4 Responses to “The lessons from Northern Rock”

Comments

1. Charles Calomiris: Willem Buiter asserts, with no factual support, that “the main problem” with the division of authority in Britain over financial regulation and assistance is the separation of monetary authority and bank supervision; that is, that the FSA is the information collecting authority while the Bank of England is the lender. This is a fatuous argument, usually made by US central bankers, as part of their battle to retain supervisory and regulatory turf. The US, notably, is almost the only developed economy in the world that has not separated monetary and regulatory/supervisory authority. This puts the US in the company of countries not generally known for their good governance (including Russia, Indonesia, Jordan, Kenya, Nigeria, and Pakistan).

   The information known by FSA examiners is as easily communicated to the decision-makers at the Bank of England as it would be if the examiners were housed at the Bank of England. Furthermore, there is no reason to believe that housing supervision within a central bank would improve the quality of that information. Indeed, the literature on this question generally emphasizes the conflicts of interest that arise when combining financial supervision/regulation with authority over monetary policy. This understanding of the desirability of separation probably explains why so many countries other than the UK (Australia, Canada, Japan, the eurozone, India, Mexico, Sweden, South Korea, Denmark, China, Chile, and many others) have separated the monetary authority from banking supervision and regulation. Doing so avoids conflicts of interest that can compromise the efficacy of regulatory policy and politicize monetary policy.

   Professor Buiter’s discussion of the Northern Rock bailout also seems to assume that the protection of all depositors was desirable in the first place. My reading of the literature on banking crises and bailout policies, and my understanding of the proper role of central banks, and the helpful roles that they have played historically, lead me to conclude that the bailout of depositors was undesirable. The proper response of the Bank of England would have been to protect other British banks from any fallout from the failure of Northern Rock, and to allow it to be closed down, with potential loss to its depositors. British resolution policies should be reformed to make limited and explicit protection of depositors credible, and to ensure that depositors receive the funds due them as quickly as possible, but blanket bailouts of depositors lead to a greater tolerance for poor risk management, with huge attendant social costs.

   Posted by: Charles Calomiris | November 13th, 2007 at 10:21 pm | Report this comment
   

2. Andrew Smithers: I agree with Willem Buiter’s comments, but think that there is one important lesson to which he did not draw attention. This is the inadequate level of bank capital required by current regulations. This will be underlined if Northern Rock proves to be insolvent and its bailout to be costly for taxpayers.

   The drama has emphasised that bank retail deposits are in practice, even if not in theory, guaranteed by taxpayers. In return for this guarantee, with its consequent subsidy, banks are regulated. Banks, like all businesses, make profits from taking risks. The greater the risks taken, the higher will be the returns in good times and the greater the risk of bankruptcy in bad ones. The naïve view is that profitable banks are sound banks. The opposite is true; the more profitable they are at the peaks of their profitability, the more risky they are. What matters is not just profitability, but its variability. One test of good regulation is therefore that the average return on equity in good times should not be too far above the equilibrium return. Otherwise the return in bad times will tend to be so low that bankruptcies will occur and a heavy cost may fall on taxpayers. Banks in Europe and America currently have average returns on equity which are well above long-term equilibrium returns on corporate equity in general. UK banks’ returns on equity have been around 20 per cent after tax for the past six years or so. Long-term equilibrium real returns on corporate equity seem to be stable at something less than 7 per cent. Significant losses in some years will be needed for average returns to match equilibrium levels.

   It is happily improbable that the regulators can obtain the assurance of competition authorities that banks will have their high returns protected by barriers to entry and other limits to competition. Regulations therefore need to be changed so that banks must hold higher equity ratios than they do at present to support their lending levels. (Basle 2 does not seem to do this.) Without changes in regulations, bank profits are likely to be very volatile and new banking crises are likely to emerge when profits fall. The average current dividend pay-out ratio of UK banks is 1.85, so dividends are equal to 10.8 per cent on equity capital. If bank returns on equity were at equilibrium, let alone below, dividends per share would need to be heavily cut. A reluctance to cut dividends per share will inhibit the growth of bank equity. There is therefore a significant risk that falls in returns on equity to equilibrium levels will be accompanied by a change in bank lending from the excessive ease of recent years to excessive tightness in the future.

   It is of course easy to see why bank profits are likely to fall and very difficult to forecast how and when this will happen. It seems sadly likely that higher equity capital ratios will be required as a consequence of the next banking fiasco rather than to ameliorate it.

   Posted by: Andrew Smithers | November 14th, 2007 at 1:24 pm | Report this comment
   

3. James Macdonald (guest commenter): When considering how to resolve the Northern Rock problem, the best adage is the old Irish response when asked for directions - “well, I wouldn’t have started from here.”

