BoE's King says provision of extra liquidity undermines pricing of risk UPDATE

BoE's King says provision of extra liquidity undermines pricing of risk UPDATE

	Published : Wed, 12 Sep 2007 10:49 By : Agencies Print this Story

(Adds further detail from King's paper)

LONDON (Thomson Financial) - The Bank of England's governor Mervyn King defended the central bank's arms-length approach to the instability sweeping the world's financial markets.

Breaking his self-imposed purdah on the events of the last month or so, King said the provision of extra liquidity by central banks could potentially undermine the pricing of risk, and is unlikely to bring down spreads in short term London Interbank Offer Rates (LIBOR), the main manifestation of the credit crunch.

And though he said the turmoil in the financial markets has 'clouded' the UK economic outlook and that it is too soon to quantify the economic impact of higher short-term borrowing costs, he said it should not pose any long-term problems if managed well.

'The current turmoil, which has at its heart the earlier under-pricing of risk, has disturbed the unusual serenity of recent years, but, managed properly, it should not threaten our long-term economic stability,' King said in a letter to John McFall, the chairman of the influential Treasury Select Committee, ahead of a meeting between the two next week.

Despite his relative optimism, King conceded that the financial system is vulnerable to further shocks.

The BoE has been curiously quiet since the credit crunch erupted last month, in contrast to the US Federal Reserve and the European Central Bank.

On Aug 17, the Fed sought to ease some of the liquidity problems afflicting US financial markets by cutting its discount rate, the rate at which the Fed lends to commercial banks, by half a percentage point to 5.75 pct.

The aim of the move was to help banks who were having trouble borrowing money from other banks, since it reduces the cost of borrowing from the Fed.

Meanwhile, the ECB has been holding additional tenders to help deal with the liquidity concerns afflicting its own bank representatives.

The BoE has in its way tried to bring down overnight borrowing costs by raising its target for the reserves banks choose to hold at the Bank by 6 pct to 17.63 bln stg.

'As expected, some pressure on interest rates for overnight borrowing was relieved,' King said.

For longer-term issues, King stressed that the job of the central bank is to maintain economic stability, by setting interest rates to meet the 2 pct inflation target.

'If, in the wake of a shock to the financial system, the terms on which the financial system extends credit to the private sector become less favourable, then borrowing and overall demand would weaken,' he said.

'Other things being equal that would lower the inflation outlook but of course, other things are not equal,' he added.

King noted that the BoE's August Inflation Report implied that some slowdown from recent strong rates of economic growth was needed to meet the inflation target.

'It is too soon to tell how persistent and how large any change in credit conditions for household and corporate borrowers will prove to be,' he said, adding that a new BoE Credit Conditions Survey will be available to the rate-setting Monetary Policy Committee when it meets next.

King said the second responsibility of a central bank is to maintain the smooth functioning of the payment system among banks, but was sceptical about whether additional central bank liquidity to reduce market interest rates is a third, given it may encourage 'excessive risk-taking' and could 'sow the seeds of a future financial crisis'.

'The key objectives remain, first, the continuous pursuit of the inflation target to maintain economic stability and second, ensuring that the financial system continues to function effectively, including the proper pricing of risk,' he said.

'If risk continues to be under-priced, the next period of turmoil will be on an even bigger scale,' he warned.

pan.pylas@thomson.com

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