Bank Of England Shipwrecked On Northern Rock

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.

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.

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.

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.

The Financial Services Compensation Scheme means that savings up to GBP2,000 are protected in full, and the next GBP33,000 at 95%. Beyond GBP35,000, there is no protection. Savers who were in a line outside Northern Rock branches often had deposits in excess of GBP50,000 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.

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.

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.

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 rumored 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 organization. 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.