Following the collapse of Northern Rock in 2007, the Bank of England faced an urgent need to inject liquidity into the UK financial system. Under the circumstances, the Bank of England was willing to accept a wider-than-usual range of collateral against loans, but it wanted a correspondingly higher interest rate against any weaker collateral that it accepted.  To resolve these issues, the Bank of England consulted Professor Klemperer, a leading researcher in auction theory who had played a major role in the design of the auction for the British 3G telecom licenses in 2000

Professor Klemperer’s research on the ‘product mix’ auction directly addressed the Bank of England’s problem: 

  • Allowing a broader range of collateral;
  • Charging different interest rates for the loans depending on the quality of the collateral in order to reduce moral hazard;
  • Allowing market conditions, as revealed by the bids, to determine both the interest rate premium for inferior collateral and the proportion of inferior collateral accepted;
  • Permitting borrowers to specify how the collateral they supply will depend on the auction outcome.

In 2010 the new auction was adopted as the Bank’s standard mechanism for long-term repo (ILTR) operations. With input from Professor Klemperer, the Bank further amended its ILTR operations in 2014 to increase the availability and flexibility of the Bank’s liquidity insurance provision, providing liquidity at longer maturities, against an even wider range of collateral, at a lower cost and with greater predictability of access.

Commenting in a magazine article in 2010, Paul Fisher, Executive Director, Markets and Member of the Monetary Policy Committee noted “the Bank’s Indexed Long-Term Repo [auctions] represent a world first in central banking … This is potentially a major step forward in practical policies to support financial stability”. In 2012, former Governor, Sir Mervyn King, observed “The Bank of England’s use of Klemperer auctions in our liquidity insurance operations is a marvellous application of theoretical economics to a practical problem of vital importance to financial markets.”

Professor Klemperer and his co-author Dr Elizabeth Baldwin are currently working on developing the product-mix auction design for application to other environments, utilising tropical geometric techniques.

 

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