Mathew Sim
Sterling money markets are a critical part of the plumbing of the UK financial system. They act as the main conduit for short-term borrowing and lending between banks, and a whole range of other institutions, financial and non-financial. And the ebb and flow of activity in sterling money markets is also crucial to the Bank of England as the first stage in the transmission mechanism of monetary policy, linking changes in the Bank’s policy rate – Bank Rate – to activity and prices in the wider economy. So when things go wrong in this market, as they did during the financial crisis, the effects reach into every part of the UK economy and, given the significant role of international banks in London, beyond. So what happened in the autumn of 2008, and why?
On the eve of the financial crisis, sterling money markets – the market for short-term borrowing and lending – were a picture of relative tranquillity. An extended period of reform since the 1990s had created a market that was deep and liquid. Interest rate volatility was low, volumes were high and new instruments were being developed. This same market – calmed by reform and so attracting little attention, beyond that of a handful of specialists, in times of stability – would go on to take centre stage in some of the most dramatic episodes of the 2007-08 period.
‘Something is rotten…’
In the UK, the first signs of turbulence emerged with the failure of Northern Rock, but gained pace rapidly after the collapse of Lehman Brothers in September 2008. For sterling money markets, this prompted a wave of uncertainty and risk aversion, as market participants were left wary of which of their counterparties were still creditworthy. That uncertainty was particularly pronounced given the significance of banks, both as borrowers and lenders, in pre-financial crisis money markets. Unsure of where their money was still safe, and when they might have sudden need for sterling liquidity, the willingness of market participants to engage with one another dropped sharply. This affected even those counterparties that were considered safe. These developments were, of course, an international phenomenon, and affected money markets globally. As put by Bill Dudley, President of the New York Federal Reserve at the time, in relation to dollar money markets, it was a case of ‘I won’t lend to you even though I think you’re okay because I am not sure others will lend to you either’.
That breakdown in confidence was apparent in both the volume and cost of borrowing in sterling money markets. The intensification of counterparty risk concerns and uncertainty around their own liquidity needs prompted lenders to demand far higher rates of compensation for lending in some cases, and outright refusal to lend in others. Libor-OIS spreads – a measure of the additional risk premium attached to bank funding, and so a proxy measure of perception of bank creditworthiness – drifted higher over 2008, before jumping sharply in the wake of Lehman’s failure in September 2008 (Chart 1). And activity overall dropped away, particularly between banks (Chart 2).
Chart 1: 3 month Libor-OIS spreads
Chart 2: Sterling interbank deposits between UK resident banks
Where lenders were willing to part with their money, they were typically willing to do so only under more stringent conditions. Reassurance against counterparties defaulting was increasingly sought in the form of high quality collateral. Activity in unsecured money markets consequently fell away, while that in secured markets remained more resilient (Chart 3). And fewer lenders in the money market were willing to lend for long periods, for fear of being caught short in a fast-changing environment. As such, at the peak of the crisis in September 2008, almost all unsecured lending was on an overnight basis, and, even a year later, lending at greater than three months was virtually non-existent.
Chart 3: Turnover in brokered overnight unsecured and secured money markets(a)
‘For this relief much thanks’
What emerged during the financial crisis was a smaller, and more limited, sterling money market than had existed in the years before. And where financial institutions had previously relied on money markets for funding, the evaporation of readily available liquidity threatened catastrophe as they struggled to find alternative sources of funding quickly enough. In the near term, that emerging funding gap was largely filled by the official sector, particularly central banks. In the UK, that process had started in the first half of 2008, with the introduction of the Special Liquidity Scheme. But it accelerated as the liquidity crisis intensified. During September 2008, the Bank of England’s lending to the financial sector through normal channels expanded to almost £200bn (Chart 4), while the worst afflicted banks, RBS and HBOS, sought an additional £50bn in emergency liquidity assistance. Putting that in context, the size of the Bank’s balance sheet averaged only around £75bn during 2000-06.
Chart 4: Liquidity provision by the Bank of England
For policymakers, balancing the twin demands of a vastly greater degree of liquidity provision and maintaining stability in money market rates to ensure effective transmission of policy changes proved unsustainable under the existing framework for interacting with money markets. This became acute in March 2009, when the Monetary Policy Committee began its programme of asset purchases, introducing far more reserves into the banking system than banks would have chosen to hold voluntarily. So the Bank of England had to adapt that framework. It replaced its reserves averaging system – which largely left banks to decide their own need for reserves, and therefore liquidity – with a floor system which tied the amount of reserves in the banking system to the MPC’s decisions around quantitative easing.
‘How is it that clouds still hang on you?’
Confidence in money markets returned over time, in part as a result of such large scale official intervention globally. But the consequences of the financial crisis persisted. There has been no return to the pre-crisis world of plentiful money market liquidity, with the evaporation of access after Lehman’s bankruptcy prompting a persistent shift in attitudes toward the use of the money markets and liquidity management more generally.
Mathew Sim works in the Bank’s Monetary Analysis Division
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