Help us George, just not like that!

Oh George, what are you trying to do with the housing market?  The help-to-buy scheme is 100% politics and 0% economics. It will boost house prices, as if the Bank of England wasn’t doing enough, and perhaps give a “feel good” factor to the economy in time for the next election.  Perhaps that’s all you care about but its bad news for the UK economy in the medium to longer term.

The trouble with QE is that the cash isn’t getting through to real economy. Banks say this is because there isn’t enough demand for loans so lending isn’t growing quickly. So how do you boost lending to households? Well, one way is to make it easier for them to borrow by reducing the deposit they need to get a mortgage. So George has attempted to tackle the supply/demand breakdown in the lending markets with his help-to-buy scheme.

This might well be his economic argument for this very political policy but it is highly misplaced and dangerous. By introducing the “help-to-buy” scheme he’s making imbalanced supply/demand in the housing market even more imbalanced. Government intervention in broken markets is fine and can help as long as they address the broken bit of that equation. In the case of the London housing market it’s the supply side that’s broken not the demand side. By saying “we want to help young people get on the housing ladder” whilst not addressing the supply side only stores up problems in the future. It’s a very short sighted view at helping the housing market. What happens when house prices go up to such an extent that people can’t even save up a 5% deposit because 5% then is the equivalent to 10 or 20% today? By increasing lending, banks’ profits should improve but it also means that if the government ever wants to get out of this program it will be reliant on the banks to offer 95+% mortgages, something that just a few years ago politicians were saying were unsafe for the economy.

Where are all the houses?

London’s population has risen ever higher over the last 25 years after the Thatcher government made the UK a much more attractive place to do business. Not only this but EU integration has allowed increased migration across countries with many coming to London to find jobs. 

This is all well and good and should be encouraged but London’s rising population has not been matched by increased supply.  Real house prices have risen higher with population growth, an indication of demand outstripping supply. The government continues to do too little to address this problem.

Ldn housing

Another problem today is that fewer families are deciding to move out of London because transports costs have risen substantially in recent  years. This means even less supply is hitting the market.

A couple good links on what’s straggling London housing supply:

The Economist – London house prices 

The Economist –  Belt too tight



Posted in Bailout, Bank of England, Banking, BOE, Conservatives, Economics, London, Osborne, Politics, Quantitative Easing, UK | Tagged , , , , , | Leave a comment

Thatcher’s Britain

The passing of Baroness Thatcher reminds us that the UK was in a terrible state in the 1970s and how far it had fallen from the peak of its powers hundred years before.  What made Britain the global superpower in the 19th century was its entrepreneurial, market based values that embraced technology and innovation.

Unless technology and efficiency is embraced by competitiveness, an economy becomes stuck in a Malthus styled decreasing-returns-to-scale model. Thatcher broke this unproductive model by driving through much needed supply side structural reforms and investment in technology which generate higher productivity and increasing returns to scale; more being produced by fewer people, freeing up others to do more productive jobs.

Breaking the unions created massive social division and perhaps Thatcher’s mistake which has plagued the Conservative Party ever since, is that the regeneration of docklands and Canary Wharf which has proved so important in London wasn’t repeated around the country in the former industrial towns and cities. This, perhaps, is one area that the present Tory party can aim to set free the wealth building powers of the market in the poorer regions of the country by introducing economic zones to incubate businesses and research in high tech industries.

From 1980 to 2013, the UK grew more quickly than its major trading partners, as Figure 1 shows, on a per capita basis, even outpacing the US.  However, the UK started from a much lower level of real GDP per capita (Figure 2).

UK 1980 to 2013 index 090413

Figure 1 Source: Oxford Economics

UK 1980 to 2013 090413Figure 2 Source: Oxford Economics

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The last time I lent out EUR18 billion….

This whole Cyprus situation is crazy for more than the obvious reasons, it reminds me of the last time I lent out EUR18 billion. In 2007 I was a repo trader at a large “overleveraged” US bank. One of my roles was to invest the firm’s leftover cash on a daily basis. Every day and throughout each day, the treasury department would phone up to let me know how much cash to invest. The bank’s reserves had to be invested in only the safest assets – European government (since it was all Euro cash) bond repo. This is a loan collateralised by government bonds. I would lend cash out to other banks and get government bonds in return for a period of one day.

