Occasional tremors in financial markets had been evident over the past year or so, and again in July this year. It was impossible to tell whether they constituted a gradual release of pressure on risk premia that had become overly compressed, or whether they signalled a more disruptive movement to come. On August 9 the question was answered. As if to highlight the global nature of the crisis, the unexpected revelation by a French bank that its investment funds could no longer value their exposures to US sub-prime mortgage loans produced a sharp reappraisal of the risks they were taking by investors around the globe. The returns demanded by investors on all risky assets rose – from packages of bank loans to plain vanilla company shares – so the prices of those assets fell. And in some markets for complex financial instruments, investors realised that perhaps they did not understand as much about the nature of the risks involved as they should. So not only did asset prices fall, but the markets in some of these instruments virtually closed. There were no buyers. This freezing of capital markets led to a chill in banking systems around the developed world. Banks that had relied on selling packages of loans in securitised form found that they couldn’t sell them. Investment vehicles that held securitised loans have found it difficult to finance their holdings by borrowing.
Faced with the possibility that they would have to finance these vehicles themselves, banks with spare cash have hoarded it and have become reluctant to lend to other banks beyond very short maturities. That has been evident in the spreads between interbank lending rates and central bank interest rates in the UK and equally in the euro area and United States. The bottom line is that banks that had financed themselves by borrowing from their peers, or by securitising and selling their loan assets, found that their funding dried up. In the United Kingdom, Northern Rock was particularly exposed. It was able to borrow only at shorter and shorter maturities. The present financial crisis is of a most unusual nature in that it comes against a background of five years of strong growth of the world economy and a decade and more of remarkable economic stability at home. Moreover, most banking and financial crises in the past – from the failure of Overend and Gurney in 1866, to the collapse of BCCI in more recent times – were associated with bad loans and significant losses on assets. The remarkable fact about this crisis has been the relatively small size of the bad loans compared with the total assets of banks. The crisis has arisen instead from the way banks have managed their liabilities. What did the Bank of England – as the central bank – do for the banking system?