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 queue. British deposit insurance does not prevent runs from banks in trouble. It guarantees they will happen. The run was quite rational.
The offer of liquidity assistance from the Bank of England was insufficient to eliminate the panic because the public feared Northern Rock was insolvent. Being told by the authorities it was not did not help. What else, after all, could those worthies say if they were not going to close it down at once? Why, moreover, should the public at large have greater confidence in a financial institution than the markets?
The government's decision to guarantee all deposits is completely understandable. First, depositors vote. Second, any politician knew that the sight of thousands of ordinary people trying to obtain their money from a supposedly regulated institution was fatal to the government's reputation for competence. Third, it is absurd to expect ordinary people to assess the strategy of a long-established institution, particularly when it increases its loans massively over a short period. Finally, contagion spreads. On Monday, the shares of institutions dedicated to lending for house purchase collapsed (see chart). Northern Rock may have not been a systemically important institution. But its implosion became a systemically important event.
I must declare an interest: members of my immediate family had money in Northern Rock. As an individual, therefore, I am pleased. As a hard-nosed commentator, I deplore it. But no British government would have behaved differently. If it had failed to do so, the flight to institutions deemed "too big to fail" would have become a Gadarene rush.
Yet the decision to guarantee deposits raises large questions. Deposit liabilities are nationalised, while the financial system's assets, albeit regulated, remain in private hands. If you do not understand the implications of that, you have not paid attention to what has been happening in the financial sector.
This story raises several questions. The first is whether the disaster could have been prevented. Note that what went wrong in this case was not Northern Rock's strategy on lending, but rather on borrowing. Should the regulatory regime have insisted that it insure itself against the possibility of disruption in the markets on which it depended for finance? I do not know the answer. But that has now become a big question more broadly.
The second issue is whether the crisis could have been better handled Some argue that it would have helped if the Bank of England had been less "Victorian" in its determination to lend only against good collateral at a penal rate and in its refusal to intervene in financial markets. Yet a lower three-month interest rate might not have saved Northern Rock. If the Bank had been prepared to accept a wider range of collateral, more institutions might have approached it, which would have made the condition of Northern Rock seem less uniquely dreadful. But it would also have had to charge less than a penal rate, to encourage them to do so. That would have amounted to a sizeable subsidy to badly managed institutions.
Another line of argument is that the Bank should have been able to lend, or arrange a takeover by some other institution, covertly rather than offering lender-of-last-resort facilities overtly, as it did last week. But this, it argues, is today impossible. Northern Rock was obliged to give a profits warning. Similarly any proposed takeover would have had to go before shareholders. Depositors would have known that the deal might have fallen through, with dire results for them. So, argues the Bank, transparency itself guaranteed a run.
The third question, then, is what is to be done in future. A part of the answer is advanced by my colleague John Kay, in his adjoining column. Normal insolvency procedures should not be applied to banks. Moreover, deposit insurance will have to be more generous and its availability more immediate. But the shareholders of failing institutions must receive no bail-out. That is why I still believe the Bank is correct to insist on providing liquidity at a penal rate against good collateral. That should give some incentive for shareholders to insist on prudent management.
Yet there are other and wider questions. As long as governments cannot - or will not - let ordinary depositors suffer inconvenience, moral hazard runs rife. The answer must surely include tighter regulation: more capital, perhaps an obligation to obtain long-term subordinated debt and specific liquidity requirements.
Finally, is this the end of the story of crisis and contagion? "Far from it" is my guess. If we can have such trouble with the financial system when the real economy is healthy, I tremble at what may happen when conditions start to become worse. The financial system looks more insecure than I feared. The unwinding of past excesses may well bring more unpleasant surprises. But it is necessary, and healthy, all the same.
