Bank of England is out of control...

... in the sense that the BOE is not IN control.

Mervyn King, the Governer of the BOE wrote to the Chairman of the House of Commons Treasury Committee , T.Hon. John McFall MP in advance of his meeting them with the Monetary Policy Committee (MPC) members on the 20th September .

Three distinct policy instruments can be deployed by central banks: interest rates, money market operations, and other general liquidity support operations.

1. The fiddling with interest rates is mostly a form of delusional self importance exercised by the MPC and is a one trick pony with which they try to adjust the wholly spurious way UK Domestic inflation is calculated.

2. Money market operations are described by King thus ..

" ...the smooth functioning of the payment system among banks – the short-term money markets and what is known as the high value payment system. Central banks discharge that responsibility by providing reserves that enable banks to settle among themselves. In the reform of our money market operations a year ago, we made very clear, and this is a unique feature of the British system, that the banking system as a whole will get the reserves that it itself requests."

In other words they merely act as managers, responding as required to market con ditions.

3. So King ponders ....

" So, third, is there a case for the provision of additional central bank liquidity against a wider range of collateral and over longer periods in order to reduce market interest rates at longer maturities?"

"On the one hand, (my father was always asking for one handed accountants and economists) the provision of greater short-term liquidity against illiquid collateral might ease the process of taking the assets of vehicles back onto bank balance sheets and so reduce term market interest rates. But, on the other hand, the provision of such liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behaviour. That encourages excessive risk-taking, and sows the seeds of a future financial crisis."

There has however been a lengthy history of excessive risk taking which the BOE have sat and watched develop.. CDO's , slicing and dicing, and all manner of asset backed but assetless parcels of debt swapped around on shorter and ashirter terms to finance deeper and riskier debt with near banks and veru distant banks such as hedge funds and outright fraudsters.

Now the crunch has arrived ... as he outlines on Page 9 ...

In addition, central banks, in their traditional lender of last resort (LOLR) role, can lend “against good collateral at a penalty rate” to an individual bank facing temporary liquidity problems, but that is otherwise regarded as solvent. The rationale would be that the failure of such a bank would lead to serious economic damage, including to the customers of the bank. The moral hazard of an increase in risk-taking resulting from the provision of LOLR lending is reduced by making liquidity available only at a penalty rate. Such operations in this country are covered by the tripartite arrangements set out in the MOU between the Treasury, Financial Services Authority and the Bank of England.

Because they are made to individual institutions, they are flexible with respect to type of collateral and term of the facility. LOLR operations remain in the armoury of all centralbanks.

Now the credit crunch has delivered up it's first victim. The Bank is caught between a Northern Rock and a Hard place. With nearly 20% of all UK domestic mortgage lending, with some £24 Bb. of customers deposits, they cannot finance their £113 Bn. loan book.

The shareholders have sensed the impending crisis, with the shares halving in value in the last 6 months. Now the BOE as LORL is going to bail them out.

"The moral hazard of an increase in risk-taking resulting from the provision of LOLR lending is reduced by making liquidity available only at a penalty rate."

Bollocks. The Bank is forced to keep them afloat because the ripples would run, far, wide and deep - the decision is not financial, it is political. Next bank up for support will be Barclays - we will learn more in the morning when the BOE makes a statement about bailing out the improvident bankers of Northern Rock.

Meanwhile 3 month LIBOR is nearly 125 basis points over base rate and will go up further after the BOE announcement. Mortgage rates will rise for lenders, unrelated to BOE Base Rates which the Bank fondly imagines that it manages - remote from the actual, real market.

The guys who run the financial services know what a bag of shite they have been hawking around, they have withdrawn from inter-bank lending because they know what a heap of ordure it all is.

Prudent savers will be moving their deposit accounts out of Northern Rock in the morning... where to ?Try Santander AKA Abbey.