September 19, 2007
From a bank run to nationalising deposits
Financial panic has hit both the public and politicians of the UK over the past week, to deliver two remarkable results: the first run on a British bank since the collapse of Overend and Gurney in 1866; and the transformation of bank deposits into public debt at the stroke of a pen. These are historic times.
How then could these astonishing events have happened? Contagion is the answer, just as it was during the Asian financial crisis of a decade ago. When Thailand announced the devaluation of the baht in July 1997, few foresaw the way the crisis would spread. Yet contagion was not random. Some countries were more vulnerable to the disease than others.
The same is true of Northern Rock, a specialised housing lender that saved itself the cost of raising deposits from the public by selling its loans into the wholesale market. This was a profitable strategy until the crisis in subprime US mortgages and securitised finance undermined investor confidence. Northern Rock failed to insure itself against this contingency. Credit – or trust – fled and, with it, its business model.
The drying up of these markets ultimately forced the bank to seek help from the British authorities, who promised to provide financing. But their effort to rescue Northern Rock was the equivalent of screaming “fire” in a theatre. The public, alarmed, wanted its money back.
As the public panicked, so did politicians. A solvent government will not let ordinary depositors lose significant quantities of money. Deposit insurance is the way to eliminate the possibility. But in the UK such insurance covers only 100 per cent of the first £2,000 and 90 per cent of the next £33,000. Worse, in the case of an insolvency, depositors take their place at the back of a lengthy queue. British deposit insurance does not prevent runs from banks in trouble. It guarantees they will happen. The run was quite rational.
The remainder of this column can be read here (FT.com subscription required). Discussion from our guest economists is free.
David Miles: Martin Wolf describes the announcement from the Chancellor as representing a “nationalisation of deposits”.
That is a mis-leading interpretation. What the government announced was that a bank that was in the same position as Northern Rock would have its deposits guaranteed beyond the level already covered by the Financial Services Compensation Scheme. In other words, the depositors of a bank that was receiving lender of last resort support from the Bank of England would get extra guarantees from the government. Such a bank would be one judged solvent by the Financial Services Authority – the UK bank regulator. Such a bank would almost certainly have seen its share price fall (as did Northern Rock’s) on news that it was receiving emergency support from the central bank – so its management and shareholders would have paid a heavy price. And in the event that such a bank subsequently failed – despite being judged solvent by the FSA – the government would only be providing top-up guarantees to the existing (industry funded) deposit insurance scheme that already covers more than 90% of the first £35,000 of deposits.
To describe this as “nationalization of deposits” is not sensible.
David Miles is chief UK Economist at Morgan Stanley and visiting Professor of Financial Economics at Imperial College, University of London.
Posted by: David Miles | September 19th, 2007 at 10:39 am | Report this commentPatrick Honohan: It’s awfully good of the Chancellor to offer this guarantee (not least to the 25,000 Irish depositors at Northern Rock who reportedly hold an average deposit balance of £90,000 per person). I wonder what depositors in the BCCI, who waited years for partial reimbursement after its failure in 1991, think? And one could add to the list of financial hard-luck stories that might be equally deserving.
Wouldn’t you agree that, had politicians held their nerve, a day or two more of queues at Northern Rock branches might well have seen off the retail run (when all of the withdrawals had been met)? And that such an outcome would have left less debris.
I wonder what makes you think a more generous deposit insurance scheme would have helped Northern Rock to survive its liquidity woes, given that these were largely caused by problems in rolling over wholesale funding.
I doubt that any limited deposit insurance can be a very significant factor in stabilizing the wider financial markets these days
Your “screaming fire” analogy is spot on. That granting this loan facility had this effect can be traced to the fashion of setting an over-rigid set of conditions under which liquidity loans may be provided. Several central banks have tried to define their lender-of-last-resort role in a very restrictive way. On the other hand, both the Fed and the ECB have allowed themselves the capacity for a degree of flexibility in the acceptable collateral that would have enabled the Bank of England to advance funds to Northern Rock without any hullaballoo — and no sceaming “fire”.
Patrick Honohan is professor of international financial economics and development at Trinity College, Dublin
Posted by: Patrick Honohan | September 19th, 2007 at 2:45 pm | Report this commentWillem Buiter: The government socialised the risk to the deposits (and depositors) of any bank granted a Liquidity Support Facility like the one provided for Northern Rock.
It would have been preferable to take a leaf out of the FDIC’s book by taking Northern Rock into public ownership when the provision of the credit line failed to stop the run on the bank. It could have reopened immediately, under new management, to handle existing business commitments. How much existing shareholders would have gained or lost under this arrangement would depend on the value realised when the company, or its assets, were privatised again in due course.
