The Bank of England was slow to respond to the Northern Rock (LON:NRK) crisis. Until Wednesday, September 19th, the Bank of England was more concerned about fighting inflation than about the risk of deflation. The Federal Reserve and the European Central Bank had both injected large sums into their money markets, but the Bank of England had maintained its resistance. The Governor of the Bank, Mervyn King, was still resisting the persuasions of the major British banks at his meeting on Tuesday evening. Until the previous week, there had been an expectation that the Bank’s interest rate would rise by another quarter per cent before the end of the year.
The change of policy was very abrupt. The Bank decided to lend billions of pounds on three month terms to embarrassed mortgage banks, starting with an initial injection next week of £10 billion. In the meantime the Chancellor, under the pressure of a bank run on Northern Rock – the first in 141 years – had decided to guarantee all the deposits of Northern Rock, which may come to £30 billion or more. That specific commitment was accompanied by a far bigger general commitment. The Chancellor said that he would give the same guarantee to the depositors of any bank that found itself in the same position as Northern Rock.
What was the position of Northern Rock? Essentially, its problem was a combination of being overleveraged and overdependent on the money market. Although its deposits from small savers were vanishing in the run on the bank, small savings had normally provided much more reliable lending than the money market, though are costlier to attract and administer. With small savers wanting to get out and the money market refusing to lend, Northern Rock was effectively insolvent, though still trading profitably.
The Chancellor of the Exchequer, Alastair Darling, was therefore extending a guarantee for deposits with all British banks. He has not put any figure on the contingent liability that this guarantee would have created, nor indeed is the sum possible to calculate. All the debts of all the banks would come to a huge sum, far more than the existing obligations of the UK Government, or than the annual GDP of the United Kingdom. Theoretically it is a guarantee that could make the United Kingdom itself insolvent. Certainly it goes well beyond the resources of the Bank of England or the British gold reserve, half of which was sold by Gordon Brown – now the Prime Minister – at or near the bottom of the market.
Of course, in practice, the guarantee is not as rash as it sounds. The British banks do have large liabilities but they have – at present values – even larger assets. It is perfectly possible that the Government would make a profit if it did have to make good Mr. Darling’s guarantees. The assets the Government might take as collateral would exceed the liabilities. Nevertheless, it is an extraordinary thing for any Government to do. If British banks now enjoy this guarantee, can it ever be removed? Will there be a time when a Chancellor can afford to announce that the guarantee has been removed? Will all bank debt have to be guaranteed by Governments, to be regarded as acceptable? If HSBC is guaranteed, at last resort, by the British Government, does that give it a commercial advantage over European Union banks, which are not guaranteed by the European Central Bank or by the EU itself? Will that prove to be compatible with EU law? Does Mr. Darling have any statutory authority to offer this guarantee to Northern Rock, or to any other British banks? Will the Government introduce new legislation which will provide a statutory basis for such guarantees?
The questions crowd in faster than they can be answered, and certainly faster than they will be answered. It looks as though the immediate objective of restoring confidence may have been achieved, but at the same time the crash is not over. If one looks at the impact of other recent crashes in markets, it has usually taken years before business returned to normal.
The 1987 crash on Wall Street occurred when I was attending an investment meeting in New York, so I have vivid memories of it. I remember an Australian analyst remarking that he had never been as scared since he was in a foxhole in Vietnam. President Reagan set up the Brady Commission, which reported in 1988; they made a number of points which are relevant to the 2007 crash as well as to 1987 itself.
“Analysis of market behaviour during the mid-October break makes clear and important conclusion. From an economic viewpoint, what have been traditionally seen as separate markets are in fact one market. Under ordinary circumstances, these market places move sympathetically, linked by financial instruments, trading strategies, market participants and clearing and credit mechanisms. Confronted with the selling demands of a limited number of institutions, regulatory and institutional structures designed for separate marketplaces were incapable of effectively responding to ‘intermarket’ pressures… Liquidity sufficient to absorb the limited selling demands of investors became an illusion of liquidity when confronted by massive selling, as everyone showed up on the same side of the market at once.”
The three regulatory institutions which were – and are – trying to deal with the 2007 crisis in London – and London itself is not alone – are the Government, the Bank and the Financial Services Authority. They have failed to pursue a coherent policy. The Government lacked the experience; the F.S.A. failed in its analysis of bank debts; the Bank was trying to fight the momentum of events. Britain’s regulatory system will need to be reorganised. The independence of the Bank of England has proved to be an illusion – perhaps it always was.
Markets and Money