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Bank of England Shipwrecked on Northern Rock

As the Northern Rock crisis unfolds, scrutiny has shifted from the poor management decisions of the company directors and is now focused on the Bank of England.

The initial reaction of the Bank of England was to leave Northern Rock at the mercy of market forces. However, as soon as queues of depositors were reported on television, the bank was forced to intervene on the basis of political pressure.

This constituted and embarrassing U turn for the Governor Mr Mervyn King, and many commentators take the view that his credibility is irreparably damaged..By sending out a lifeboat, the Bank of England has been shipwrecked on Northern Rock

 

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Story Update on 19 September 2007

The handling of the liquidity crisis at Northern Rock by the UK authorities has become a major embarrassment for the government and Gordon Brown in particular. The new Prime Minister has always stressed his achievements as Chancellor of the Exchequer during the period 1997 to 2007, while he was waiting in the wings for Tony Blair to retire. Yet within several days, his reputation for prudent economic management has been undermined.

The problems at Northern Rock, and other financial institutions, did not appear overnight. The crisis in the USA subprime loans market was well documented, as was the fact that this dodgy debt had been repackaged and sold on to UK and EU banks. Major banks in Germany as well as Barclays Bank in the UK are rumoured to have significant exposure to these dubious assets.


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Northern Rock is a proactive UK mortgage lender who attracts some 73% of its funds from the wholesale market, and only 27% from private depositors. The subprime banking crisis effectively dried up the source of these funds from other mainstream UK banks and financial institutions.

During August, the central banks of the USA and the EU were increasing liquidity in the markets in an effort to avoid fallout from the subprime banking crisis of the USA. There were rumours of several well known institutions being in trouble, but these rumblings remained as rumours within the financial and stockbroking fraternity. They did not extend to the general public.

In the UK, the situation was different. Mervyn King, the Governor of the Bank of England, was making statements to the effect that banks should act with prudence and not expect the Bank of England to bale them out if they get into difficulties due to their own stupidity. He reputedly said that central banks should only act when there are 'economic costs on a scale sufficient to ignore the moral hazard of the future'.

What he meant by this is that if banks get into trouble due to their their own stupidity, it would not be helpful for the Bank of England to bale them out. This is because, in a capitalist economy, organisations with poor management will either go out of business or, on the basis of market and shareholder pressure, change their policies and senior management personnel. The unintended effect of a Bank of England bale out would be for the imprudent policies to be underpinned and possibility rewarded, or even repeated in the future by both the failing organisation and other players in the marketplace. The Governor was seeking to maintain the clear blue water between the market orientated economy of the UK, as epitomised by the achievements of the City of London, and the lacklustre financial centres of the EU and even the USA.

What differentiated the UK from the USA and the EU, was the response of the respective governments and central banks. The Federal Reserve and the EU central bank were significantly easing liquidity pressures in financial markets during the summer of 2007. The Bank of England adopted a laissez faire posture and made statements to the effect that financial institutions should not expect to be protected by the Bank of England if they make imprudent decisions.

Bank of England Lifeboat launched to rescue Northern Rock
 

When the Northern Rock crisis became public and the Bank of England announced support, its position was endorsed by the UK government and the Chancellor of the Exchequer, Alistair Darling. However, ordinary investors were not persuaded by the Chancellor's bland assurance that Northern Rock was solvent, and there was a run on the bank. At this stage, Northern Rock was shipwrecked.

The Financial Services Compensation Scheme means that savings up to £2,000 are protected in full, and the next £33,000 at 95%. Beyond £35,000, there is no protection. Savers who were in a line outside Northern Rock branches often had deposits in excess of £50,000 invested in the bank.

The media coverage of panicking depositors who took no notice of the assurances of the Chancellor of the Exchequer evidently riled Gordon Brown, the Prime Minister. On 17 September 2007, the government announced that all savings in Northern Rock would be protected. This had the desired effect, and the run on the bank was contained.

The media coverage of panicking depositors who took no notice of the assurances of the Chancellor of the Exchequer evidently riled Gordon Brown, the Prime Minister. On 17 September 2007, the government announced that all savings in Northern Rock would be protected. This had the desired effect, and the run on the bank was contained.

On 19 September, the Governor of the Bank of England made a major U-turn. Only the week before, he was stating that central banks should only intervene when there are 'economic costs on a scale sufficient to ignore the moral hazard of the future'.

In plain language, what this means is that intervention by the Bank of England is a last resort. It should only take place in dire circumstances. If the Bank bales out any financial institution which experiences problems, due to its own stupidity or imprudent policies, the Bank's support could be construed as endorsing or even rewarding bad practice and could encourage other institutions to take excessive risks in the pursuit of profits.

The Bank of England has now announced a package of measures which will effectively enable all UK banks to weather the current crisis, regardless of whether they have operated imprudently or not. If these loans turn bad, then the lender will be shipwrecked.

This has now moved the focus of attention away from the troubles of Northern Rock and has led to questions concerning the Bank of England's handling of the crisis. Some commentators are suggesting that Mervyn King, the Governor of the Bank, should resign.


Shipwrecked on the Rocks
 

This U-turn raises a series of intriguing questions. Firstly, if these measures had been put in place two weeks ago, would the crisis at Northern Rock have been averted?

Although this is a hypothetical question, the answer is probably in the affirmative. Whether such a move would be good for the UK economy is probably to be answered in the negative.

Secondly, could the problems at Northern Rock have been handled better? The answer is undoubtedly yes. Northern Rock would have been an attractive target for takeover activity. However, the damage to the brand name is now irredeemable and there is little likelihood of a takeover at an early date. In any event, the brand name is likely to be a liability rather than an asset.

Thirdly, is the Bank of England to blame? While the Governor of the Bank was forced to make an embarrassing U-turn, the hidden hand of the government is easy to detect. There are few precedents for UK banks going bankrupt in recent history. While London and County Securities and other secondary banks went bankrupt in 1973, none of these companies was a major player on the scale of Northern Rock. However, in 1973, the Bank of England did launch a lifeboat scheme in order to avert a domino effect. It was rumoured at the time that Nat West Plc was at risk.

The 1973 lifeboat scheme is obviously well known to current Bank of England staff. One can infer that the Governor and his colleagues were initially prepared to let Northern Rock go into receivership and for its mortgage loans to be taken over by a stronger organisation. The depositors' funds would be safeguarded, but there would have been many sleepless nights.

It would seem that the Bank of England is independent of the UK government when it is pursuing government policy. However, if it pursues policies which it deems in the interests of the UK economy, yet are contrary to short term political expediency, then this independence is an illusion.

By sending out a lifeboat, the Bank of England has become shipwrecked on Northern Rock.

 

Copyright - Leslie Hardy, 16 September 2007

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