Economics-Watching: Putting Out the NBFIRE: Lessons from the UK’s Liability-Driven Investment (LDI) Crisis

[from the International Monetary Fund Working Paper 2023/210]

by Ruo Chen & Esti Kemp

Liability-Driven Investment (LDI) funds were at the center of the severe stress that emerged in the UK gilt market in the aftermath of the September 2022 UK “mini-budget.” The episode, which came on the heels of the “Dash for Cash” and “Archegos” stress episodes in the previous two years, highlights underlying vulnerabilities in the large and diverse non-bank financial institution (NBFI) sector. This paper seeks a deeper understanding of the factors that amplified the gilt market turmoil which ultimately led the Bank of England (BoE) to undertake temporary gilt purchases on financial stability grounds in late September/early October 2022 to restore orderly market conditions and enable LDI funds to build their capital positions. With the gilt market stress and the BoE’s purchases now fully unwound, this paper identifies the key reasons for the success of the BoE’s intervention. Then, drawing also on findings of the 2022 UK Financial Sector Assessment Program (FSAP), the paper discusses key gaps and policy issues related to the monitoring of financial stability risks in the broader NBFI sector for both individual jurisdictions and international standard-setting bodies.

[read the working paper (archived PDF)]

World-Watching: Bank of England—Bank Rate Increased to 1.25%

[from Bank of England]

The Bank of England’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target, and in a way that helps to sustain growth and employment. At its meeting ending on 15 June 2022, the MPC voted by a majority of 6-3 to increase Bank Rate by 0.25 percentage points, to 1.25%. Those members in the minority preferred to increase Bank Rate by 0.5 percentage points, to 1.5%.

Read the Monetary Policy Summary and Minutes [Archived PDF]

Education and the World As “Rorschach Test”

The Rorschach test is a projective psychological test in which subjects’ perceptions of inkblots are recorded and then analyzed using psychological interpretation, complex algorithms, or both. Some psychologists use this test to examine a person’s personality characteristics and emotional functioning.

It is also called “an Inkblot test.”

We use this test as a metaphor that suggests that people see what they want to see and choose to see.

Here’s an example based on the Verdi opera La Forza del Destino. The black intellectual leader, William E.B. Du Bois, sees it as a veiled racial story where Professor Niall Ferguson of Stanford/Harvard tells the story of how he emerged from a performance of the opera on the very day that Britain devalued the pound sterling in 1992.

Black Wednesday refers to September 16, 1992, when a collapse in the pound sterling forced Britain to withdraw from the European Exchange Rate Mechanism (European Monetary System).

Thus the opera, La Forza del Destino is both a Verdi opera and a kind of “raw material” for personal and private interpretation with Du Bois seeing racism and Ferguson seeing national or financial fate.

La Forza del Destino or The Power of Fate, (often translated The Force of Destiny) is an Italian opera by Giuseppe Verdi. The libretto was written by Francesco Maria Piave based on a Spanish drama, Don Álvaro o la fuerza del sino (1835), by Ángel de Saavedra, 3rd Duke of Rivas, with a scene adapted from Friedrich Schiller’s Wallensteins Lager. It was first performed in the Bolshoi Kamenny Theatre of Saint Petersburg, Russia, on 10 November, 1862 O.S. (N.S. 22 November).

(Wikipedia)

Synopsis—Act 1

The mansion of Leonora’s family, in Seville.

Don Alvaro is a young nobleman from South America (presumably Peru) who is part Indian and who has settled in Seville where he is not very well regarded.

He falls in love with Donna Leonora, the daughter of the Marquis of Calatrava, but Calatrava is determined that she shall marry only a man of the highest birth. Despite knowing her father’s aversion to Alvaro, Leonora is deeply in love with him, and she determines to give up her home and country in order to elope with him. In this endeavor, she is aided by her confidante, Curra. (Me pellegrina ed orfana—“Exiled and orphaned far from my childhood home”).

