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Banks' scary auction

• Robert Peston
• 25 Sep 07, 02:45 PM

How do you cause a run on a bank?

Well, according to the wags in the City, you put a brilliant economist and two former Whitehall permanent secretaries in charge of the .

It's not the funniest joke ever and it's not fair. But it contains a grain of truth.

The Bank seems to have lost the feel it had for markets during the previous few years when successive deputy governors were former investment bankers (also, the previous Governor, Eddie George, had a nose for the important weather in the City, even though he was a Bank lifer).

So will the Bank redeem itself with tomorrow's 拢10bn auction of three-month loans?

Well, it has already injected just a bit more confidence in markets simply by announcing that it would be having the auction. Bankers are reassured that the Bank is at last prepared as a matter of routine to lend longer than overnight and against a much wider range of collateral than hitherto. By way of evidence, the interest rates at which bankers are prepared to lend to each other have come down.

But this very success could also spark disaster.

The Bank is charging a penal, minimum interest rate on the three-month money of base rate plus one percentage point, or 6.75 per cent.

Why? You all know the answer, so repeat after me: "moral hazard". Yes it is once again because of Mervyn King's understandable fixation on spanking the banks for getting us into this money-markets mess in the first place.

But here's the problem with his refusal to charge a market interest rate, as opposed to a punitive one. A bank would have to be truly desperate to want to take advantage of the pricey money - and heaven help said desperate bank if its identity were to leak.

The big banks, , , and so on, are awash with cash and have no problem borrowing from other banks at the interbank market rate of 6.34 per cent. So it would be totally irrational for any of them to borrow from the Bank at 6.75 per cent and none of them will do so.

The only banks for whom it would be rational to take advantage of the Bank's auction would be those smaller banks in danger of running out of money and to which the other bigger banks don't dare lend.

In other words there will be a massive stigma attached to accessing the Bank's new facility. And for that reason, no bank would do so unless it were in pretty dire straits - which magnifies the stigma.

That said, in theory the names of any borrowers won't be disclosed. But I am not sure that's sustainable under Stock Exchange listing rules. Asking the Bank of England for this money is so plainly a massively price-sensitive event (it would knock the relevant bank's share price for six) that the borrowing bank would surely have to tell its shareholders that it had done so. Just remember how the share prices of and were pummelled by unsubstantiated rumours that they were running out of cash.

There's only one bank which can take advantage of the auction with impunity. And that's - simply because its reputation has already been smashed up by having received emergency loans from the Bank of England. In fact, it would probably be irrational for Northern Rock not to participate in the auction.

The risks of doing so for any other bank are daunting, to put it mildly.

Some bankers are therefore trying to gee themselves up with the thought that Mervyn King might yet have a Damascene conversion.

If at this last hour the Bank switched to charging a market rate, all the banks would be delighted to participate in the auction - because there would be neither be a prohibitive financial cost nor a devastating reputational one.

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