The turmoil has also affected all of the Bank’s work; from the setting of interest rates, to the scale and structure of our market operations, and to our joint work with the FSA and Treasury to deal with institutions under stress and to help design an effective international response to the crisis. For example, like other central banks, we have adapted our money market operations to provide the liquidity the banking system as a whole has required. First, we have allowed banks to increase their reserve balances at the Bank, increasing the size of our overall provision of central bank money; second, within that larger total, we have shifted the balance towards longer-term lending as the terms of market finance have shortened; third, we have widened the collateral we accept for longer-term repos. And in April, we introduced a special scheme to provide banks with up to three years’ finance for legacy assets which have become illiquid. Last week we offered extra sterling liquidity through our usual Open Market Operations and provided US dollar liquidity as part of co-ordinated action with the Federal Reserve, ECB, Bank of Japan and Swiss National Bank. We also extended the window in which banks can swap their legacy assets under the Special Liquidity Scheme until January next year. Even once the window closes, the Scheme’s asset swap will provide liquidity for a period of up to three years, something many people have not fully appreciated.
Our investment banks have suffered losses in their trading books and a wider group of banks have lost money on their treasury books because of the fall in the values of structured credit of all sorts. At the same time they have found that some of their major sources of finance, notably securitisation and medium term unsecured lending, have dried up and others, notably shorter term lending in money markets, have become much more expensive (Chart 4). What is more, all these effects have lasted longer than expected and seem set to continue for some time. Banks have responded by hoarding liquidity and trying to reduce their leverage by raising new capital (not without difficulty in some cases) and by constraining the growth of lending. One direct effect has been a marked tightening of credit conditions over the past year (Chart 5), which seems still to be underway. That in turn is pushing down asset prices and demand. Our forecasts and our policy decisions have reflected our best assessment of the likely impact of this feedback. We brought down interest rates earlier in the year to cushion the impact of the change in bank behaviour. In effect we have relied on the credit squeeze in large measure to produce the slowdown we consider necessary. But we are fully aware of the risk that the squeeze on banks and the feedback to the economy could prove more powerful than expected. That risk does not just arise from the drama of the last week or two.