To manage risk, banks adhere to a leverage ratio. This means that they borrow against the value of the assets on their balance sheet, similar to a home buyer borrowing so many times the value of their deposit. When the value of the assets go up, the bank’s leverage goes down. Similarly if the assets fall in value, the leverage ratio goes up. But as a profit maximising business,  banks maintain a specific leverage ratio so when the value of the assets rise, they would borrow more against the higher value of their assets. But what this also means is if the value of the assets fall, the bank has to sell assets on its balance sheet to lower the leverage ratio. The cash generated from the sale of these assets generates cash which ends up with the bank’s treasury and in the short term, is invested in short term assets such as repo.

So in the first half of 2007, the asset backed and mortgage backed securities (ABS and MBS) markets started to fall, which sent the bank’s leverage ratio higher causing the bank to sell off some assets. Sharp falls in the price of assets meant bigger asset sales to bring the leverage ratio back in line. The sales generated cash and on one particular day it led to me having to invest EUR18 billion in European government bond repo or to put it another way, lending out EUR18 billion. This was more like parking cash on an overnight or tomnext (starting tomorrow for one day) basis than any sort of risky lending.

Now where have I seen that figure lately…oh yes, the GDP of Cyprus is EUR18 billion and just shy of the EUR18.3 billion bailout (EUR10bln from Troika plus EUR5.8bln from bank levy etc plus EUR2.5 bln Russian loan extension).

This shows at least two things. One how small Cyprus is in the grand scheme of things (although very important given the ramifications for the rest of the Eurozone) and two just how much liquidity and lending banks were involved in pre-financial crisis. 

For more on bank exposures and bank runs during the financial crisis read the below extract from my paper, “Fear and Uncertainty in the Money Markets: The Role of Asymmetric Information during the 2007-2009 Financial Crisis.”

See References at bottom for top papers on bank runs and liquidity squeezes (fairly relevant given events in Cyprus).

 1.      Laying the Foundations of a Liquidity Shock

Non-Inflationary Consistently Expansionary, or  N.I.C.E,[1] is how Mervyn King, Governor of the Bank of England, described the decade before the 2007-2009 financial crisis. Although the decade was littered with events such as the bursting of the dot com bubble, an increase in the awareness of the security threats following September 11 2001 and corporate scandals, such as Enron, the capitalist system of developed countries appeared, on the surface, to be stable. By 2007, stock markets had enjoyed a long period of growth, the new Euro Zone appeared to be a success and Britain had not had a recession since the early 1990s. It was a time of spend today, pay later as consumers enjoyed low interest rates while household wealth was boosted by a long period of house price growth.

Although, there were several doomsayers, notably Rajan (2005) and Roubini (2006), expectations of the future were optimistic. This was as true in the markets as it was on the high street and can be illustrated by Figure 1. The chart shows the difference between two benchmark rates for secured and unsecured lending over a three month period in the U.S., Europe and the U.K.


Figure 1: The Libor[2]/OIS[3] spreads in US and UK, Euribor/OIS spread for Euro Zone. Source: Bloomberg.

As can be seen from Figure 1, in the period before August 9 2007, the spread between these rates was extremely stable in the US, Euro Zone and the UK.

Although, Figure 1 illustrates the stable conditions of the interbank market before August 9 2007, it does not show the growing problems in the subprime mortgage market.

Over the previous ten years, the mortgage-backed securities (MBS) market had grown very quickly, initially encouraged by a policy by President Bill Clinton to address the growing poverty-wealth gap in the United States[4]. The aim was to make it easier for the poorer members of society to buy their own house by easing the borrowing constraints that existed for people with very little of their own capital. The intentions were good but this proved to have unintended consequences. The policy was continued by President, George W. Bush, and under his leadership, regulations were eased to allow banks to package together sub-prime mortgages with prime mortgages to create tradable assets similar to a bond. This process is called securitisation. Gorton (2008) explains the securitisation process, describing a market so complex, both in terms of how these products were structured and the network of investors involved, that it was impossible to know where the risks to investors and banks lay.

