Following the collapse of Northern Rock in 2007, the Bank of England urgently needed to inject liquidity into the UK financial system. In the circumstances, the Bank 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 consulted Professor Paul Klemperer, a leading researcher in auction theory who had designed (with Ken Binmore) the auction for the British 3G telecom licenses in 2000.
Professor Klemperer’s ‘product-mix’ auction directly addressed the Bank of England’s problems:
- 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, Klemperer’s new auction design was adopted as the Bank’s standard mechanism for long-term repo (ILTR) operations. The Bank further amended its ILTR operations in 2014, with input from Professor Klemperer and Dr Elizabeth Baldwin, to further increase the flexibility of the Bank’s liquidity insurance provision, against an even wider range of collateral.
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 has more recently helped the Bank of England develop other auction facilities, and has also advised other countries’ central banks on related matters. He and Dr Baldwin are currently working on adapting the product-mix auction for other environments.
Another strand of Professor Klemperer’s work develops (with Jeremy Bulow) a new financial instrument, “Equity Recourse Notes”, to support financial stability.
Related Research Papers
Baldwin, E and P. Klemperer (2016) “Understanding Preferences: “Demand Types” and the Existence of Equilibrium with Indivisibilities” (http://www.nuff.ox.ac.uk/users/klemperer/demandtypes.pdf)
Bulow, J and P. Klemperer (2015) “Equity Recourse Notes: Creating Counter-cyclical Bank Capital,” http://www.nuff.ox.ac.uk/users/klemperer/ERNs.pdf The Economic Journal, 125, pp. F131-F157.
Bulow, J and P. Klemperer (2013) “Market-Based Bank Capital Regulation” (http://www.nuff.ox.ac.uk/users/klemperer/MBBCR.pdf)
Klemperer, P. (2004) Auctions: Theory and Practice, Princeton University Press, Princeton: US
Klemperer, P. (2008) “A New Auction for Substitutes: Central Bank Liquidity Auctions, the U.S. TARP, and Variable Product-Mix Auctions” Mimeo: Oxford University
Klemperer, P. (2010) "The Product-Mix Auction: A New Auction Design for Differentiated Goods" http://www.nuffield.ox.ac.uk/users/klemperer/productmix.pdf Journal of the European Economic Association, 8, 2-3, pp 526-536 (reprinted in The Handbook of Market Design, Z. Neeman et al (eds.) 2013, and in The Handbook of Spectrum Auction Design, M. Bichler et al (eds.) 2017.)