King of the Bank of England caused the Credit Crunch

The annual speech at the Lord Mayor’s Banquet for Bankers and Merchants
of the City of London at the Mansion House by the Governor of the Bank of England has a lengthy history - it is a tradition. It is the time of year when the Governor provides a broad review of past activity and future expectations. The Oracle speaks.

What he said last year at the Mansion House on Wednesday 20 June 2007 to the City Glitterati as they fumbled over their 3rd or 4th brandy, adjusted their weskits and lit up their vast cigars .... on expectations for inflation (and how totally fucking wrong they were) has been examined here before.

Our central view remains that inflation will fall back this year as the rises in domestic gas and electricity prices last year drop out of the annual comparison, and the recent cuts in prices feed through to household bills.

How wrong could he be ?

As ever, there is room for differences of judgement as to the appropriate level of Bank Rate – as shown by the differing views within the MPC. But every member of the Committee is determined to bring inflation back to target and keep it there – or as close to the target as possible – indefinitely.

So as a result he and the MPC have three times reduced Bank rate since then. ... resulting in what the Daily Mail has today ... (Brent is US$114 a barrel as the market open today)

Elsewhere he delivered a surprising (and in retrospect a shattering message) ...

Your decision to grant independence to the Bank of England ten years ago is widely and rightly regarded as a fundamental improvement to the conduct of economic policy in this country, and we in the Bank are grateful to you for giving us the opportunity to demonstrate the benefits of an independent central bank.

This is of course a delusion - for example King , 30 odd working days later he was asked by Loyds Bank to be allowed to take over Northern Wreck with support from the BOE but handed this hot potato very swiftly (within hours) to the Chancellor in the lievely expectation that he would refuse. Which he did.

Financial stability more generally is a topical concern in financial markets. More than
one banker and merchant in the City has said to me recently, “I cannot recall a time when credit was more easily available”. How worried should we be?

His answer takes some time to deliver - it is one that changed the world. It's force has been overlooked, misjudged and largely unheard.

Securitisation is transforming banking from the traditional model in which banks
originate and retain credit risk on their balance sheets into a new model in which credit risk is distributed around a much wider range of investors. As a result, risks are no longer so concentrated in a small number of regulated institutions but are spread across thefinancial system. That is a positive development because it has reduced the market failure associated with traditional banking – the mismatch between illiquid assets and liquid liabilities – that led Henry Thornton and, later, Walter Bagehot to promote the role of the Bank of England as the “lender of last resort” in a financial crisis.

Distributing credit risk around may spread it, but it fails to reduce it. The result is that the "the mismatch between illiquid assets and liquid liabilities" is further from understanding, monitoring and control. The total risk is the same but identification is more difficult and deliberate concealment on many, many more balance sheets, not only within the control of the FSA but often offfshore is not only made possible , but certain. Control by the Central Bank has evaporated.

New and ever more complex financial instruments create different risks. Exotic instruments are now issued for which the distribution of returns is considerably more complicated than that on the basic loans underlying them. A standard collateralised debt obligation divides the risk and return of a portfolio of bonds, or credit default swaps, into tranches. But what is known as a CDO-squared instrument invests in tranches of CDOs. It has a distribution of returns which is highly sensitive to small changes in the correlations of underlying returns which we do not understand with any great precision. The risk of the entire return being wiped out can be much greater than on simpler instruments. Higher returns come at the expense of higher risk.

Mervyn has identified the increase in risk - he fails to say what he intends to do about it, unless the key is here ...

Whether in banking, reinsurance or portfolio management, risk assessment is a matter of judgement as much as quantitative analysis. Ever more complex instruments are designed almost every day. Some of the important risks that could affect all instruments – from terrorist attacks, invasion of computer systems, or even the consequences of a flu pandemic – are almost impossible to quantify, and past experience offers little guide.

Then he adds a lesson we all learnt at a very early age... are we to assume this modest understatement encapsulates a policy ?

Be cautious about how much you borrow is not a bad maxim for each and every one of us here tonight.

The wonderfully understated double negative is a kicker - he continues....

The development of complex financial instruments and the spate of loan arrangements without traditional covenants suggest another maxim: be cautious about how much you lend, especially when you know rather little about the activities of the borrower. It may say champagne – AAA – on the label of an increasing number of structured creditinstruments. But by the time investors get to what’s left in the bottle, it could taste rather flat. Assessing the effective degree of leverage in an ever-changing financial system is far from straightforward, and the liquidity of the markets in complex instruments, especially in conditions when many players would be trying to reduce the leverage of their portfolios at the same time, is unpredictable. Excessive leverage is the common theme of many financial crises of the past.

To which he adds ..

Are we really so much cleverer than the financiers of the past?

So there we have it , Uncle Mervyn's Old fashioned Home Remedy for Financial Stability ...be careful how much you borrow - be careful how much you lend

The result ... well, 200 miles up the Great North Road the Northern Wreck were getting ready to ready to close their accounts for the half year 11 days later. Within a month the FSA had approved their Basle II arrangements so they could having seen a massive 40% growth in lending with a rise in attributable profits of less than 1% agree on a dividend rise (eventiually of course to remain unpaid) of 33%.

Nearer at home the rate at which bankers charged for interbank lending reflected Uncle Mervyn's Old fashioned Home Remedy for Financial Stability be careful how much you borrow - be careful how much you lend .... was kicking in.

36 days later Northern Wreck released their accounts and the shares dropped £1 in minuutes - a gleeful and unconcerned CEO had unloaded all his shares at the top of the market in January.

Another 9 days after that the gap between Bank Rate and Libor had reached the limit - the bankers had absorbed Uncle Mervyn's Old fashioned Home Remedy for Financial Stability - be careful how much you borrow - be careful how much you lend

The Bankers stopped lending and borrowing ....

Read the full speech here