Whether Northern Rock is solvent now or was solvent when it obtained the credit line depends entirely on the quality of its assets, something about which the contributors to this Forum are unlikely to have any information sourced from disinterested parties.
Posted by: Willem H. Buiter | September 19th, 2007 at 2:50 pm | Report this commentMartin Wolf: I am much closer to Willem Buiter than David Miles. Indeed, I do not understand what David is saying. The government has agreed to guarantee deposits at Northern Rock and so, implicitly, of institutions like it that fall into similar difficulties. What then does it mean to say, as David does, that the government would “only be providing top-up guarantees to the existing industry-funded deposit insurance scheme”? That is surely one hell of an “only”. What would it have cost Northern Rock to acquire such insurance in the market? The answer is that it could not have done so at any price, let alone one it could have afforded. So I stick by my view that the government has nationalised bank deposit liabilities or, more precisely, written an open ended insurance policy to bank depositors at no premium. We have socialised deposits and privatised profits - a true disaster.
Moreover, whether the shareholders and management do pay a price is yet to be seen. If this really is a liquidity problem, they will not pay any price at all. On the contrary, they will emerge entirely unscathed. The reason for this is that the government and Bank have protected them against the illiquidity brought upon them by their own risky funding strategy. Is this not dangerous? What happens if banks suffer no penalty for running such strategies? We know the answer: they will run their banks even more dangerously.
I agree with Willem that Northern Rock should have been nationalised in return for the guarantee, thereby giving taxpayers compensation for the risk they are running and properly penalising the management and shareholders. I regret not having said so.
I also agree - and said so in my column - that nobody knows whether Northern Rock is solvent, certainly not me and certainly not its depositors. What they did know is that other banks would not lend to it. As I pointed out in my column, why should small depositors have greater confidence in Northern Rock than do other banks?
I hope to return to Professor Honohan’s interesting comments very soon.
Posted by: Martin Wolf | September 19th, 2007 at 8:13 pm | Report this commentAlan Taylor: Mervyn King played a good backward defensive in the face of many bouncers from the Treasury Select committee. The panic and market irregularities are not over yet. Did the FT and others rush to judge and target criticism on the governor and the Bank?
The obligatory question - what would Bagehot do? - seems to suggest that abundant lending on all kinds of collateral to all kinds of parties (at a penalty rate) is what is needed – but only in a real panic.
Thus was the panic of 1825 ended, and Bagehot is quite clear that in general to treat a money market panic the Bank should accept anything a wide range of securities that would be good collateral in “normal times”.
The BoE’s response of lending at a penal rate against many assets and at less than 100 per cent of collateral seems to fit with Bagehot’s recipe. (If, as Martin notes, they can stick to it.) But did they wait too long? The situation was not wholly within their control and was limited by unfortunate regulatory and legal constraints. Also the threat of a systemic panic, rather than something that would hit the Rock, was not clear early on.
King argued that before the megaphones were unleashed and “fire” was shouted there was no panic — so the Bank did not need to go into full-swing liquidity provision. This is a reasonable argument. By the weekend the facts on the ground were very different. You just have to draw a line (probably moveable, depending on macro risk). Others’ discretion has become unconstrained sooner, but (in Martin’s analogy) King has been tougher in the game of chicken than most, and no central banker wants the car to crash. They all have to yield somewhere.
So a big problem was too much transparency. Bagehot is pretty explicit about how rumours multiply and the dangers of that. A bailout involving taxpayers money needs transparency and accountability down the road, but LLR lending by BoE in the heat of battle is a delicate matter.
Is secrecy is impossible? Banks and other corporations keep plenty of other nasty liabilities secret in off-balance sheet locations etc. and we never see profit warnings on those. Now maybe that isn’t a good thing … But why can’t an emergency loan from BoE be kept under wraps, at least for a while?
King was right to bring up covert operations. As one Brit said on TV, stood in a line outside a branch, “when the government says Don’t Panic, that’s when I start to worry.” This “Old Lady doth protest too much” view is going to be a risk that attends any overt LLR action.
Lastly, John Kay brings up an idea that keeps coming around in bad times: narrow banking. It may soon be back in debate again. If we put our checking account cash in government-bond backed accounts with a check writing facility, traditional banks die. They become deposit free and will have to raise 100 per cent finance on wholesale markets – and be allowed to fail like any other fly-by-night mortgage company with no affect on any depositors. If so, one day people may look back and say that Northern Rock’s problem wasn’t that it had too few deposits - the problem was that it had any deposits at all.
Posted by: Alan M. Taylor | September 21st, 2007 at 7:23 am | Report this commentWillem Buiter: Narrow banking would only be a solution to the problem represented by bank runs if effective political pressure for a de facto or de jure government guarantee of saving instruments were limited to deposits withdrawable on demand and subject to a sequential service (first-come-first served) constraint, used as medium of exchange/means of payments.
