No bailout for lenders – King

He also highlighted the potential for banks to cut back on new lending, tightening the supply of credit available to the household and corporate sector.

King set out his views in a paper submitted yesterday to the Treasury Committee, chaired by West Dunbartonshire Labour MP John McFall. The governor is not due to appear again before the committee until September 20, but highlighted his wish to submit in advance an "extensive" explanation of the Bank's analysis and judgments "given the importance and complexity of developments in financial markets".

Some financial market players have criticised the Bank of England for being less interventionist than the European Central Bank and US Federal Reserve in the current financial market crisis.

However, King sees nothing for which to repent and hammers home in his paper a view that any move to bail out financial institutions for risky or reckless lending is likely to do more harm than good in the long term by setting a potentially dangerous precedent.

The current financial market troubles have been triggered by a massive default by US households with poorer credit ratings served by the sub-prime mortgage sector. This has killed demand for securities backed by the cash flows from sub-prime mortgages, spilled over into the wider credit markets, and hit equity prices.

In the paper, King mentions the action taken by the Bank of England last week to reduce the overnight interest rates at which banks can borrow from each other.

He notes that the increase in demand for liquid assets "helps to explain why the compensation needed for banks to lend to other banks over periods longer than overnight has risen".

King points out this higher demand for liquid assets comes at a time when banks face the prospect of having to take investment vehicles that they have backed, but which are unable to raise funds in current conditions, directly on to their balance sheets.

King highlights the rise in three-month interbank lending rates. The three-month British Bankers' Association London Interbank Offered Rate (Libor) for sterling hit a nine-year high of 6.90375% on Tuesday. Although it eased slightly yesterday to 6.9025%, it remains way above the Bank of England's base rate of 5.75%.

In his paper, King mulls whether there is "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".

He says: "This is the most difficult issue facing central banks at present and requires a balancing act between two different considerations. On the one hand, the provision of greater short-term liquidity against illiquid collateral might ease the process of taking the assets of vehicles back on to 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."

He takes the view that such liquidity support should be provided only where there could otherwise be heavy economic costs and a threat to the financial system.

King says: "Central banks cannot sensibly entertain such operations merely to restore the status quo, ante. Rather, there must be strong grounds for believing that the absence of ex-post insurance would lead to economic costs on a scale sufficient to ignore the moral hazard in the future. In this event, such operations would seek to ensure that the financial system continues to function effectively."

He returns to this "moral hazard" issue later in the paper.

King says: "The moral hazard inherent in the provision of ex-post insurance to institutions that have engaged in risky or reckless lending is no abstract concept. The risks of the potential maturity transformation undertaken by off-balance sheet vehicles were not fully priced. The increase in maturity transformation implied by a change in the effective liquidity in the markets for asset-backed securities was identified as a risk by a wide range of official publications, including the Bank of England's Financial Stability Report, over several years.

"If central banks underwrite any maturity transformation that threatens to damage the economy as a whole, it encourages the view that, as long as a bank takes the same sort of risks that other banks are taking, then it is more likely that their liquidity problems will be insured ex post by the central bank.

"The provision of large liquidity facilities penalises those financial institutions that sat out the dance, encourages herd behaviour and increases the intensity of future crises."

Noting the Bank's role as a lender of last resort (LOLR) at a penalty rate of interest to commercial banks facing temporary liquidity problems, King adds: "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 Unless they (such injections of liquidity) were made available at an appropriate penalty rate, they would encourage in future the very risk-taking that has led us to where we are.

"All central banks are aware that there are circumstances in which action might be necessary to prevent a major shock to the system as a whole. Balancing these considerations will pose considerable challenges, and in present circumstances judging that balance is something we do almost daily."

King, who highlights in the paper the fact that losses from US mortgage defaults "so far remain small relative to the capital of the banking system", concludes: "The key objectives remain, first, the continuous pursuit of the (2% annual UK consumer prices index) inflation target to maintain economic stability and, second, ensuring that the financial system continues to function effectively, including the proper pricing of risk. If risk continues to be under-priced, the next period of turmoil will be on an even bigger scale."