Mr.

THE BANK OF ENGLAND AND ITS INFLUENCE ON THE UK MONEY MARKETS.

In the following essay, I am going to show to what extent the Bank of England can affect the money market, I will use the recent crisis faced by the Northern Rock Bank as an example to elaborate on the matter.

The power of the Bank of England comes from the fact that it has a monopoly on the supply of liquidity. The Bank of England can set interest rates.

It all begun with the banks having a lot of cheap money and they were desperate to lend, so they tapped into the American sub prime market which provided finance for people with poor credit rating (known as ninjas-no income no job or assets), this was known as the collateral loan obligation, CLO.

The system was such that financiers would set up a separate company and borrow for example Ð'Ј900 million perhaps from insurance companies and pension funds on which they paid low interest, they then added about Ð'Ј100 million of their own money making Ð'Ј1bn in total, with this billion they bought mortgages from a bank in America and the mortgages brought in an income of about Ð'Ј 80million which was more than the interest they had to pay say about Ð'Ј50 million so the profit was Ð'Ј30million from only Ð'Ј100million of their own money.

The advantage of the CLO was that they were not banks, banks are regulated and regulations are costly and it restricts the ability to conduct business as large reserves are needed, the have restrictions on operations and they have to report on a regular basis.

More and more banks got involved in the CLOs and the subprime market boosting the profits even further, the market for CLO s became popular in Wall Street, but in reality it was a time bomb waiting to explode.

It wasn’t just US banks, from 2003 UK banks piled into the market, they put billions through their US subsidiaries into the American sub prime market and found ways of investing millions more into all kinds of loans and securities backed by the subprime market. All these operations were kept off balance sheet but even publicly available figures are huge:-

• HSBC - Ð'Ј48BN

• RBS - Ð'Ј12BN

• BARCLAYS - Ð'Ј12BN

• ALLIANCE & LEICESTER - Ð'Ј756MN

• LLOYDS TSB - Ð'Ј594MN

• HALIFAX вЂ" 430MN

By 2005, $600bn worth of subprime mortgages had been issued in the US, at its peak this global market raised more than Ð'Ј3trillion but the fact was that this credit bubble depended on people with bad credit histories not defaulting, the bankers chose to ignore this due the profits that were being made.

On top of everything the bankers were being told that CLOs were low risk by their credit rating agencies, CRA, which analyzed the risk of financial products and assigned ratings.

Previously CRAs had rated government and company debt but now they found themselves evaluating these complex new securities, there were two problems they didn’t have sufficient information to make a proper analysis and second they had a conflict of interest because they were paid by the issuers of the securities in other words the worked for the seller rather than the buyer.

Unsurprisingly CRA’s rated the debt of the CLO’s as high as possible (AAA), this is the same rating that the Bank of England, BoE, would have got. CRA’s are unregulated yet on the strength of their credit ratings many banks got involved in CLOs.

The amount of money generated handed one UK bank a golden opportunity. The Northern Rock, NR. The NR was not like other banks, this former building society was heavily reliant on risky short term loans to provide funds for their own long term mortgages. NR directors found this more profitable than being funded from a wide range of safer sources like other banks.

NR expanded rapidly snapping up 20% of the UK mortgage market and became the UK’s 5th largest bank. This all worked well as long as their lenders had confidence to lend them money.

The CLOs and similar products were on the increase and were taking over from banks for providing credit. The BoE had not woken up to this fact and still believed the banks were funding the buyers in the city, they didn’t understand these new structures and their effects and the FSA the regulatory body also failed to pick up on this. The FSA thought the loan market was low risk.

In august 2007, interest rates started rising and the people began to default, the bankers became worried about the losses and the ability of their fellow banks to repay loans, they started holding bank more money in case of crisis, which resulted in banks not lending to each other.

By august 9th 2007 banks had become so unwilling to lend that international markets were seizing up, they knew there were losses but nobody would admit to it and the crisis was intensified by the bankers tradition of secrecy.

On the 4th of September, inter bank lending froze as a direct result of the CLO market, NR relied now on borrowing from other banks and suddenly found other banks didn’t want to lend to them.

The BoE

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