Gorton (2008) notes that in 2006, new synthetic indices for asset-backed securities were introduced to the market, known as ABX and this improved the publicly held information with respect to both the value and risk of MBS. Plus, it provided investors a tool with which to hedge exposures by buying and selling protection against falling prices. Gorton says that the common knowledge generated by the introduction these indices led ABX prices to fall due to the demand for protection, as well as the ability of investors to short the market putting even more downward pressure on prices. When house prices began to fall at the end of 2006, this is what happened.

These risks were either not overtly clear or disregarded by the broader market and it was assumed that only small players in the financial markets such as hedge funds would be lost. However, when the French bank, BNP Paribas, announced large losses in two of its hedge funds and stopped investor withdrawals on August 9 2007, the crisis escalated as the markets realised the problems were much larger than previously thought, with many of the world’s largest banks heavily exposed to MBS, the whole banking system was now threatened.

However, the reason for the escalation of the crisis wasn’t necessarily due to the absolute size of the MBS losses, as Brunnermeier (2009) writes, since the overall losses from the mortgage market were relatively modest compared to the $8 trillion of U.S. stock market wealth lost between the all-time high in October 2007 and October 2008. The reason for what has been described as the worst crisis since the Great Depression[5] is the result of an over-reliance by banks on short-term funding to finance longer-term assets.

The repo[6] market is one of the key tools banks use to manage their funding requirements. According to Hördahl and King (2008), repo markets doubled in size between 2002 and 2007 with roughly $10 trillion in both US and Euro-Zone repo markets and $1 trillion in the UK repo markets.


Figure 2: The growth and decline of overnight repo trading before and during the financial crisis. Source: Federal Reserve Bank of New York.

This form of financing was particularly popular with primary dealers especially the former investment banks Morgan Stanley, Goldman Sachs, Lehman Brothers, Merrill Lynch and Bear Stearns who did not have a customer base of depositors to form the basis of their capitalisation. This meant that due to their over-reliance on short-term funding, these banks were much more at risk to a liquidity freeze than other deposit taking banks.

These banks raised financing through the issuance of short-term debt by issuing commercial paper[7] as well as in the term repo market, while the overnight repo market was used to fine tune daily liquidity. Banks with a large customer base of depositors did not have to rely on this form of financing to such a degree and this is why the primary dealers were most at risk from the liquidity crisis that ensued. Figure 3 shows the effect this had on primary dealer credit default swap (CDS)[8] prices. The cost of insuring the primary dealers’ debt rose much higher than retail banks such as Bank of America and JP Morgan. This is particularly clear in the period after September 2008. However, it can also been seen that the market had concerns about Lehman brothers as far back as June 2008.

bank cds

Figure 3: The chart shows how CDS prices behaved between January 2007 and December 2010. Source: Markit.

Adrian and Shin (2010) explain how banks actively manage leverage[9] in order to maximise profits by using the assets on its balance sheet to finance other investments. Since the loan is a fixed size, if the asset price increases, the total leverage a bank is exposed to falls but if the asset price falls then leverage will increase. This is an example of passive leverage management. Since banks had fixed leverage targets set by the Value-at-Risk (VaR)[10] measure, however, they undertook active leverage management. This means that when the price of assets increases, instead of allowing the firm’s leverage to fall, the bank actively puts to use the spare capital that can be raised by maintaining a specific leverage ratio and one way to do this was in the overnight repo markets. However, if the assets’ value falls, the bank must sell assets to reduce leverage.

Several problems arose from this strategy. Adrian and Shin (2008) find that since banks generally all had a similar policy, the banking system was particularly vulnerable to a shock. For instance, if all banks held similar assets, there is a danger of creating a negative feedback loop when asset prices dropped because all banks would be selling the same or similar assets to reduce leverage at the same time. In turn, this would put even more downward pressure on asset prices, leverage would rise again and the same process of reducing the balance sheet would take place. Brunnermeier (2009) describes this as a liquidity spiral as banks are forced to sell assets but also face increasing haircuts.[11]

Liquidity spirals of this nature accelerated in March 2008 , when Bear Stearns was forced into a buyout by JP Morgan, and September 2008, when Lehman Brothers collapsed, because assess to funding in the markets was blocked.

If a bank is over-reliant on short-term loans, the lender can decide either not to renew the loan or shorten the maturity of the loan. The shorter the maturity, the more often the borrower must access the markets to secure funding. This is why these banks were particularly vulnerable to a liquidity squeeze in the interbank markets. If lenders suddenly decided to reduce lending and hoard cash, as happened from August 9 2007, banks would find it more difficult to secure funding.

