The Bank of England made a U-turn yesterday in its response to the credit crunch by offering to lend banks money for three months secured against mortgages.
The Bank said it would release £10bn of funds to help unblock the key three-month inter-bank lending rate. Until yesterday, Mervyn King, the Bank's Governor, had said it was not the Bank's job to free that market and doing so would reward banks for their risky behaviour.
The interest rate on the funds will be at least 6.75 per cent, the rate at which it lends to banks overnight if they are short of funds. Though banks will be able to put up mortgage assets instead of government bonds, they will not get all their assets back. The Bank is understood to believe this makes the move consistent with its hard-line stance on helping banks.
But the decision was seen by many as further backtracking by the Bank in its response to the credit crunch and the Northern Rock crisis. It intensifies pressure on Mr King, who faces a grilling by MPs on the House of Commons Treasury Committee this morning. Opposition members had already questioned the Bank's apparent trimming of its hard-line position.
Mr King, whose term as Governor ends in June, said in a paper to the committee last week that "the provision of such liquidity support undermines the efficient pricing of risk by providing ex-post insurance for risky behaviour".
A senior economist at a UK bank said: "I don't think they have done themselves any good, and Mervyn King will come under the spotlight, particularly with his term up for renewal."
Yesterday's move was the latest change in tactics by the Bank and the Government in response to the credit crunch. The most dramatic was the Chancellor's announcement on Monday that the Government would guarantee the deposits of all Northern Rock depositors as thousands lined the streets to get their savings out of the bank.
"With 20-20 hindsight, if the Bank had done what the ECB and the Fed did we wouldn't have seen people on the street queuing to get their money out," said Jonathan Said, a senior economist at the Centre for Economic and Business Research.
Mr King has taken a tougher line on the credit crisis than the European Central Bank and the US Federal Reserve, ruling out an interest rate cut or a major injection of funds to help banks unless the economy was in danger. The ECB has injected billions of euros into the market secured against a wide range of collateral. The Fed cut interest rates by half a point on Tuesday.
"It is a huge change," said Trevor Williams, the chief economist at Lloyds TSB. "It leaves the Bank looking as if it is playing catch-up."
Banks have stopped lending to each other as they hoard cash to provide for potential obligations caused by their exposure to asset-backed securities. The Bank's move will let them borrow against these securities, leaving them freer to lend to each other.
The Bank is making the money available as the three-month sterling inter-bank lending rate continued to fall, easing to 6.55125 per cent from 6.75 per cent. It has intervened because it predicts future strain from Nor-thern Rock's need for funding.
The Bank's move in the wake of the Fed's rate cut cheered the markets. The FTSE 100 index rose almost 3 per cent to 6,460. All banks rose except for Northern Rock, which fell 16 per cent on talk of a sell-off at a knockdown price.
A number of banks had considered buying Northern Rock before the crisis erupted. Lloyds TSB, which pulled out of talks at the beginning of last week, is understood to have lost interest in bidding. Analysts said that HSBC, HBOS and Royal Bank of Scotland had also cooled on the idea.
The Bank of England and Northern Rock
8 August: Mervyn King says that problems in themarkets are "not an international financial crisis"
9 August: The money markets freeze as investors panic, leaving Northern Rock without funding
5 September: The Bank of England says that it will ease reserve requirements for banks and make £4.4bn available once a week, funds secured against Government bonds
12 September: Mr King tells the Treasury Committee central bank action cannot be expected to bring down the rates at which banks lend to each other beyond the overnight rate
14 September: Northern Rock says that it has arranged unlimited emergency funding from the Bank of England
17 September: The Chancellor, Alistair Darling, guarantees the savings of Northern Rock depositors and of all UK banks
18 September: The Bank of England offers £4.4bn in secured funding two days ahead of schedule
19 September: The Bank of England announces £10bn of funds, secured against mortgage assets, to ease the three-month money market