clearing banks with a large amount of cash on a regular basis - say once a month - through direct dealings of the kind that took place during the ERM crisis, while keeping daily operations within the discount market.

Far from sounding a death knell for the discount market, one senior discount house figure says this would appease critics among the clearers and make the function of setting interest rates more efficient.

When monetary union seemed likely, the prospects for the discount market certainly looked bleak, since the Bank would have had an uphill task holding out against European methods of dealing directly with commercial banks. But in the post-ERM era, the Bank appears as determined as ever to hang on to its system.

A third and much more fundamental City criticism of the Bank's money-market role is that its techniques for setting interest rates are too inflexible, leading to sudden large changes when continual fine tuning would be preferable.

In Germany and the US, central banks are able to shift money- market dealing rates gently, without immediately prompting a change in mortgage and other lending rates. They use other official rates such the Lombard rate in Germany to signal high-profile changes of policy that affect the economy generally.

The Bundesbank has lowered money-market rates 0.8 per cent since mid-September, but the Lombard rate has fallen only 0.25 per cent. The markets interpret this as a quiet but deliberate easing. Some City firms have been pressing for a switch to a German or US-style system.

The Bank failed when it tried to achieve a flexible system a decade ago, but John Shepperd, a bond-market economist at Warburg - which recently closed its discount house - says it could be done.

He believes the Bank of England should move to flexible dealing rates in the very short-term bill markets, instead of the rigid rates now used. At the same time, it should adopt some equivalent of the Lombard rate for indicating official policy. Official rates would be used to anchor mortgage and other important interest rates while dealing rates fluctuated.

That way, Mr Shepperd says, part of the drama would be taken out of changes and the system would be more efficient. The Bank would have early feedback about market reactions, and there would be less risk that mortgage and other interest-rate moves would be badly received and reversed.

The Bank is not impressed. It believes the German, British and US systems are more alike in practice than critics accept, and claims that it has its own subtle ways of testing market reaction. These include deliberately manipulating money-market shortages to hint at future intentions.

Robin Leigh-Pemberton, the Governor of the Bank of England, last week answered critics of the Bank's skills with an all-embracing excuse. In a speech to industrialists, he said the underlying problems in the markets were not technical but were the 'exceptional and increasing tensions' between the domestic needs of a re-unifying Germany and the rest of Europe. That one is harder to answer.

(Photograph omitted)

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