Upcoming Challenges of Fiscal Sustainability and Bank Liquidity

Upcoming Challenges of Fiscal Sustainability and Bank Liquidity Presented by: William A. Allen (NIESR) Date: 24th April 2023 Forthcoming Events 1. Fiscal sustainability. Public Sector Net Debt/GDP Ratio National Accounts Taxes/GDP Ratio Explanation:  Debt/GDP and tax/GDP ratios have both been rising and are both relatively high by historical standards: debt/GDP is 101% now compared with 36% in 1997.  Fall in debt/GDP ratio isn't forecast until after general election.  Gilt market likely to be periodically dysfunctional - large deficits, heavy maturities, QT, debt sustainability and price discovery. 2. Bank Liquidity  The Silicon Valley and Credit Suisse experiences show that the Liquidity Coverage Ratio requirement is out of date. SVB and CS lost deposits much more quickly than the calibration of the LCR requirement assumed possible. SVB UK subsidiary lost 30% of its deposits in a single day.  Liquidity regulation will have to be reconsidered. Obvious temptation to use LCR as a means of increasing demand for government debt, but: a. Conceptual flaw of minimum liquidity ratio - freezes liquid assets. b. Creates pressure on central bank to monetize government debt in an emergency (fiscal dominance of monetary policy). c. LCR ignores the inherent liquidity of short-term loans to private borrowers.  Any revision will affect the objective of monetary policy - e.g. a simple tightening of the LCR (not necessarily to be recommended) would cause a new restriction of credit and would affect the inflation outlook. It would need to be decided by experts in banking, financial stability and monetary policy. Summary  Since the financial crisis, the issues that the B of E has had to deal with ca classified simply as 'monetary policy', or 'financial stability'.  Nor do they all affect the B of E alone: debt management objectives of the DMO have been subordinated to monetary policy objectives, so that the Treasury and DMO have been affected incidentally but heavily by the MPC, which hasn't internalized the financial costs and risks of its actions.  Gilt market liquidity breakdowns are likely to continue periodically: continuing deficits, heavy maturities, QT, and doubts about sustainability will make price discovery difficult. Threat of fiscal dominance. B of E can't ignore fiscal policy. Division of labor exploited in 1997 is no longer reliable.  Bank liquidity regulation will have to be reconsidered. Any revision will affect the objective of monetary policy - e.g. a simple tightening of the LCR (not necessarily to be recommended) would cause a new restriction of credit and would affect th inflation outlook.  Decisions on future liquidity regulation should be taken by experts in both financial stability and monetary policy, because the decisions will have implications for the objectives of both. Proposal  B of E structure now seems Byzantine. Inter-relationships between decision-making bodies have to be carefully managed - 'concordats', lack of clarity about demarcation, etc.  It would be simpler and more efficient to have a single executive board responsible for monetary policy, financial stability and financial market operations, and for internal management of the B of E. 1. Would include members from outside existing B of E staff. 2. Would be responsible for financial risks taken by B of E, including those taken under Treasury indemnity. Would therefore have internalized QE financial risks. 3. Would need to be able to meet at short notice. 4. Minutes would be published except as regards internal management.  PRA board would continue as at present.  Liaison with Treasury about 1. Fiscal policy. 2. Market operations involving government securities and Exchange Equalization Account. Treasury rep could attend board meetings (ex-internal management). DMO could brief executive board. How Would It Help? - Trade-offs among objectives (price stability, financial stability) are not desirable or permissible. - Single executive board would facilitate discussion of 1. Trade-offs in speed of meeting objectives (e.g. inflation target vs bank liquidity). 2. Means of meeting objectives (e.g. what assets to buy in QE programs). 3. Financial risks, to B of E or government. 4. All members would internalize trade-offs. Independence of the Bank of England Would the proposal weaken the independence of the B of E?  Independence already weakened in principle by QE, which requires Treasury assent.  But Treasury assent has been freely given since 2009 (or so it appears), and the B of E has in practice been super-independent.  It wouldn't be sustainable to subordinate the cost/risk objectives of debt management policy to those of monetary policy permanently. 13 years is enough. The B of E can't remain super-independent.  Proposal merely recognizes the facts that: 1. The B of E's objectives are interdependent, in that actions taken in pursuit of one objective affect the other, and those of the Treasury. 2. The B of E's objectives can be undermined by fiscal dominance. 3. The B of E's monetary policy objectives can be influenced by debt management policy (Tobin).  Ignoring those facts would endanger the B of E's independence.