When Alvaro arrives to fetch Leonora, she hesitates: she wants to elope with him, but part of her wants to stay with her father; she eventually pulls herself together, ready for their elopement. However, the Marquis unexpectedly enters and discovers Leonora and Alvaro together. He threatens Alvaro with death, and in order to remove any suspicion as to Leonora’s purity, Alvaro surrenders himself. As he flings down his pistol, it goes off, mortally wounding the Marquis, who dies cursing his daughter.

This is the racial aspect on which W.E.B. Du Bois focuses.

Niall Ferguson, by contrast, sees a different “Rorschach inkblot” and hones in on the financial policy story which went like this:

Soros’ Quantum Fund began a massive sell-off of pounds on Tuesday, 15 September 1992. The Exchange Rate Mechanism stated that the Bank of England was required to accept any offers to sell pounds. However, the Bank of England only accepted orders during the trading day. When the markets opened in London the next morning, the Bank of England began their attempt to prop up their currency as per the decision made by Norman Lamont and Robin Leigh-Pemberton, the then Chancellor of the Exchequer and Governor of the Bank of England respectively. They began buying orders to the amount of 300 million pounds twice before 8:30 AM to little effect.

The Bank of England’s intervention was ineffective because Soros’ Quantum Fund was dumping pounds far faster. The Bank of England continued to buy and Quantum continued to sell until Lamont told Prime Minister John Major that their pound purchasing was failing to produce results.

At 10:30 AM on 16 September, the British government announced a rise in the base interest rate from an already high 10 to 12 percent to tempt speculators to buy pounds. Despite this and a promise later the same day to raise base rates again to 15 percent, dealers kept selling pounds, convinced that the government would not stick with its promise. By 7:00 that evening, Norman Lamont, then Chancellor, announced Britain would leave the ERM and rates would remain at the new level of 12 percent; however, on the next day the interest rate was back on 10%.

It was later revealed that the decision to withdraw had been agreed at an emergency meeting during the day between Norman Lamont, Prime Minister John Major, Foreign Secretary Douglas Hurd, President of the Board of Trade Michael Heseltine, and Home Secretary Kenneth Clarke (the latter three all being staunch pro-Europeans as well as senior Cabinet Ministers), and that the interest rate hike to 15% had only been a temporary measure to prevent a rout in the pound that afternoon.”

For W.E.B. Du Bois, the story within the story of the Verdi opera is the color-line that governs the world, while Ferguson sees the story as a “dramatic” instance of financial and economic force or working out of trends that becomes a destiny.

Hence people see what they choose to see and interpreting and seeing are wrapped up in each other.

Students should assimilate this aspect of the world.

Note: one source of the Du Bois interpretation of the opera comes from the University of Chicago book, Travels in the Reich: 1933-1945 (edited by Oliver Lubrich, 2012) which has a chapter on Du Bois in Germany in the thirties where he plunges into music and opera and highlights this Verdi one.

Bank of England Statistical Releases—February 2022

(from the Bank of England)

Money and Credit

Overview

These monthly statistics on the amount of, and interest rates on, borrowing and deposits by households and businesses are used by the Bank’s policy committees to understand economic trends and developments in the UK banking system.

Key Points
  • Net borrowing of mortgage debt by individuals amounted to £4.7 billion in February. Mortgage approvals for house purchases fell slightly to 71,000 in February, from 73,800 in January, but remains above the 12-month pre-pandemic average up to February 2020 of 66,700.
  • Consumers borrowed an additional £1.9 billion in consumer credit, on net, of which £1.5 billion was new lending on credit cards.
  • Sterling money (known as M4ex) increased by £7.2 billion in February. Households’ holdings of money weakened with net flows of £4.0 billion, compared with £7.2 billion in January.
  • The effective interest rate paid on individuals’ new time deposits with banks and building societies rose by 10 basis points to 0.77%.
  • Large businesses borrowing from banks rose to £4.0 billion in February, whilst small and medium sized businesses repaid £0.5 billion. Private non-financial companies (PNFCs) redeemed £4.1 billion in net finance from capital markets.

