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Leading article

There may be trouble ahead

Wednesday, 19th September 2007

Extraordinary measures are sometimes necessary to quell the madness of crowds. When Diana, Princess of Wales’s mourners threatened to vent their angry grief on the institution of monarchy itself, it became necessary for the Queen to speak directly to her people.

We should also ask whether Northern Rock’s managers were deluded or unlucky. It is true that the freeze in inter-bank lending which has been at the heart of Northern Rock’s problems was driven by troubles in the US sub-prime mortgage sector that bear no relation to the quality of Northern Rock’s own mortgage book. But the fact is that the bank was hell-bent on expansion, offering aggressive mortgage terms in a weak housing market and relying on sophisticated ‘securitisation’ techniques for much of its funding. Share analysts started warning six months ago that this business model was unsustainable, but the managers held their course and the FSA did nothing to stop them. Northern Rock was solvent, say the bureaucrats, so no intervention was needed; but a stern word in the management’s ear might have averted crisis, and the FSA stands clearly accused of failing to address the impending crisis with sufficient urgency when the money market seized up in early August.

The charges against the Bank of England look even more serious. Unlike its European counterpart, the Bank declined to pump liquidity into the inter-bank market in August — but if it had done so, Northern Rock’s funding problem might have remained manageable long enough for an orderly refinancing or takeover before panic set in.

Only ten days ago, the Governor, Mervyn King, told the Treasury select committee that, to avoid ‘moral hazard’, there should be no state bail-outs for banks in difficulties — advice which the Chancellor rapidly set aside. Even the money market now shuns the Bank’s lead, setting its own interest rates significantly higher than Bank Rate to recognise increased risks. The Bank and its Governor — whose predecessors ruled the City with almost mystical authority — are diminished. That dilution of a power which rivalled his own is perhaps what Gordon Brown wished to achieve when he gave the Bank’s regulatory role to the FSA, but the structure he created has now been severely tested and found wanting — and that harms the City’s status as a global financial centre.

As to the guarantee which Brown no doubt instructed Darling to issue, its short-term efficacy hides a minefield of potential arguments. Does it apply to all banks whose depositors threaten to panic or (as the FSA chairman suggested) only to those large enough to pose a ‘systemic’ threat? Does it apply only in the present crisis, or in all future crises? Will it merely encourage financial irresponsibility and market delusion? The government averted catastrophe this week, but has stacked up trouble to come.

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