UK banks’ euro zone firewall needs strengthening. Despite a range of support measures introduced after the 2008 financial crisis, the Bank of England’s arsenal for managing a pan-European liquidity freeze looks underpowered when compared with the European Central Bank’s three-year loans. But if the euro zone cracks, UK lenders would be better off turning to the government for support.
The BoE has three conventional liquidity support mechanisms. Banks can borrow against liquid collateral for up to six months via its Indexed Long-Term Repo (ILTR) auctions. More troubled banks can swap illiquid collateral for gilts for up to a year through the Discount Window Facility (DWF). And, since late last year, lenders have been able to use the Extended Collateral Term Repo facility (ECTR), which uses an auction system that allows banks to pledge ropier collateral, albeit for a higher fee.
The ECTR is the nearest British rival to the ECB’s longer-term refinancing operation (LTRO), under which euro zone banks have so far borrowed 1 trillion euros. But there are two big differences. First, UK banks can only borrow from the ECTR for 30 days, while the LTRO runs for three years. Second, unlike the ECTR, the LTRO is unlimited. If a Greek euro exit caused the market for bank debt to freeze, UK banks would be at a significant disadvantage.
But that doesn’t mean the BoE should rush to mimic the ECB. Long-term liquidity facilities encumber large chunks of banks’ balance sheets, making unsecured bank lending less attractive. Moreover, central banks are only supposed to field liquidity shocks, not long-term funding freezes.
Fortunately, the UK has an option not available to most euro zone lenders: government support. When the market froze in 2008, the UK Treasury’s Credit Guarantee Scheme provided 250 billion pounds worth of multi-year guarantees on bank debt, almost all of which has been repaid. A new CGS would help to prevent a credit crunch while preserving the BoE’s integrity and taking advantage of the UK’s historically low bond yields.
Part of the reason the ECB was forced into three-year loans was the difficulty of persuading the euro zone’s 17 members to support each others’ debts. Without this headache, the UK has no need for an LTRO of its own.