BOE's King Loath to Aid Market, Cites Moral Hazard (Update2)

By Svenja O'Donnell

Sept. 12 (Bloomberg) -- Governor Mervyn King refused to relax the Bank of England's system for money-market lending, rejecting calls to provide commercial banks with more longer-term cash to reduce borrowing costs.

``The provision of such liquidity support undermines the efficient pricing of risk by providing ex-post insurance for risky behavior,'' King said today in written testimony to the U.K. Parliament's Treasury Committee. ``That encourages excessive risk- taking, and sows the seeds of a future financial crisis.''

The U.K. central bank has been more reluctant than the U.S. Federal Reserve and the European Central Bank to provide emergency funds to banks hurt by the collapse in the subprime mortgage market. While the Bank of England will offer extra money this week to cut overnight rates, it has ruled out action to ease three- month borrowing costs or to change its collateral rules.

``The danger for the BOE is that the markets think they simply don't care,'' said Ken Wattret, an economist at BNP Paribas in London.

Increasing defaults on U.S. subprime mortgages have pushed up credit costs around the world. In the U.K., the gap between three- month money market rates and the benchmark central bank rate has widened to the most in at least two decades.

The ECB, the Fed and other central banks have loaned financial institutions more than $400 billion in the past five weeks to help lower lending rates.

`Last Resort'

The ECB alone has injected 253.5 billion euros ($352 billion) since Aug. 9, which compares with the 4.4 billion pounds ($9 billion) offered by the Bank of England. Today, the ECB loaned banks an additional 75 billion euros for three months. The Fed on Aug. 17 cut the rate at which it loans money directly to banks and dropped its bias toward fighting inflation.

The Bank of England ``should provide liquidity to the market as a lender of last resort,'' said former policy maker Willem Buiter in an interview Sept. 7. ``They show no inclination to do that.''

Barclays Plc President Robert Diamond has also called on the bank to do more, telling the Sunday Telegraph in an interview published Sept. 2 it needs to inject more liquidity into the market to restore investors' confidence.

`Flexible Tool'

King responded to the criticism by saying today that central banks should only act when there are ``economic costs on a scale sufficient to ignore the moral hazard in the future.''

The bank is nevertheless ``monitoring credit conditions intensively'' and King stressed that ``interest rates are a flexible tool'' that ``can be adjusted quickly when necessary.''

The market turmoil has already increased borrowing costs for consumers and businesses, King said, and ``other things being equal, that would lower the inflation outlook.'' He nevertheless gave no clear hints on the bank's rate intentions.

``It's too soon to tell how persistent and how large any change in credit conditions for household and corporate borrowers will prove to be,'' King wrote.

The Bank of England's Monetary Policy Committee will next decide on rates on Oct. 4. The bank's benchmark rate currently stands at 5.75 percent, the highest among the Group of Seven industrialized nations.

The Bank of England has also faced calls to loosen its rules on the collateral it accepts in return for loans at its regular market operations.

``The bank could do more by making it clear that it is willing to accept a three-month operation against any kind of collateral they can put a price on,'' said Buiter.

For King, the danger is that central bank intervention to bail out investors may store up greater trouble for the future.

``If risk continues to be under-priced, the next period of turmoil will be on an even bigger scale,'' he said.

Last Updated: September 12, 2007 07:05 EDT