It was not an iceberg that caused the crash of Northern Rock and fortunately there was no loss of life; but it will be remembered, like the sinking of the Titanic, for years to come. None of us had seen queues of worried depositors outside bank branches before. We can remember it happening in It’s a Wonderful Life, but this was real life; and the pictures went round the world.
The affair must have damaged the Bank of England’s standing among other central banks. People say it is the first such event since Overend, Gurney in 1866. Although there have been numerous bank failures since then, none has involved queues of voters.
The bankruptcy of Overend, Gurney was momentous. Crowds gathered in Lombard Street clamouring to withdraw deposits, causing widespread panic and bankruptcies of other firms. But it was not a high street retail bank — Gurney & Co of Norfolk, which became part of Barclays, was a separate business, though there were family connections. Overend, Gurney was a large discount house with an international reputation, and its failure caused massive business disruption.
The firm had expanded very rapidly on the back of the growth of trade following the end of the American Civil War. But a growing proportion of its lending became careless and was bad. ‘A child who had lent money in the City of London would have lent it better,’ said Walter Bagehot. The failure led other banks immediately to stop lending to each other. The Bank of England, which had astutely foreseen the failure, was ready to provide liquidity to the market. This it did up to the limit of its own resources; and it then had to ask the Treasury for more. Gladstone, the chancellor, and Lord John Russell, the prime minister, agreed on the basis that they would get the necessary parliamentary approval as soon as possible ex post facto.
When there is a bank crisis, the authorities have to provide liquidity to the market rapidly to ensure business does not seize up and to prevent contagion. When people see depositors rushing to withdraw their money from a bank, all will do so. They do not stop to consider the quality of the bank’s lending. They want to put their money somewhere safer. They are sensible to respond in that way; for if a large number of depositors want their money back, the bank will not have enough liquid resources to meet all the demands, even if it has not made loan losses.
The first duty of a bank is to repay deposits on time. Nevertheless every bank borrows short and lends long. This is how it makes a profit. The skill is to manage things so that the deposits do not get withdrawn en masse and suddenly.
The ‘fringe bank’ crisis of 1974 taught us all these lessons over again. I was a non-executive director of one of the best known, Mercantile Credit. Its lending was sound. Its deposits came from the money market. When it was revealed that one or two small banks, one of which had ‘Mercantile’ in its name, had engaged in bad lending, the money market stopped lending to all fringe banks, good or bad — rather as the immediate trigger for Overend, Gurney’s demise was the bankruptcy of an unrelated firm with ‘Overend’ in its name.
Fortunately the governor of the Bank of England, Gordon Richardson, formed the Lifeboat, and arranged for some fringe banks to be bought by clearing banks which were able to refinance the deposits at an economical rate. Mercantile Credit, which already had Barclays as a shareholder, was sold to Barclays in 1975. The other shareholders suffered (the sale price was 10 per cent of its pre-crisis value) but no depositors lost money. The business continued and Barclays got a very good buy.
Northern Rock’s rapid expansion in pursuit of market share was financed largely out of money-market funds rather than retail deposits. It certainly raised eyebrows. However, the board seems to have overlooked how rapidly money-market attitudes can change. When credit markets tightened, because of poor-quality lending in the US housing market, Northern Rock’s ability to raise funds from the money market dried up. Statements by the government and the regulators that it was ‘solvent’ — meaning that its assets were worth more than its liabilities — did no good. Reassurance from public authorities tends not to work: two days after Overend, Gurney’s failure, the Foreign Office issued a circular to foreign business centres saying that British business was ‘essentially sound’. Immediately, so it is said, ‘every English signature was suspected abroad’.
Last-resort lending was called for, but the suggestion that the Bank of England should have previously provided more liquidity to the market to support just one bank’s risky business model is strange. There is over £13 billion of taxpayers’ money out to Northern Rock right now. So long as Northern Rock’s assets — its loan portfolio — are sound, this money is only lent, not spent. But the situation cannot continue, because the cost of that money is too high in relation to the income from Northern Rock’s assets. So its business must be put into hands whose credit is good enough to be able to finance the assets at an economic rate.
Should all this have been foreseen? Of course. Attributing blame between the board, the FSA, the Bank of England and the Treasury is not as important as learning from the disaster. And each should avoid blaming the others; responsibility is not reduced even if it is shared.
The merging of capital market activities into banking over the last quarter-century makes it inevitable that there is a regulator for market participants separate from the central bank; but the relationship between them needs tightening. And the deposit insurance scheme needs repair. It should cover deposits fully, up to a sensible, retail-market level; and it should work so as to enable depositors to get their money quickly without the protracted wait they must endure under the current system. It must work so as to reassure depositors but not to bail out shareholders. Their money must be left as risk. Otherwise there is a big risk of ‘moral hazard’, the phrase which covers situations where a publicly arranged safety net allows others in the private sector to take undue risks which will be rewarding if they come off, but leave insurers or taxpayers with the bill if they do not.
The Treasury guarantee of post-crisis retail deposits itself has a moral-hazard dimension. Should a bank in trouble be given public support to allow it to continue? It may help to work out a tidy solution, but it is the troubled bank’s shareholders who benefit.
There is also the question of what happens in the eurozone, or indeed across other borders. Northern Rock was a domestic affair. But if it happens to a bank in the eurozone, the ‘lender of last resort’ responsibility would, in the first instance, lie with the central bank of that bank’s home nation. However, the requirement for additional liquidity would very soon reach a level which would need the help of the European Central Bank. If the problem spread to other banks in that country, the question would rapidly develop a political dimension. The question would arise: why should eurozone countries with strong economies have to help the ECB to provide assistance for banks in a weaker country? Yet more problems might arise if a bank with business in more than one EU country got into difficulties.
Such questions are consequences of the globalisation of finance, the eurozone being a particularly structured kind of globalisation. The UK would not be exempt from eurozone problems, for not only is London the centre of the wholesale euro deposit market, but also the UK is part of ‘Eurosystem ’, which oversees market activity and coordinates the activities of EU central banks. The answers to these questions are not easy. No doubt stress-testing simulations are carried out. Moreover, already Northern Rock has triggered action in Brussels, and you can bet there will soon be calls for additional EU regulation. Ecofin, the committee of EU finance ministers, is already at work on the management of cross-border financial crises. Let us hope the questions remain hypothetical.
Sir Martin Jacomb was, among other senior City posts, a director of the Bank of England and deputy chairman of Barclays. He writes here in a personal capacity.