   It may well be true that the queues outside Northern Rock could have been avoided if the government had given an explicit guarantee for retail deposits as soon as the Bank of England’s line of credit was announced. It may also be true that the run would not have occurred if the UK had a more generous deposit insurance program. But neither of these points deals with the most important issue, since avoiding a run would still have left Northern Rock dependent on government financial backing.

   The real question is how the UK taxpayer could have avoided ending up as the involuntary principle creditor of a failing bank, at risk to the tune of over £40 billion, and with no easy exit strategy.

   The first line of attack, much put about by bankers (including Northern Rock’s directors) and recently reiterated by DeAnne Julius, is to blame the Bank of England. The argument runs that if the Bank had supported the interbank market in August and September by lending for longer periods against a wider range of collateral at non-penalty rates, then the crisis would never have occurred.

   This seems unlikely. Banks are unwilling to lend to Northern Rock even now that it has massive direct support from the Bank of England and the government - this is why the Bank’s line of credit is being utilised as Northern Rock’s interbank deposits run off. It is doubtful that banks would have been any more willing to lend to the Rock, already seen as dangerously illiquid, in the absence of any direct public support, at a time when they were scrambling to build up their own liquidity. The only likely result of liberal Bank of England intervention in the money market would have been that the banks would have been able to rebuild their balance sheets on the cheap, without having to pay the salutary penalty of higher rates in the interbank market.

   The second line of attack is to blame a failure of regulation. It is clear in hindsight that attempts to stress-test the regulatory system were inadequate. They failed to foresee the difficulties of arranging a last-minute takeover of an illiquid bank. When they did point up weaknesses, such as the need for improved deposit insurance, no action was taken.

   But more important than this is the failure of Britain’s light-touch (aka soft-touch) regulatory system, already discussed by Andrew Smithers. The FSA’s discreet and emollient regime may have attracted business to London, but it also allowed Northern Rock to accumulate mortgages of £100 billion on a capital base of just over £3 billion. Not only was the bank allowed to leverage itself beyond any reasonable level of prudence, it was not required to maintain any liquidity insurance in spite of the fact that only one quarter of its funds came from retail depositors.

   The contrast with the United States is relevant. The US regulatory system has been rightly criticised as overly permissive – it was there that the subprime debacle was allowed to develop. However, it is salutary to note that the most conspicuous American casualty of the crisis, Countrywide Financial, had capital that was twice as large in relation to its assets as Northern Rock. It also maintained unutilised lines of credit equivalent to 6% of its liabilities. This, as much as the stronger level of US deposit insurance, is the reason why Countrywide is still just afloat while Northern Rock has sunk.

   Posted by: James Macdonald. (Author of A Free Nation in Debt: The Financial Roots of Democracy) | November 17th, 2007 at 11:27 am | Report this comment
   

4. Willem Buiter:

   I would like to thank Charles Calomiris and Andrew Smithers for their comments.

   As regards Charles Calomiris’s points, let me start by noting that just because a point is made by the Fed, and just because it may well be self-serving, does not make it invalid. Having the supervisor/regulator and the lender of last resort in the same institution may well increase the damage done by possible regulatory capture. Even without LoLR resources at its disposal, a bank regulator can do many agreeable things for the banks its regulates, but I agree that putting ulimited liquid resources at the disposal of the regulator can create problems.

   The most important form of mitigation here is openness and, ex-post accountability. This includes effective Parliamentary oversight of the regulator/supervisor and of the monetary authority - something that is lacking entirely in the UK.

   Charles is, however, poorly informed about the facts of the Northern Rock debackle and/or terminally naive about the problems of coordinating independent institutions. The institutional separation of the individual bank-specific information and the financial resources required for the effective discharge of the LoLR function was an important contributor to the delays and confusion surrounding Northern Rock. The Bank and the FSA were clearly, almost openly, at cross-purposes about a possible sale of Northern Rock to Lloyds-TSB, before its problems became public knowledge. The FSA (and the Treasury) have been sniping at the Bank and (at least in the case of the Treasury) briefing against the Bank ever since the Liquidity Support Facility was established and the run on Northern Rock started. I believe that when the lessons of Northern Rock are digested, there will be action around the world to put information and the means to act upon it in the same place.

   As regards deposit protection, I have no strong views about its desirability. All I tried to say was that if you decide to do it, you’d better do it right.

