I ought to declare an interest. I am a part-time adviser to Goldman Sachs. Goldman Sachs are also advising the government on its financial strategy as regards Northern Rock. I am not involved in that activity and this blog represents my personal views only. 

A private sector ending to the Northern Rock saga is looking increasingly unlikely. For some reason, press and pundits alike appear to favour nationalisation as the least bad option. I favour cutting Northern Rock loose, that is, an end to any further lending to Northern Rock through the Liquidity Support Facility and no further rollover of the existing loans when they mature. I would maintain the deposit guarantee. 

It is possible that Northern Rock could survive on its own in the real world. Pigs may fly. It is also possible that a private sector rescue would be mounted once the government turns off the tap and it is clear that no further sweeteners can be squeezed out of the tax payer. The most likely outcome would be that Northern Rock would default on some of its obligations and would be put into administration. So the real choices are nationalisation or administration. 

The arguments against nationalisation are straightforward and powerful. Governments should not own banks other than the central bank. Even temporary public ownership is undesirable, unless the bank in question is systemically important, that is, unless its demise would threaten financial stability in the UK. With the Treasury’s deposit guarantee in place for Northern Rock and any other UK bank that might find itself in similar circumstances, Northern Rock is no more systemically important than a ball bearings manufacturer in Slough. I am sure that the UK Treasury would find a competent team of managers to run Northern Rock for as long as it would be in public ownership. The name of former Lloyd’s of London head Ron Sandler has been mentioned as the likely Chairman of the Northern Rock board under public ownership.  But public ownership, even temporary would distort competition, un-level the playing field in the banking sector.  For that reason, nationalisation could well run into trouble with the EU competition authorities.

In addition, public ownership of Northern Rock would no doubt further increase the exposure of the tax payer to that institution. Loans through the Liquidity Support Facility now stand at just below £30 billion; the Treasury guarantee of the deposits (retail and wholesale) and of most other secured and unsecured debt (other than subordinated debt, a few other trifles and Northern Rocks main securitisation vehicle the £50 bn Granite facility) probably about doubles that exposure. Throwing good money after bad is a well-established public sector tradition, but otherwise has nothing much to recommend it.  

Unless shareholders were paid, in a nationalisation, significantly more than their shares are worth (zero, thanks to limited liability), there would be time-consuming and costly litigation by disgruntled shareholders. It is not a pretty sight watching shareholders - both long-standing small stock owners and Johnny-come-lately opportunistic vulture funds – trying to extort additional money from the taxpayer.

If instead Northern Rock were left to sink or swim on its own, and if, as I expect, this would lead forthwith to its being put into administration, the government’s and taxpayers’ exposure would be capped. The shareholders would probably lose everything. This would represent a normal and appropriate imposition of market discipline on the owners of an institution that engaged in reckless funding practices.

The administrator might try to sell the business as a going concern, or sell all or part of it to a range of interested parties. The government loans would be reasonably senior, and ought to be repaid, with interest, in due course. There is no urgency in the timing of the payment of the government which, unlike the private sector, is not subject to liquidity constraints. All that matters is the present discounted value of the debt service is receives. I am ignoring the contribution of alternative solutions to party-political point scoring and political embarrassment.  

If by now the Treasury, the Bank of England and the FSA have not figured out a way of swiftly repaying Northern Rock’s depositors when the bank gets put into administration, all those involved should be taken out and shot after a fair trial. True, putting the bank into administration would cause depositors’ claims (like the claims of the other creditors of the bank) to be frozen. But offer of cash by the Bank of England in exchange for the deposits of Northern Rock (with the Bank of England’s exposure guaranteed by the Treasury) ought to be accepted instantaneously by the Administrator. Refusing to accept this offer should expose the Administrator to law suits. The Bank of England could then sell the deposits again to a UK bank that is both solvent and liquid (preferably one with many branches). The depositors of Northern Rock could either decide to hold their accounts with this new bank, or could withdraw the money, in small bills, not consecutively numbered. All this ought to take no more than two working days.

Cutting Northern Rock loose is likely to result in significant job losses for current Northern Rock employees. Significant job losses in the UK banking sector, especially in the home finance sub-sector, are inevitable in my view, even if Northern Rock were ‘rescued’ through nationalisation. The home lending sector has over-expanded in response to a house price boom and bubble and excessively relaxed lending standards (125 percent loan to value ratios, if secured and unsecured loans are added together, five or six times annual household earnings loans etc.). The sector has to contract. Is it better to spread the misery of the unavoidable job losses over a large number of banks or to concentrate them among the employees of the bank that made the biggest hash of its funding strategy? I can see no economic reason, based either on equity or on efficiency, for preferring the equal sharing of misery over the more concentrated sharing of misery. Political considerations (the North East is traditional Labour territory) would favour the equal sharing of misery. That ought to be sufficient reason for not doing it.

So send Northern Rock back into the markets. It would be fair and honest. It would also help correct the perverse incentives created by the UK policy of the past couple of decades towards bank insolvency, that no bank is too small to be too large to fail.

January 15th, 2008 in Economics, Financial Markets, Monetary Policy, Politics | Permalink