Morris and Shin (2004) note that when a liquidity shock hits, traders’ trading horizon shrinks. In other words, the trader becomes much more concerned about securing funding for the immediate future i.e. overnight, and less concerned about funding for longer periods. This is because if funding cannot be found for today, then tomorrow does not matter since the trader will have lost his job.

Figure 4 shows the average interest rate on European general collateral.[12] At the key dates where banks were particularly stressed in August 2007 and September 2008, the repo rate spiked higher.


Figure 4: Chart shows the average daily rate for overnight European general collateral repo between 2005 and 2011. Source: Bloomberg.

Usually, primary dealers used the overnight market to invest excess funds that had been held back in reserve by the bank’s treasury department until the last moment in case of a shock or unforeseen funding requirement. But the spike in repo rates indicates that banks were relying on the overnight markets to raise funds because lending from other sources had dried up.

The collapse of liquidity drove Lehman Brothers to collapse on September 15 2008 while Merrill Lynch was saved by Bank of America. The two remaining Wall Street investment banks, Morgan Stanley and Goldman Sachs faced extreme pressure and were forced to become holding banks.[13]

A move against a bank such as this, represents asymmetric information, says Brunnermeier (2009). In this case, the market suspects a bank of struggling to finance its positions and rumours build in the market adding to the reluctance to lend to it. In the end it becomes a self-fulfilling prophesy. Since the primary dealers all financed themselves in the short-term markets, the liquidity freeze spread to the other associated banks leading to a systemic problem or bank run as Uhlig (2010) describes.

[1] Speech given by Mervyn King, Governer of the Bank of England October 14 2003.

[2] Libor = London Interbank Offered Rate. It is an unsecured interest rate since it is the average interest rate banks receive from interbank deposits. Libor is the daily reference rate for a range of maturities, from overnight to twelve months, at which banks can borrow unsecured funds from one another. The rate is the adjusted average of a group of designated contributor banks fixed at 11 am London time. Euribor is similar but it is fixed at 11 am Brussels time for the Euro currency.

[3] OIS = Overnight Index Swap also called EONIA swaps in the Euro Zone, SONIA swaps in the UK. An OIS is an agreement to swap a fixed rate of interest for a floating rate. The floating rate is the average of the overnight interest rate fixings (EONIA, SONIA, effective Fed Funds rate) over the whole period of the trade. At the end of the period, only the difference between the fixed rate and the average floating rate is exchanged between counterparties. No notional is exchanged; therefore, the OIS rate is equivalent to a secured interest rate.

[4] Rajan (2010).

[5] Crisis described by the IMF as the worst crisis since the Great Depression in April 2008

[6] A repo is a collateralised loan where the borrower pledges an asset as collateral in return for a loan. The presence of collateral makes the loan less risky for the lender because if the borrower defaults on his loan the lender still holds the asset. This arrangement means that interest rates charged are lower than other forms of loan such as unsecured loans.

[7] Commercial paper (CP) are short-term debt instruments, equivalent to US T-bills, but issued by a company and not the government.

[8] Credit default swaps (CDS) are used by investors to insure against the event of a loan default. For example, the seller of a Morgan Stanley CDS agrees to protect the buyer in the event that Morgan Stanley defaults on an underlying loan, such as Morgan Stanley issued commercial paper.

[9] Leverage – Banks pledge long term assets as collateral to gain access to funding. A bank’s leverage is the proportion of the balance sheet used to raise funding. It is defined as the ratio of total assets to equity, where equity is the difference between the value of the assets and the size of the loan used to buy the assets.

[10] Value-at-Risk (VaR) is a widely used probability measure that calculates the risk of loss on a portfolio of assets.

[11] A haircut is a discount on the value of a collateralised loan or repo. For instance, a 5% haircut will mean the borrower receives only $95 million while having to pledge $100 million of collateral in return. During the financial crisis, haircuts increased on risky assets as firms demanded greater protection from volatile prices.

[12] General collateral is the term used to describe a basket of government bonds used as security on a loan as part of a repo, as opposed to identifying specific bonds.