I don’t think that’s the case. The people who hold more than £100,000 with Northern Rock don’t hold them as transactions balances. For many it represents their life’s savings. I got one anxious e-mail from someone whose mother was in a nursing home, had all her savings in an account with Northern Rock (as deposits of one kind or another) and paid her nursing home premia from that account. Those were not transactions balances that would be held in a narrow bank.
Would moving savings that are not transactions balances out of deposit accounts - this is what would happen if narrow banking were introduced - and having narrow banks free of run risk eliminate or weaken the ability of the savers (the (former) depositors) to extract a free guarantee of their savings from the state?
Small savers, especially those saving for retirement or already retired an living of retirement savings, want their savings to be safe. Telling them that the world is an unsafe place cuts no ice. If the introduction of narrow banking were to cause them to invest their retirement savings in unit trusts or other non-deposit investment vehicles, the political pressure to get these investments guaranteed by the government, if there were a threat to the value of these investments, would be comparable to what we see today with the deposits.
You would not see a run on the unit trust headquarters, although you would see demonstrations of grey and blue-haired pensioners outside Parliament and petitions at 10 Downing Street.
Is there something uniquely intimidating to politicians about a long line outside a bank of depositors desperate to take their money out? It is interesting to speculate why this would be. The continued withdrawal of Northern Rock’s deposits, once the Liquidity Support Facility (’credit line’) was in place, no longer had any impact on Northern Rock’s ability to continue functioning. By drawing on the credit line (allegedly uncapped and open-ended!), it could do without depositors completely. Using the credit line would (I hope) be more expensive than raising funds by retaining deposits or attracting new ones, but that only impacts on Northern Rock’s shareholders. It is hard to believe that the deposit guarantee was provided to support Northern Rock shareholders.
What about fears of contagion to other UK banks? With the Liquidity Support Facility extended to these other banks and building societies also (as they all are no doubt solvent), they too could continue to function without depositors and deposits. There would be no threat to the stability of the UK banking system, even though there were lines around the block outside each branch office of every UK bank and building society.
We would have achieved half of the move towards narrow banking through this non-sytemically dangerous universal bank run. Clearly, deposits would no longer be available for transactions purposes, but this would be a nuisance, not a disaster. Cash, travellers cheques, transferable negotiable bills of exchange and other similar instruments would soon take over the role of transactions medium from the defunct deposits. Why not give every UK household and business a non-interest-bearing account with the Bank of England, an account that could be accessed through, say, any post office or sub-post office in the land?
So if there is an effective Lender of Last Resort, deposit insurance is redundant from the point of view of banking sector survival and financial stability. Deposit insurance is also not sufficient to allow a solvent but illiquid institution like Northern Rock to survive, as it was Northern Rock’s inability to roll over its maturing non-deposit liabilities that was causing it trouble. (If the deposit insurance were to extend to new deposits as well - it does not, of course, in the case of the Liquidity Support Facility - the wholesale market funding-challenged bank could offer such outrageously high interest rates on its deposits that it might be able to fund itself entirely through deposits!)
So if there is a LOLR, deposit insurance is neither necessary nor sufficient for banking and financial stability. Unless the sight of long lines outside the banks would have significant negative effects on consumer and/or business confidence, there are no macroeconomic stability arguments for deposit insurance provided there is an LOLR.
The deposit guarantee offered by the Chancellor was therefore in my view motivated not by concern for the stability of the UK banking system, which had already been safeguarded by the Liquidity Support Facility, but by the intolerable political embarassment created by the highly visible lack of confidence of the UK public in its banks, its central bankers, its regulators and its government.
Posted by: Willem H. Buiter | September 21st, 2007 at 4:54 pm | Report this commentPatrick Minford: Martin has written a lot in recent months about money and banking. Of course, as always, he says a lot of good things; but I do not agree with his basic thrust. Rather than pick him up on particular comments let me try to summarise what I see as his position.
1) The expansion of broad money and credit has been excessive, may have been a ‘bubble’, and has posed a threat of inflation in spite of central banks’ inflation-targeting rule for interest rates.
2) Recent actions by the Fed and the ECB to inject large amounts of cash into short-term security markets has encouraged moral hazard - ’sown the seeds of the next financial crisis’. By implication the Bank of England was right not to do so and events since, culminating in the offer of 100 per cent deposit guarantees by HM Treasury for banks facing runs, have done so in spades.
