by Willem Buiter

The announcement that the UK Treasury had authorised the creation of a Liquidity Support Facility for Northern Rock at the Bank of England came on September 13, 2007.  The Treasury’s announcement of a guarantee for all of Northern Rock’s deposits (not just the retail deposits) and most of its other unsecured credit followed on September 18.  Two months have passed now, and Northern Rock is still on life support, having drawn over £20 bn from the LSF - just under 20 percent of its assets.   

What went wrong and what lessons can be learnt?

(1) The Tripartite arrangement between the Treasury, the Financial Services Authority and the Bank of England, for dealing with financial instability is flawed. Responsibility for this design flaw must be laid at the door of the man who created the arrangement - the former Chancellor and current Prime Minister, Gordon Brown.  The Treasury, as the dominant partner in the arrangement, also bears primary responsibility for its operational performance. 

The main problem with the arrangement is that it puts the information about individual banks in a different agency (the FSA) from the agency with the liquid financial resources to provide short-term assistance to a troubled bank (the Bank of England).  This happened when the Bank lost banking sector supervision and regulatory responsibility on being made operationally independent for monetary policy by Gordon Brown in 1997.  It’s clear this separation of information and resources does not work. 

There are two solutions.  Either banking supervision and regulation are returned to the Bank of England, or the FSA is given an uncapped and open-ended credit line with the Bank of England, guaranteed by the Treasury, so the FSA can perform the Lender of Last Resort function vis-à-vis individual troubled institutions.  The Bank would of course retain the Market Maker of Last Resort Function of providing liquidity to markets and supporting systemically important financial instruments.

(2) The UK deposit insurance arrangements (which had been in place since 1982) are flawed.  The amount covered was too low, the deductible for deposits over £2000 was an invitation to run, and the time (allegedly up to 6 months) it could take for depositors to get their money back was far too long.  Responsibility lies with the Chancellor, although the Bank and FSA could have been better advisors and counsellors to the government in these matters. The necessary reforms are obvious.

(3) The FSA did not properly supervise Northern Rock. It failed to recognise the risk attached to its funding model.  Stress testing was inadequate.  The "war-games" organised by the Tripartite arrangement parties also seem to have suffered from a lack of imagination.  I would add that I doubt whether the pace of Northern Rock’s expansion in the first half of 2007 was consistent with the maintenance of adequate controls for verifying the creditworthiness of its customers.  There are limits to the pace of ‘organic growth’.  It is possible that credit quality can be maintained when you offer six times annual income as a mortgage loan, or when you offer a combined mortgage and personal loan package equal to 125 percent of the value of the home.  Possible, but not likely.  Regrettably, the "light touch" UK regulator turned out to be a "soft touch" regulator, and did not blow the whistle.

(4) Bank insolvency law in the UK is flawed.  A bank that goes into administration has its deposits frozen.  The UK needs a US-style arrangement, where the regulator can take a threatened bank promptly into public ownership, ring-fence its deposits so they can be transferred immediately to the depositors, and reopen the bank immediately to manage its existing activities and commitments while a longer-term plan for is worked out.

Provided a troubled and potentially failing bank can be taken into public ownership, I don’t believe there is any need to give banks a dispensation from the laws governing its take-over by, sale to or merger with another institution.  The EU Market Abuse Directive was never an obstacle to an undercover rescue or support operation for Northern Rock.

(5) Following the announcement of the Liquidity Support Facility, there should have been a joint appearance by the Prime Minister, the Chancellor of the Exchequer, the Governor of the Bank of England, the Chairman of the FSA and the CEO of the FSA, looking solemn and reliable, and intoning jointly: "your money is safe". It might not have prevented the banana-republic-style bank run that started on the 14th, but it was worth a try.

(6) In case even the joint appearance of the Talking Heads would not do the job, the Treasury should have guaranteed the deposits of Northern Rock at the same time the LSF was announced.

(7) The Bank of England has a flawed liquidity policy. It accepts as collateral, both at the Standing Lending Facility (discount window), and in liquidity-oriented open market operations (repurchase agreements) only instruments that are already liquid (UK and European Economic Area government bonds, bonds issued by a few highly-rated international organisations and, under exceptional circumstances, US Treasury securities.  It should emulate the ECB and the Fed and accept as collateral also private instruments, including illiquid and non-traded instruments such as mortgages and asset-backed securities.  Provided this collateral is priced severely or even punitively, and has a further ‘haircut’ or discount applied to it, there will be no moral hazard and the Bank can expect not to lose money.

(8) The Bank should recognise that the spread between, say, three month Libor and the expected policy rate over the three month period (as measured, for instance, by the spread of three-month Libor over the three-month Overnight Index Swap rate) can reflect liquidity risk premia as well as default risk premia.  It should aim, through repos at these longer maturities, to eliminate as much of the ‘term structure of liquidity risk premia’ as possible. This corrects a market failure. It does not create moral hazard.

Points seven and eight assign the Bank the responsibility to be the Market Maker of Last Resort, to provide the public good of liquidity when disorderly markets disrupt financial intermediation and threaten fundamentally viable institutions. 

(9) The Bank should lend at the discount window at longer maturities than overnight.  Loans of up to one month should be available (properly priced and with a short back and sides, and at a punitive rate).  Given points (7) and (9), the discount window would become, for all banks and on demand, what the Liquidity Support Facility purpose-built for Northern Rock is now.

(10) Northern Rock should have known about the Bank of England’s repo and discount window policy. Given these policies, its funding policies were reckless. 

No party involved in this debacle comes out smelling of roses.  At least the Bank of England appears to be willing to learn, and even to admit that it made some errors. We are still waiting for the Treasury to admit to anything less than perfection.

(11) My last observation concerns the failure of effective Parliamentary scrutiny of and oversight over the laws, rules, regulations and institutions that brought us this debacle. Parliament has done little more than sniping ex-post at the other principals in this drama.  Finger-pointing and blame allocation are not, however, substitutes for effective ex-ante Parliamentary scrutiny of the laws, rules and regulations and institutions at the point that they can still be moulded and shaped.  Where was Parliament when it could have done some good?

Tags: UK economy

November 13, 2007 4:05pm in Uncategorized | Comment