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.
As I mentioned earlier, the problems in the US subprime market had widespread and profound effects on the international financial markets. These loans had been packaged together with other securities into structured products and sold to investors around the world. The uncertainty over where the potential losses were created a general distrust between the banks and a general increase in risk aversion. The former was expressed in a rise in the differences between interbank rates and risk-free government bonds, what are known as TED spreads. The latter was expressed in, for instance, rising credit spreads (see figures 7 and 8). For a few weeks now we have seen signs that the tensions in the credit market have eased. The credit spreads have declined and the cost of insuring against losses has fallen (see figure 9). Other signs are that the banks have been able to sell off loans from their balance sheets. They have also been able to strengthen their own capital, although a large part of this process still remains. The stock markets have also recovered. The uncertainty in the interbank market has prevailed longer; the TED spreads have remained high but have fallen over the past few days. In Sweden the TED spreads have also risen, but unlike other countries the markets have continued to function without any intervention from the Riksbank. Despite the fact that there are positive signs, it is still too early to assume the danger is past.