How to safeguard savers in a banking crisis


The Northern Rock debacle could, and should, have been avoided through the deposit protection and special administration mechanisms that are found in most other countries.

Many people blame the Northern Rock debacle on the tripartite division of responsibilities between the Financial Services Authority, the Bank of England and the Treasury. But there are three separate roles. A regulator should protect the public in its dealings with financial institutions. A central bank should provide cash to the public and manage monetary affairs. A government department should formulate policy for the banking sector. A central bank which combines all three roles can compensate for failure in any one of them by printing money. But this is not, in the long run, a good idea.

Some see Northern Rock as a failure of supervision by the FSA. But this is to misunderstand the role bank regulation can play. Northern Rock adopted a strategy of aggressively pursuing market share in mortgages using cheap funding from the overblown securitisation market, and the strategy collapsed when the wholesale funding markets on which it depended dried up. The errors were errors of business judgment. We have every reason to think that Northern Rock was honestly and efficiently run.

Some people did think that Northern Rock’s strategy was risky. But the principal facts about the company’s market share, its business model and its methods of financing were as well known to the market as to the FSA. The company’s shares reached a record high only four months before it had to seek Bank of England support. It is inconceivable that the FSA could have forced a change of business approach on a well-regarded business which was providing good value mortgages to millions of households. Does anyone think that the FSA should adjudicate on activist investor Knight Vinke’s criticisms of HSBC or ask Barclays where it is going after the failure of its approach to ABN-Amro? The FSA does not have the competence, and should not have even the appearance of authority, for such intervention.

Just as it should not be the FSA’s job to stop banks doing foolish things, it should not be the Bank of England’s job to free banks of the consequences of doing foolish things. Perhaps the Northern Rock problem could have been avoided if the Bank had been willing to flood markets with liquidity at an early stage. But while it would be helpful to car manufacturers if a public agency provided liquidity when they suffered a build-up of unsold stock, there is no good reason why the government should do this and compelling reasons why it should not. The most important is that the scale of profits and personal enrichment in financial services makes any public subsidy to the industry unacceptable.

There is a public interest in preventing systemic collapse of the banking system. American policy is still influenced by memories of how the Great Depression was aggravated by successive bank failures. When Franklin D. Roosevelt became US president in 1933, the country’s banks were closed – not in protest or celebration of the inauguration, but to prevent panicking depositors from taking their money out. The American answer to these problems, followed in most other countries, is a scheme of deposit protection combined with a regime of special administration which facilitates the transfer of the assets and liabilities to stronger institutions.

There was no danger at all of systemic failure in Britain until queues began to form outside Northern Rock branches and they formed because no adequate assurances could be given to savers. Deposit insurance provided only for the first £2,000 of savings, and Britain has no mechanism for freezing the activities of a troubled bank. Without proper deposit protection, a run was inevitable on the announcement, or rumour, of problems. With only the weapon of insolvency available, reorganisation of the bank could occur only after the taxpayer replaced the withdrawn wholesale funding.

The specific events of August could not have been predicted, but the failure of a major financial institution was a contingency virtually certain to occur at some time in complex and turbulent financial markets. The responsibility for implementing adequate legal mechanisms for that contingency lies with the government department responsible for financial services activities – the Treasury.

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