Banker Swap

‘What would have happened to Britain’s economy if the ECB’s Mario Draghi, rather than Mervyn King, had been governor of the Bank of England in 2007?’

Observers of the European financial scene cannot have overlooked a worrying anomaly. In recent years the Bank of England has been unhelpful to UK-based banks, whereas the European Central Bank has mollycoddled their competitors in the eurozone. The issue has come to a head with the ECB’s latest exercise, the provision of three-year loan facilities at a cost of only 1 per cent to any bank with eurozone activities and half-decent collateral. In two so-called long-term refinancing operations (or LTROs) in December and February, the eurozone’s banks have successfully applied for more than 1,000 billion euros of ECB money. This staggering total is higher than the national output of the Netherlands and more than four times that of Greece.

Plainly, Mario Draghi, who has been president of the ECB since November 2011, believes in the virtues of long-term central bank assistance to the commercial banking sector. Before the LTROs, dozens of Eurozone banks were having difficulty in funding their assets. Rather than call in loans, they sold government bonds. The resulting falls in the value of eurozone sovereign debt undermined confidence in the single currency project. With good reason, many commentators believed that the eurozone’s break-up was imminent. 

Draghi’s LTROs acted like a magic potion. In the weeks following the first LTRO, banks’ sales of government bonds stopped and the eurozone sovereign debt crisis disappeared from the headlines. Moreover, the ECB’s help has undoubtedly given a large number of troubled banks enough time to reorganise their affairs. While the ECB loan is outstanding, banks will earn profits on their good assets, boosting their solvency. Further, banks that have been short of cash in the recent period of market turmoil now have an extended opportunity to sell loan portfolios to banks with strong deposit resources. 

At the macroeconomic level, too, the ECB manoeuvre has had positive results. With the banking system (and hence the quantity of money) no longer at risk of shrinkage, forecasts are being made of a eurozone recovery later in 2012. The message of “the Draghi bazooka” (as the LTROs have become known) is that a long-term central bank loan can be of immense benefit to a banking system and so to the wider economy. 

Now compare Draghi’s attitude to the job of a central bank with that of Mervyn King, the governor of the Bank of England. The global inter-bank market seized up in early August 2007. As many banks had used that market as their main source of funds in previous years, they suddenly faced a severe problem. Could they in coming months and quarters find enough cash to finance their assets? On August 9, 2007, leading British banks approached the Bank of England for an easing of collateral requirements on so-called “repurchase operations”. They expected the Bank to be flexible and pragmatic, as it had been in the past; they thought that their central bank would respond to their cash predicament in much the same way as Draghi has in his recent dealings with their European counterparts. 

But Mervyn King and Mario Draghi have utterly different views. King gave Britain’s banks a dusty answer. No, the collateral requirements could not be eased and the Bank of England would provide no special cash help. The money markets quickly realised that without central bank help several British institutions were at risk. The Northern Rock crisis — which saw the first run on a British bank for over a century — started about a month after the acrimonious August 9 stand-off. 

Still Britain’s banks hoped that a long-term loan facility would be extended to them by the Bank of England. One revelation of Alistair Darling’s memoir Back from the Brink is that he had a private meeting with the CEO of the Royal Bank of Scotland Fred Goodwin in Edinburgh in Christmas 2007. Goodwin argued that the banks’ key problem was a lack of liquidity, which could be countered by a long-term central bank loan. Apparently the conversation was cordial and relaxed, but in the ensuing months Darling got nowhere with King. In evidence to the Treasury Committee of the House of Commons in September 2008, King insisted that it was not a central bank’s responsibility to extend long-term finance to anyone. That — in his view — was a job for either the government or the private sector. 

Intellectually, Draghi and King are at opposite ends of a spectrum of views on what a modern central bank should do. But a vital practical question arises from their debate. What would have happened to Britain’s banks and its economy over the next four years if Mario Draghi (or a Mario Draghi clone), rather than Mervyn King, had been governor of the Bank of England in August 2007?

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