[13] Holding banks are forced to take on lower risk and are regulated more stringently, helping them to raise capital. Furthermore, as holding banks, Morgan Stanley and Goldman Sachs were required to increase their retail customer base of depositors adding to the banks’ income and capital base.


Adrian, T. S., Shin, H., S., (2010). Liquidity and Leverage. Journal of Financial Intermediation,Vol. 19, Iss. 3, pp. 418-437.

Brunnermeier, M. (2009). Deciphering the Liquidity and Credit Crunch 2007-2008. Journal of Economic Perspectives, Vol. 23, No. 1, pp 77-100.

Caballero, R., J. (2009b). A Global Perspective on the Great Financial Insurance Run: Causes, Consequences and Solutions. MIT mimeo, January 20.

Caballero, R., J. (2010). Macroeconomics After the Crisis: Time to Deal with the Pretence-of-Knowledge Syndrome. NBER Working Paper Series.

Caballero, R., J. (2010). Sudden Financial Arrest. IMF Economic Review, Vol. 58, No.1.

Caballero, R. J., Krishnamurthy, A. (2008). Collective Risk Management in a Flight to Quality Episode. The Journal of Finance, Vol. 63, No. 5.

Diamond, D. W., Dybvig, P. H. (1983) Bank Runs, Deposit Insurance, and Liquidity. Journal  of Political Economy, Vol. 91, No. 3, pp. 401-419.

Gorton, G., B. (2008). The Panic of 2007. NBER Working Paper Series.

Hördahl, P., & King, M. (2008). Development In The Repo Markets During The Financial Turmoil. BIS Quarterly Review. Bank of International Settlements, December.

Morris, S., Shin, H., S. (2004). Liquidity Black Holes. Review of Finance, Vol. 8, pp. 1-18.

Pritsker, M. (2010) Knightian Uncertainty and Interbank Lending. Unpublished paper, Board of Governors of the Federal Reserve.

Rajan, R. G. (2010). Fault Lines. Princeton University Press.

Roubini, N. (2006). Why Central Banks Should Burst Bubbles. International Finance, 9(1) pg 87-107.

Uhlig, H. (2010). A Model of a Systemic Bank Run. Journal of Monetary Economics. Vol. 57, pp 78-96.

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UK: Driving down a blind ally

The UK Budget is seriously missing the point. It will not create any growth and the already bleak forecasts will have to be downgraded again.

Here’s why.

The financial industry was one of the main drivers of the economy before the 2007 crisis. It is a highly productive industry that used to generate huge output by a relatively small amount of people. So cutting back on the finance industry means the UK industry can’t grow as quickly as it could before. In fact it barely grows at all.

UK financeSource: ONS

The government has two options. Either go back to this financial sector model or develop other sectors. The financial sector is very important to an economy, it is  more productive than most other sectors and provides funding to enable other sectors to grow too. But relying on it too much makes the economy vulnerable to shocks. Just look at Cyprus.

So the UK needs a new growth model. But the government seems to think that the day-to-day point scoring in the House of Commons is much more important than solving the deep deficiencies of the economy.

The government needs to get serious about investment in capital, both human and fixed, for this to happen.

What it is doing, however, is spending ever more money on the biggest cost to the economy and less on everything else. The NHS. Spending on the NHS should be linked to the GDP growth because in bad times, like now, it sucks up government spending that should be spent elsewhere. Because spending on the NHS is large (30% of all government departmental spending), even a small cut is equivalent to much larger cuts in other departments eg. NHS budget is around £108bln, 1% of that is £1.08bln. To raise the same savings in a department such as International Development with a £9bln budget you need to cut by more than 10%!

UK budget

Source: OBR, author’s own calculations

It’s not just that the government can save money by cutting NHS spending but it can make it much better and more efficient too.

Keynesians talk about fiscal stimulus but let’s be clear, if a fiscal stimulus is to be spent, spend it on things that will produce an on-going return at the end of it rather than tax credits that give a short-term or one off boost once they’re spent.

The UK needs structural reform and in a time when we can’t produce as much as we used to, that means cutting back on big government and using the savings to invest in areas that will change the UK growth model to produce long-term growth.

