As the monopoly supplier of central bank money, which is the most liquid asset of all, the central bank is able to provide liquidity, either bilaterally (in the event of an idiosyncratic shock), or to the banking system as a whole (in the event of a market-wide shock). In doing so, there are some important constraints. Support from the central bank is not available to prop up a failing institution. The Bank of England will only lend to those commercial banks that are, in its judgment, solvent and viable. This is for two related public policy objectives. First, the central bank needs to guard against moral hazard – that is, our policies should not undermine the commercial banks’ responsibilities to manage their own liquidity prudently. If commercial banks know that we will always bail them out, then they may take too much risk: the bank’s shareholders and management might seek to profit from the extra gains arising from risky lending whilst relying on the authorities when the risks crystallise. Second, and in consequence, the central bank needs to protect its own balance sheet (and hence public money) against the risk of loss. As a result, central bank lending should be collateralised, and subject to haircuts which are prudently calibrated to be sufficient if the counterparty was to default. In a crisis, it can be difficult to judge whether a bank really does have just a temporary liquidity problem or an underlying solvency problem.
The pre-positioning drive has gathered pace in the last year or so – there is now over £ of collateral pre-positioned for use in the DWF. After applying appropriate haircuts to each piece of collateral pre-positioned, this means the Bank could, subject to solvency and viability assessments and repayment plans, lend around £ in the DWF without the complications of further detailed collateral checks. 11 Although not a substitute for firms  9  Further details on how central banks can use their money market operations to implement monetary policy and provide liquidity support to banks are set out in Clews, Salmon and Weeken (2010), “The Bank’s money market framework”, available in the Bank’s Winter 2010 Quarterly Bulletin. 10  Further details are available at http://www.bankofengland.co.uk/markets/marketnotice100719.pdf. 11  That is around 10% of annual nominal UK GDP in 2011 – slightly higher than that in the United States, where the lendable value of collateral pledged by all depository institutions in the Discount Window (around $ in January 2012) is equivalent to around 8.5% of nominal US GDP in 2011. BIS central bankers’ speeches  5  building up their own holdings of high quality liquid assets to a more satisfactory level, that represents a very substantial “war chest” of potential liquidity in the event of significant adverse shocks. There is limited cost to the counterparty of pre-positioning, as collateral can be withdrawn on demand for use in other operations or market transactions.