Mervyn King, Governor of BoE has given a speech explaining the move.
First his analysis on why did this crisis take place? The savings in emerging marklets increased (after South East Asian crisis) and this led to low interest rates worldwide (supply of savings increases implies interest rates fall) . As interest rates remained low for a while, the investors started to search for high yields which meant complex products and finally the fall. He refers (does not mention it though) to BNP Paribas stating in its press release that it can’t value the funds it was running.
Then he goes on to say what went wrong with Northern Rock and how BoE offered help.
First, we did our routine work in the money markets of lending to the banking system against high quality collateral, such as government debt, and at Bank Rate set each month by the Monetary Policy Committee.
We were, however, pressed to do more than our routine job and to lend in exchange for other collateral, including the financial assets for which the markets had virtually closed. Banks, in particular, said they wanted us to help them turn illiquid assets into cash.
Well, it seems there was a lot of pressure. So BoE extended liquidity only at a penalty rate to reduce moral hazard.
The problem was not with the help, the problem was that King always mentioned no help would come from BoE in this crisis.
He takes a dig at Larry Summers comment:
Some commentators have taken issue with these concerns about moral hazard, arguing, by analogy, that fire departments put out fires started by people who smoke in bed. I agree that we have fire services to do precisely that. And if a fire starts in the financial system, the central bank will put it out if it threatens to spread. But fire services do not offer free insurance for people who smoke in bed or set fire to their own house, thereby encouraging them to take risks that endanger others.
Summary: Summers does not believe in Moral Hazard, but King does.
He explains how cases of Northern Rock and Countrywide (a US home mortgage company) were different. Latter could rescue itself as its deposits were well insured and US itself has a well developed insurance scheme for depositors.
What are his lessos?
1) Bank Regulation should focus on liquidity as well. So far the focus is on capital not liquidity. Superb insight. Economist also points this aspect.
2) Authorities in UK should be allowed to pre-emptively take action in case of Banks (it is allowed in US)
3) Central banks should operate as lenders of last resort.
Then he discusses Bank of England stance on inflation, economy etc.
Excellent speech from King. Highly recommended reading,