   There are two efficiency arguments and an equity argument for deposit protection. The equity argument is that ‘widows and orphans’ should be protected. It calls for the protection of retail deposits held by natural persons only, say up to £50,000 and available at very short notice. The first efficiency argument is that the fixed cost of monitoring and verifying the creditworthiness of individual deposit-taking institutions makes it socially wasteful to have all small depositors engage in such activities. Again, retail deposit insurance is a solution to that problem. Finally, bank runs can lead to socially inefficient liquidity crunches for institutions that have illiquid assets and liabilities that are withdrawable on demand and subject to a first-come, first served (sequential service) constraint, banks, that is. Unless the bank can borrow against its illiquid assets, it may be forced into inefficient insolvency. So yes, some form of limited deposit insurance is probably desirable.

   As regards Andrew’s points, I agree that banks tend to take excessive risks during good times. Whether what is required is higher capital requirements or a reduction in the banks’ capacity to hide exposures in off-balance-sheet vehicles, is something I am not entirely clear on. By requiring the consolidation of most of the bank-sponsored off-balance-sheet vehicles (sivs, conduits and whatnot) into the balance sheet of the sponsoring bank for purposes of capital adequacy calculations, could well solve most of the problem. Further help may come from better risk-weightings which may follow a review of the role of the rating agencies. Even without changing any of the required capital ratios, a lot more capital will have to be held if the overrated assets of the banks get re-rated and the hidden exposures brought back onto the banks’ balance sheets.

   CENTRAL BANKS AS LENDER OF LAST RESORT AND MARKET MAKER OF LAST RESORT: WHERE THE BANK OF ENGLAND WENT WRONG

   I would also like to use this reply to restate my views on where the Bank of England erred in its liquidity provision policy. This is important, because I believe that the relevant lessons have not yet been learnt.

   First, I distinguish between providing liquidity to individual banks and other individual financial institutions in distress – the lender of last resort (LoLR) function- and providing liquidity to markets for financial instruments that are normally liquid but have become disorderly and illiquid – the market maker of last resort (MMLR) function. The Bank of England’s policy towards both functions was incorrect.

   As regards the LoLR function, LoLR support should be offered to institutions that are illiquid but solvent. While I have no first-hand knowledge of the asset side of Northern Rock’s portfolio, those who do (or who assert they do) assure us that most of its assets are sound. Northern Rock should have been able to access the Bank’s LoLR facilities in that case.

   The discount window of the Bank of England (its Standing (collateralised) lending facility) is, however, ineffective as a source of liquidity for two reasons. First, it only provides overnight loans. The Fed lends at up to one month maturity at its primary discount window. Second and most importantly, the Bank of England only accepts as collateral securities that are already liquid: UK government securities, sovereign debt instruments issued by other European Economic Area governments, high-rated debt instruments of a few international organisations (e.g. the World Bank), and, under exceptional circumstances, US Treasury securities. So the Bank of England’s discount window only does maturity transformation of long-maturity liquid assets into overnight liquidity. This is useless in a crisis. The ECB accepts as collateral at its discount window (the Marginal Lending Facility), a wide range of euro-denominated debt instruments (rated at least in the A category) issued by both sovereign and private issuers. It can accept nonmarketable and illiquid assets, including asset-backed securities. The Fed can accept as collateral at its discount window anything it deems fit.

   So, with the Bank of England’s discount windows useless because Northern Rock held very few liquid assets, the Bank of England and the Treasury had to create the purpose-designed Liquidity Support Facility for Northern Rock. All this did was to enable the Bank to lend to Northern Rock in the way its own discount window ought to have lent to Northern Rock, had there been a properly designed collateral and maturity policy at the discount window. The discount window is, in principle, anonymous. The Liquidity Support Facility was in the public domain, because of the mistaken belief of the Governor, that undercover, secret LoLR support for Northern Rock would lead to conflict with the Market Abuse Directive. That, of course, is and was incorrect. The ECB is reported to have provided undercover support to troubled Eurozone banks without creating any MAD problems. Obviously, the MAD was not created to rule out discrete, secret LoLR support where it is needed to limit unnecessary damage.

   The Bank’s provision of liquidity to the markets was also flawed, and continues to be so. Here too it accepted (until it changed its mind after Northern Rock hit the rocks and interbank markets remained in turmoil - as they were again yesterday, especially at 3-month maturities) as collateral in repurchase operations (repos) only the same short list of highly liquid and highly rated securities that it accepts at its discount window. The menu of securities it is willing to purchase outright in open market purchases is equally restricted. The Bank only sets the overnight repo rate (using its restricted list of collateral) and used to intervene at longer maturities only ‘at market rates’. That is, it did not seek to influence market rates at longer maturities than overnight. It attributed the gap between, say, 3-month Libor and the expected policy rate (bank rate) over that three month horizon, as mainly reflecting market participants’ perceptions of default risk. The Bank did not consider it to be its business to address default risk of UK-registered banks through its repos and open market operations, and I fully concur.

