Northern Rock

From The Economist:

The queues that formed outside Northern Rock, the country's fifth-biggest mortgage lender, represented the first bank run in Britain since 1866. The panic was prompted by the very announcement designed to prevent it. Only when the Bank of England said that it would stand by the stricken Northern Rock did depositors start to run for the exit. Attempts by Alistair Darling, the chancellor of the exchequer, to reassure savers served only to lengthen the queues of people outside branches demanding their money. The run did not stop until Mr Darling gave a taxpayer-backed guarantee on September 17th that, for the time being, all the existing deposits at Northern Rock were safe.

[...] the Bank of England emerges worst. At the outset, Mervyn King, its governor, talked tough. Mr King wanted to teach financiers that they should not expect the central bank to bail them out if they took on too much risk. Unlike the European and American central banks, the Bank of England held back from pumping cash into the markets and then did so modestly, insisting on the usual top-notch collateral. It argued that central-bank money could do little to save the three-month interbank lending market, which had gummed up.

The Bank of England's tough line has turned out to be wrong, and events have forced Mr King to relent. On September 19th, the day after the run on Northern Rock had ended, the Bank of England performed a breathtaking volte-face. It announced that over the next few weeks it would indeed be providing funds to try to sort out the three-month market. Furthermore, it said that it would lend against riskier collateral, including mortgages.

The charge against Mr King is that his purism turned a crisis into a fiasco. If the Bank of England had acted more promptly to restart seized-up lending markets, his critics say, Northern Rock might have muddled through. No one will ever know whether that is true. Either way, the lurches in the central bank's policy leave Mr King looking either as if he made a mistake, or as if he cannot stand up for his views.

I disagree with the Economist's take, at least in part. What would a sensible central bank/regulator/government would like to do in a case like Northern Rock's? Two things: 1. ensure the financial system does not collapse alongside the troubled bank, and 2. send a clear signal that any financial institution that is taking on too much risk is in for a world of pain. The problem is that these aims are contradictory: if a bank collapses, it is bound to send ripples through the financial system and it may well set off a domino effect; if it is rescued, the message received by other banks is that they should be more relaxed about risk - the central bank will come to the rescue if things turn ugly.

Now look at the aftermath of Northern Rock. The bank is still open and its remaining depositors are safe (good). The rest of the financial system is safe too (good). And as for moral hazard, take a look at the graph above: would you really like that happening to the bank you run or have invested money in?

With regards to the 'critics' the Economist refers to: Why should Northern Rock be allowed to 'muddle through'? These fellas took some risks which didn't work out and they should suffer as a result. The recent reforms that made it impossible for the Bank to mount a covert operation actually help reduce moral hazard: if you are in trouble, my friend, the whole world will find out - so make sure you don't walk too near the edge.

With regards to the 'purists' argument - that a bank should never be bailed out by government: do you believe that only the death penalty has any deterrent effect on murder? Is the extra deterrent effect of committing to never help out a bank in trouble worth the additional risk of an across the board financial meltdown?

Long story short: The Northern Rock affair ended pretty much the best way it could have - except on the communications front.

by datacharmer | Monday, October 08, 2007
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  1. Steve_Roberts Says:

    There is a fallacy here, in not distiguishing betwen the bank's owners (shareholders) and directors, who should not be bailed out of the consequences of their risky behaviour, and the depositors, who should be protected from the behaviour of the directors, which they knew nothing about, and were entitled to rely on the regulators (FSA and BoE) to police

  2. datacharmer Says:

    It's debatable how much insurance depositors should be allowed to enjoy at the taxpayer's expense, as there is a moral hazard issue there too (e.g. when depositors put their money in dodgy banks). I tend to agree with you that there should be more security for deposits than the current system provides for, but not unlimited protection (except in 'emergency' situations)