On 1) I think he is ignoring the evolution of modern financial markets which enable wider participation in the finance of industry by wealthy individuals and entrepreneurs and also wider provision of ‘consumption-smoothing’ to poorer members of society. This evolution has involved balance sheet changes, with banks for example taking deposits from hedge funds which took
them from wealthy individuals who would previously have put them directly into equities. Banks have co-operated with entrepreneurs in increasing firms’ gearing; as a result it has been possible for entrepreneurs to control very large firms previously managed as broadly-owned public companies with poor results.
His Minsky-like stress on the instability of these financial structures - ie their proneness to bubbles- may seem to be supported by evidence of crises like the recent one. However, a lot of recent work has shown that ‘bubble-like’ behaviour can be produced by efficient financial markets responding to news where there are chances of sharp changes of ‘regime’ (eg determining productivity and profits). True, it is also possible to explain it by models with investor irrationality and empirical tests that have real power to discriminate have so far eluded us (or at least me); so at this stage this argument is not easy to settle, I concede.
Recent evidence on inflation, on the other hand, is not kind to the credit expansion theory. In the UK, the US and the eurozone inflation has remained muted in spite of rogue behaviour of broad money. I interpret this as saying that inflation targeting has been effective in consolidating the credibility generated by the 1980s decade of inflation-reduction across the OECD,
accompanied by the education of public opinion and politicians in the mechanics and costs of inflation; meanwhile the story of credit and broad money is as above, one of financial evolution.
On 2) Martin’s views are heavily influenced by 1). Where I see evolution, he sees excessive lending encouraged by lax central banking (the ‘Greenspan put’ etc). I would argue that financial intermediaries should be supported in designing their business strategies by the assurance that the financial markets will remain stable - in the sense that there will not be bank runs, a panic closing of particular markets and so on. It is true that such an assurance will create greater willingness to take on business with risk; but this is good for economic growth and welfare. We take the view that there are enough ordinary ‘micro’ risks for financial firms without adding in
risks of systemic collapse. When the Fed and the ECB provided liquidity they were adhering to this approach; when the Bank refused it was not and was I think wrong - and reaped the whirlwind as we have seen. In fact Northern Rock’s business strategy had systemic stability as its premise; it was unlucky that the Bank chose to destroy that premise.
Finally what of ‘nationalisation of deposits’ by HM Treasury? He argues, absolutely rightly, that this was politically inevitable on public-choice grounds given the starting point of panic. The Treasury in fact did in the end what had to be done to restore confidence in systemic stability; but this should have been done in the first place by the Bank so that the overt intervention by the Treasury was unnecessary. I do not read the Treasury’s guarantee as amounting to deposit insurance in normal times for any institution; any system of deposit insurance for normal times is an entirely separate matter from action in the sort of crisis we just saw. In future the
Posted by: Patrick Minford | September 21st, 2007 at 11:28 pm | Report this commentBank should ensure systemic stability as the taxpayer’s market agent and allow overt emergency Treasury guarantees to gather the dust they ought to be covered in.
Krzysztof Rybinski: The Nothern Rock discussion can be summarized as a “shortsighted regulator problem”. There are two types of policy decisions which cause temporary change in a society’s welfare in one direction and strong welfare effect in the opposite direction in the long run. I call them easy decisions, and difficult decisions.
Easy decisions bring benefit in the short run (before the next election) but result in massive long-run damage beyond the policymaker’s policy horizon. The second type incurs some cost in the short run but brings positive long-term results; however, it materializes beyond the policymaker’s policy horizon (after the next election).
I side with Willem Buiter: nationalization of Northern Rock deposits was a clear example of an easy policy decision.
There appears to be a fundamental flaw in the policy framework, which shortens this policy horizon. It relates to both types of actions: preventive ones and mopping after ones. Regulators seem to have problems delivering a “pre-emptive policy strike” at good times. And regulators are eager to act swiftly to secure orderly functioning of financial markets, even if it carries “bail out” stigma. In both situations politicians will be happy, and the next, much bigger crisis resulting from massive moral hazard will be blamed on someone else.
I do not know what should be the solution to this “shortsighted regulator problem”. Extending a central banker’s or financial regulator’s term to 15-20 years would be too risky; if you get a bad central banker, it would last for a generation. But we should definitely work on incentives that will result in an extension of their policy horizon. I am thinking of a type of contract that was signed in New Zealand, when the central banker can be fired when inflation deviates too much from the target. Maybe charging the central banker/regulator/minister of finance a certain part of his wealth when crisis strikes (within 10 years after his term ends) or giving him a hefty bonus when stability is preserved (in the same period) would work.
Any suggestions as to how to solve the “shortsighted regulator problem”?
Dr Krzysztof Rybinski is deputy governor of the National Bank of Poland and a member of the Polish FSA
Posted by: Krzysztof Rybinski | September 22nd, 2007 at 7:05 pm | Report this comment