Read the full paper [Archived PDF].

Effective Interest Rates

Commentary on this data is now incorporated into the Money and Credit statistical release [Archived PDF, from above] to facilitate analysis.

Get the data tables [Archived Excel XLS].

Join Us for Conversations on Central Banking: Inflation and Monetary Policy

The Center for Inflation Research and the Federal Reserve Bank of Cleveland invite you to attend Cleveland Fed Conversations on Central Banking, on Tuesday, March 1, 2022, from 2:00 – 2:40 pm EST. The session topic will be Inflation and Monetary Policy.

Distinguished panelists include:

Jason Furman, Aetna Professor of the Practice of Economic Policy, Harvard Kennedy School.

Catherine Mann, Monetary Policy Committee Member, Bank of England

Ricardo Reis, A.W. Phillips Professor of Economics, London School of Economics and Political Science.

The session will be moderated by Colby Smith, U.S. Economics Editor, Financial Times.

View the entire agenda [archived PDF].

You must register in advance to attend. Upon registering, you will receive a confirmation email containing additional instructions to join the virtual meeting and a way to add it to your calendar.

If you have any questions, please contact Diane.Roberts@clev.frb.org.

Essay 95: Education and “Then and Now” Thinking

Ben Shalom Bernanke was Chairman of the Board of Governors of the Federal Reserve System from February 1, 2006, to January 31, 2014.

In many interviews in financial and economic periodicals, he blurts out the fact that his guide in the years surrounding the Great Recession of 2008, in his decisions by the advice of Walter Bagehot of the Economist of London whose main book is called Lombard Street [Project Gutenberg ebook] from 1873:

Lombard Street is known for its analysis of the Bank of England’s response to the Overend-Gurney crisis. Bagehot’s advice (sometimes referred to as “Bagehot’s dictum”) for the lender of last resort during a credit crunch may be summarized by  as follows:

  • Lend freely.
  • At a high rate of interest.
  • On good banking securities.

(Nonetheless, other economists emphasize that many of these ideas were spelled out earlier by Henry Thornton’s book The Paper Credit of Great Britain [archived PDF].)

Bagehot’s dictum has been summarized by as follows: “To avert panic, central banks should lend early and freely (i.e., without limit), to solvent firms, against good collateral, and at ‘high rates’.”

In Bagehot’s own words (Lombard Street [Project Gutenberg ebook], Chapter 7, paragraphs 57–58), lending by the central bank in order to stop a banking panic should follow two rules:

First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible.

Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them. The reason is plain. The object is to stay alarm, and nothing therefore should be done to cause alarm. But the way to cause alarm is to refuse some one who has good security to offer… No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business… The great majority, the majority to be protected, are the ‘sound’ people, the people who have good security to offer. If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security—on what is then commonly pledged and easily convertible—the alarm of the solvent merchants and bankers will be stayed. But if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other loans made will fail in obtaining their end, and the panic will become worse and worse.

We have to ask ourselves: how is it possible that advice from 1873 (i.e., Bagehot’s Lombard Street [Project Gutenberg ebook] crisis-management for that time) can be applicable in 2008?

Does this confirm the off-handed comment in This Time is Different by Ken Rogoff of Harvard that there must be true-but-opaque deep rhythms in history including financial history? Otherwise advice would be useless due to the passage of time and useful patterns would not be discernible.

In fact, Lawrence Summers at Treasury “deluged” Mexico and Latin America with loans to avert an earlier banking crisis following Bagehot’s advice. The logic is that investors must sense that Mexico, etc. will be bailed out at all costs. The idea is to avert a “downward spiral of confidence” by means of visible massive interventions.

Education should always ponder these “then and now” puzzles as part of a beneficial “argument without end.”