Buying gilts to beat crisis? It's the road to madness

Anthony Hilton
10 Mar 2009

Buying Government securities last week could yet prove to be one of the biggest single mistakes made by the authorities in their efforts to manage the financial crisis.

The issue is not whether or not the policy of quantitative easing is good or bad, but rather the way it has been implemented.

The decision by the Bank to launch it with a major purchase of Government securities, rather than buying bank loan books or corporate bonds, sent the price of gilts soaring and dropped the long-term rate of return from 1.4% to little more than 1% - a shift that has potentially disastrous implications across the financial sector.

This is because the price of long-term Government securities is the benchmark for the long-term real rate of return in the economy, and as such it is the measure that governs the valuation of pension-fund deficits and the liabilities against which insurance companies have to hold matching assets.

Roughly speaking, the drop in the long-term real return last week was one third, which adds one third to all liabilities across the financial system that use it as a benchmark.

It therefore puts huge additional pressure on companies with defined-benefit pension funds to pump in additional assets to top up the funds.

Paradoxically, given the purpose of the policy, it could even make it harder for banks to lend.

Currently, the collective deficit of their different funds was about £1 billion, but this has ballooned with the drop in interest rates to around £4 billion.

The £4 billion of capital needed to fix that hole could support £80 billion of lending to the economy - on the basis of a 5% capital-to-loan ratio.

This is, however, very much the worst-case picture because the banks may seek to ignore the deficit just as companies seek to ignore their deficits, though it is getting much harder to do given the new responsibilities of pension trustees.

More realistically, they could also agree to close the deficit over time, which means that rather than injecting enough to close the gap in one move, they would put in much less, and hope to rebuild the position over time.

But that said, the purchase of long-term gilts seems odd.

Their price has been severely distorted for years because regulatory and accounting changes force pension funds to buy them when there is nowhere near enough supply to meet the needs of these funds.

The price distortions created by the excess demand have already spread throughout the financial system, causing unnecessary and arguably illusory deficits.

These have led to even more distortions as policies are put in place to correct the earlier misalignment.

And now the Bank has given a further massive push in the wrong direction. Truly, this way madness lies.

Best bet is to beef up the FSA

When you look across the world at how different countries with different regulatory structures have coped with the current financial crisis, there is no model that seems consistently to have performed better than any other.

What you might deduce from this is that structure of itself is not important.

What matters is how the individual regulators behaved within the framework that had been set for them, not what that structure was.

Sir James Sassoon, a former UBS investment banker who has been knocking around Government and Whitehall in various guises for a few years now, yesterday published at the request of the Conservative Party a contribution to the debate on how regulation might evolve.

What can most certainly be said of this is that it is an infinitely better document than it would have been had the Shadow Treasury team written it themselves.

But it nevertheless falls into the trap beloved of politicians which holds that the response to any crisis is to toss the existing regulatory structure into the bin and start again.

This approach clearly appeals to politicians because it gives the impression that they are doing something, and it matters little to them that what they are doing is the wrong thing.

It is, however, a matter of record that when a new regulatory body is created, it takes years for it to bed down.

Indeed, it probably does not properly find its feet until it has gone through a whole cycle and been bloodied by a crisis - about now, in fact, in the case of the Financial Services Authority.

The right policy response ought surely to be to reinforce the FSA now that it has learned at first hand just how many thing can go wrong, not to start again so that all that experience is lost.