The UK doesn’t need a quick fiscal boost to get it back to growth, it needs a large scale restructuring. That means investment in infrastructure (not just large headline projects like Cross Rail), it needs investment in research, science and technology and it needs investment in education. But these investments must come from savings elsewhere and the NHS is the place. Otherwise we will see very little growth. Japan failed to address its structural deficiencies and look what happened there.

If we do this it will make us all better off and the NHS will have secured greatly improved and sustainable funding.

Posted in Austerity, Conservatives, Debt, Financial crisis, Osborne, Politics, Recession, Tax Cuts, UK | Tagged , , , , | 1 Comment

US unemployment, NAIRU and the “jobless recovery” in 2003-5

Question about US unemployment rate and the “jobless recovery” that followed 2003 peak? If you draw a line of NAIRU on the unemployment chart above, the unemployment rate only just peaks above it in 2003 so why are we all surprised that the rate of decline was so slow? Draw a line of the YoY growth of average weekly wage and you see that when the unemployment rate falls below NAIRU the average hourly wage growth (YoY) tends to trough at each instance of this since 1980 and begin to grow a gain as perhaps you’d expect. This suggests that when unemployment falls below NAIRU workers have more bargaining power in terms of wages at this point and so this is more likely to be why the unemployment rate fell less rapidly. If you take this further back beyond 1980, this relationship breaks down so the relationship ties in with the labour market reforms of the Reagan years in terms of reducing collective bargaining power. So when unemployment is below NAIRU it appears that workers have more power in wage negotiations, but above NAIRU employers have the upper hand.

US Average hourly earnings growth, unemp, NAIRU


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Crisis, what crisis? Ah, so when did it all kick off?

I recently came across a very useful paper which dates every significant event during the financial crisis. So if you’re ever left wondering, “When did our nice, cosy world of live-for-today,-tomorrow’s-going-to-be-just-fine collapse?” or “Where were the early signs of the oncoming juggernaut?” or even “When did the did central banks start doing something about it?” check out The Global Economic & Financial Crisis: A Timeline by Mauro F. Guillén, Director of the Lauder Institute, Wharton, University of Pennsylvania. 96 pages of financial crisis chronology!

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QE cash, where does it end up?

A quick note on Simon Jenkins’ piece in the Guardian today on where all the Bank of England’s QE cash has gone. He says he can’t find it anywhere but if you take a quick look at the BOE’s weekly balance sheet, or Bank Return as they call it, you’ll get an idea.

1) BOE Bank Return July 11 2007 i.e. before QE.

The “Reserve Balances” is the entry you want to look at, circled in red. It was £17b in 2007 before the financial crisis. Now look at the latest BOE Bank Return.

2) BOE Bank Return July 11 2012 i.e. after QE.

The Reserves Balances have increased to £232 billion. So banks who have been given cash as part of QE, park the excess cash they have at the BOE at the end of each day as Reserve Balances.

However, this does not mean that this cash is not being lent out or used in other ways. All it shows is that there is excess cash in the system. For example, if bank A buys a bond from bank B, Bank B deposits the cash from the transaction as Reserve Balances at the BOE at the end of each day. Or if a bank lends to a small business, the small business might either put that money in the bank or it goes and buys something. In both cases the cash ends up as Reserve Balances at the BOE. The cash only disappears if more the notes and coins are put into circulation (in which case the number “Notes in circulation” will increase) or the cash is stuffed under the mattress etc.

But given the weak lending figures, it is likely that banks are keeping much of this cash as a buffer in case of liquidity shocks, whether they be deposit flight where depositors take their money out the bank or the equilivalent in the interbank markets where banks find it difficult to raise funding in the markets.

This is similar to what is happening in the Eurozone. Until Wednesday banks left their excess cash at the end of each day in the ECB’s deposit facility where they would earn 0.25% interest but the ECB cut the deposit rate at last Thursday’s ECB meeting to 0% (implemented on July 11th) to encourage banks to lend the cash out. As can be seen, funds left in the deposit facility dropped but this cash didn’t just disappear, it turned up as excess reserves on the ECB’s current account holdings. Banks receive the ECB refi rate (now 0.75%) on funds left as current account holdings up to the level of required reserves but nothing for the funds left above that level. So now there’s no reason for banks to move money from the current account to the deposit facility.

Posted in Bank of England, ECB, Euro Zone, Quantitative Easing, UK | Tagged , , , , | 2 Comments