To understand what went on in 2008 it is useful to have some background about the UK financial system.

In 1850, to avoid having a run on the bank (à la Northern Rock in 2008) banks tended to maintain a self-imposed 60% of eligible liabilities as liquid assets – this is called the liquidity reserve ratio.

Liquid assets are usually seen as Cash and Central Bank Reserves PLUS government bonds, or gilts.

Following the banking crisis in 1866, the Bank of England became lender of last resort thus providing a safety net; the banks no longer saw any need to retain this high level of self-imposed liquidity and reduced it to 30%.

When the Bank of England was nationalised in 1947 it imposed a formal liquidity reserve ratio of 32%.

In 1963 this was reduced to 28% and in 1970 further reduced to 12.5% of eligible liabilities.

In 1981 the formal liquidity reserve ratio was abolished altogether.

The effect of relaxation and ultimate abolishment of the liquidity reserve ratio requirements meant that the banks could lend more with the risk profile of each bank entity (as opposed to the risk profile of that bank’s lending) potentially worsening.

In 2000, the Basel 2* agreement, whilst not quite permitting banks to “do their own thing”, did largely allow them to determine their own risk profiles. There is no mention of liquidity risk or ratios – but Pillar 2 (see box below) was meant to pick this up.

* Basel 2 required capital equal to the higher of:

(a) A numerical calculation based on a “model” based on historical default rates (“Pillar 1”); and

(b) A “what if” analysis looking at the portfolio against “worst case” market risks; again based on historic rates but this time extreme movements rather than the mean. Think “prudent businessman” (Pillar 2)

As a direct result, there were more easy accessible mortgages – which in turn pushed house prices up. And cheap money made the economy less efficient as the market discipline of the cost of money vanished.

Now let’s wind forward to 2008. A lot of risky mortgages, or sub-primes, had been bundled up with less risky ones which went bad; this meant the banks had to call in loans (specifically to the financial sector and commercial property investments) and thereby making significant losses.

The ratings agencies played a key role in this, giving these ‘bundles’ low risk credit ratings despite them containing high risk mortgages etc. This led to many of these ‘bundles’ being significantly over valued. So when the actual assets they were based on, for example houses, dropped in value there was little room for error.

It really boils down to confidence. Once that confidence is lost then something has to be done to restore it. The end result of the fallout from the lack of confidence following the sub-prime bundling was the potential collapse of the western banking system – this was not just limited to the UK but also the US and Europe.

In the UK specifically, there was a run on Northern Rock building society.

Something had to be done.

The question for the UK government was “what should we do?” Their predicament was that they wanted to preserve the banks and at the same time keep interest rates low.

So they instructed the Bank of England to purchase Gilts (government bonds) from the private sector – private individuals, pension funds and insurance companies – using “new” money. This all added up to about £375Bn. And this was QE(1).

Tectona tip – see our related article “Can Banks really Create Money when they Want?” which explains how banks and the Bank of England can do this.

The consequence of this was that our bank deposits were kept safe and the cost of mortgages actually fell.

And house prices and the UK stock market started to rise again.

One criticism of this approach is that quite simply the rich got richer and the gap between rich and poor widened.

Another was that of the £375Bn of new money created only about £20Bn resulted in ‘new spend’ and therefore provided any direct stimulation to the UK economy.

Worse still, a large proportion ended up in the pockets of pensioners and not where it was really needed – with those adding value to the economy (businesses and their employees). As a result, UK productivity stagnated.

Postscript:

In 2010 the UK Financial Services Authority (FSA) introduced a new quantitative liquidity requirement called the Individual Liquidity Guidance (ILG). Internationally the Basel Committee on Banking Supervision agreed on the Liquidity Coverage Ratio (LCR) in 2013, which is similar in design to the ILG. In the UK, the ILG will be superseded by the LCR from 1st October 2015. This link takes you to a working paper which estimates the average treatment effect on banks from the introduction of the ILG in the UK.

Conclusion

QE(1) was the Bank of England buying Gilts from private individuals, pension funds and insurance companies funded by creating new money. In a related article we look at whether this needs to be paid back.

That is our take on what happened in the run up to 2008 and thereafter and provides a backdrop for when you read our related articles in which we look at:

Note: A large chunk of the inspiration for this synopsis is drawn from the excellent Economic Updates produced by Roger Martin-Fagg