   However, to identify the gap between 3-month Libor and the expected policy rate over a three month horizon (as measured, say, by the OIS rate) as reflecting mainly default risk represents a serious error of analysis and judgment. In my view, most of the spread (at least 60 basis points of yesterday’s 75 basis point spread, say), represents the market’s perception of liquidity risk. There is a term structure of liquidity risk which the Bank can and should try to address by intervening aggressively at longer maturities in the interbank markets (through repos at the appropriate longer maturities) to drive down the excessive spreads. It should do so accepting as collateral in these longer-maturity repos a wide range of private sector financial instruments, including illiquid and nonmarketed instruments. The Bank announced it would do so in September, but the three interventions it announced at 3-month maturities were subject to a penalty floor (the interest rate could not be below the policy rate plus 100 basis points). Nobody came to the party.

   The fact that the Bank made its proposed market support operation subject to a penalty floor on the interest rate charged, shows it still doesn’t get the distinction between assisting an individual institution that is in trouble and supporting an illiquid market. LoLR operations have to be at a penalty rate to mitigate moral hazard. MMLR operations correct a market failure. Illiquidity is a manifestation of a breakdown of trust and confidence. Liquidity is a public good, subject to ‘intertemporal network externalities’ : my willingness to lend to you today at three month maturity, when I have the liquid resources today, depends on my perception of the risk that both I and you will be illiquid three months from now. If the authorities could credibly commit themselves today to provide unlimited liquidity in three months’ time, liquidity crises would not arise. But such a commitment is impossible. The best substitute is for the monetary authority to provide the 3-month liquidity today. The Bank of England is the only agency whose sterling liabilities have unquestioned and unconditional liquidity. They can provide this liquidity instantaneously, continuously and at no cost. They should do so; they did not. So the Bank failed in its market maker of last resort role.

   It is possible, but socially inefficient, for private banks and other financial institutions to carry on their own balance sheets enough liquid assets to weather any market illiquidity storm. They should only have to hold enough liquid assets to manage their affairs when markets are orderly. It is the job of the monetary authority to prevent or mitigate market illiquidity. This permits banks and other financial institutions to perform their valuable social functions of borrowing short and lending long, and of borrowing in markets that are normally but not always liquid, and lending in the form of assets that are often illiquid.

   To avoid creating adverse incentives for the would-be borrowers in the repos, who might offer illiquid, nonmarketable instruments as collateral, it is key that the collateral be priced in such a way as not to offer a subsidy to the borrowers. The Bank need not have superior information about what mortgages are worth, or about the fair value of the underlying assets backing asset-backed securities that might be offered as collateral. It can organise auctions that serve as reservation-price revelation mechanisms for the parties offering the illiquid securities. The reverse Dutch auction, with the Bank acting as monopoly buyer, is one example.

   To discourage unnecessary complexity in structured products, the Bank should have a positive list of financial instruments that it will make market in. To avoid a situation where private holders of illiquid instruments prefer not to have them valued at these auctions (so as to avoid having to mark them to market at prices possibly well below par), there should be a regulation that all securities in a class for which there has been an auction, should be marked-to-market at the prices established in the auction (in the case of the reverse Dutch auction, this could be at the second-highest price established in the auction).

   The Bank of England should carry these illiquid securities on its balance sheet. If, subsequently, a transparent normal market is re-established, the Bank could sell the securities again. Otherwise it can hold them till maturity. After all, the Bank is never liquidity-constrained and is uniquely well-placed to take the long view.

   So the Bank failed in its lender of last resort function and in its market support or market maker of last resort function, because it operated against too restrictive a list of collateral and at too short a maturity.

   Of course, Northern Rock knew, or should have known, about the collateral policy of the Bank of England, at the discount window and in its liquidity-oriented market interventions. Its funding policy, and its low liquid asset holdings were therefore reckless. The creation of a one-off support facility for a specific financial institution (as opposed to a discount window open to all eligible counterparties on demand, given the right collateral) should only be considered for institutions that are systemically important. For such systemically important institutions, being taken into public ownership is also an option. Northern Rock, which accounts for 2 or 3 percent of the assets of UK-registered banks, is not systemically important. It is small enough to fail. It could therefore have been allowed to sink or swim on its own.

   If the protection of retail depositors, or the prevention of a bank run, are deemed to be important, a decent deposit protection scheme would have been sufficient. The UK deposit insurance scheme is a shambles. But once the Chancellor guaranteed all deposits of Northern Rock (retail and wholesale) as well as most other unsecured creditors, the widows and orphans were safe and the risk of a run was ended. The Liquidity Support Facility for Northern Rock could and should have been ended at that point.

   Posted by: Willem H. Buiter | November 17th, 2007 at 1:55 pm | Report this comment
   

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