Northern Rock: How a Non-Systemic Risk Led to a "Systemically Important Event"

At least in the US, the Fed rate cut yesterday crowded out most other financial news. As the Wall Street Journal’s MarketBeat blog put it (hat tip Paul Kedrosky):

Lehman Brothers probably could have reported that it was shutting down operations and moving to Kazakhstan and the Fed move would have still inspired a rally.

As a result, some excellent commentary on the regulatory response to the UK’s Northern Rock crisis may be getting the short shrift. One in particular was an article by Martin Wolf of the Financial Times, in which he explains the political necessity of the government’s decision to guarantee all bank deposits. In one sense, it is a tardy fix to a poorly constructed deposit insurance scheme that would inevitably increase the likelihood of bank runs.

Wolf discusses whether the crisis could have been prevented and what other accompanying reforms are needed.

From the Financial Times:

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 lengthy 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.

Print Friendly, PDF & Email


  1. Anonymous

    We still do not know the exact mechanics of the Northern Rock episode and unfortunately it appears no one wants to dig. The run will be used to justify the action taken BUT the action precipitated the run. Were there any financial WMD? Where are they and where were they hidden? Hopefully the Select Committee will dig it out.

    The papers are beginning to dig at the supervision. Derek Wanless was director responsible for risk oversight and contacting the authorities. The company is still planning a dividend payout.

    Here is a bloggers take on the funding origins of the crisis.;jsessionid=0RHCYETX5GHSJQFIQMFSFF4AVCBQ0IV0?xml=/money/2007/09/19/ccjeff119.xml

    “Northern Rock is the first victim because it was so reliant on the conduits to buy the bonds it issued, backed by mortgage loans it had made. Northern Rock’s model was to borrow initially in the short term from other banks in the interbank market, use this money to make mortgage loans, then replace the short-term interbank funding by issuing bonds. But now, firstly, there are no buyers for the bonds; and secondly, because the banks themselves need money to fund the loans they have made themselves and (remember) to back the standby facilities they have offered to conduits, borrowing in the interbank market has become very expensive. So Northern Rock is stuck with loans it cannot sell and cannot refinance efficiently.

    Posted by Matthew Bailey on September 19, 2007 10:16 AM

    Under his diagnosis the magnitude of this financing gap, as is timing of the recognition of the problem and the amount of time that elapsed between the two. For it is obvious that until 3 months ago Northern Rock wrote business at an accelerating rate, magnifying the risks in their financing.

    Second the issue under this diagnosis is one of the price of interbank financing not the availability, and possiby the avialibiity of the secondary market and its pricing.

    So the possibility remains that the whole problem arose NOT because of funding availibility but of PRICING. Meaning the BOE and others have intervened NOT to save the bank but to save its last quarter’s profitability and that THIS ACTION LED TO THE RUN.

    If this is so the only systemic risk was that NR woud have to sell a portion of its written business MORE CHEAPLY than expected and that other banks would pick up its market share as it was forced to write less business and take losses.

    Fireworks in the Committee!!!

  2. Anonymous

    Shock Therapy On Wall Street: What’s Next?
    by Danny Schechter

    New York, September 19: It was another week in which the debt crisis rolled over financial institutions worldwide and people’s lives like an out of control freight train. On Tuesday, the US stock market received a gift from the Federal Reserve Bank in the form a half percent interest rate, twice the amount most analysts expected.


    There is panic in high places. They know this crisis is far more serious than most of us realize, and that it will not address the sub-prime problem or bring relief to the millions facing foreclosures and a tighter economic noose around their necks.

    It will, say many financial wizards, lead to higher inflation which is a way of making our money worth less. The dollar’s status as a currency took another wack.
    One analyst quoted on page one in the New York Times called it “shock therapy,” the very term writer Naomi Klein explores in her new book on “disaster” capitalism showing the link between the shock therapy once doled out in mental hospitals, shock and awe bombing, shock interrogation techniques whose aim is to “disorient” prisoners and shock strategies used in economic policy that has devastated so many countries in which it was imposed.
    Now it has come home to the US-the country that has been exporting it overseas.

    On a recent Democracy Now show, Klein explained:

    “The history of the contemporary free market was written in shocks.”…. “Some of the most infamous human rights violations of the past thirty-five years, which have tended to be viewed as sadistic acts carried out by anti-democratic regimes, were in fact either committed with the deliberate intent of terrorizing the public or actively harnessed to prepare the ground for the introduction of radical free-market reforms.”

    The only difference here is that, so farm there have been no serious reforms proposed and the market is anything but free. With its interest cut, the Fed bails out and rewards the very institutions that were profiting on ill gain profits from predatory lending.

    In some countries, people are starting to stir. Americans remain too caught up in the primaries and the war on one end, and the new wave of OJ mania on the other to take action against the looting of their pocket books. We are becoming a shell-shocked nation.

    A Cheer For The People

    We saw customers at a credit-starved mortgage bank in London lining up in the streets to pull their money out and the Bank of England pumping money in just a day after warning others, in the name of “moral hazard” rules, not to bail out lenders.

    The Times of London carried a cheer by Libby Purves for those demanding their money arguing “salute the queuers for their nerve, patience and admirable impermeability to patronizing advice.

    For how dare the stuffed suits, financial and political (and indeed journalistic), use expressions like “Don’t panic” and “Keep calm”. The withdrawers are perfectly entitled to choose who looks after their lavishly pretaxed savings. Some of them actually need money right now – like the chap on the news who wanted to pay his builder – and others just prefer not to rely on an institution that goes begging to the “lender of last resort”.

    By their presence on the streets, most of it not at all panicky in demeanour, the queuers utter a resounding raspberry to the financial industry and its political masters. It is time someone did.

    (When Will Americans do something similar? One weak but promising shift in the political wind: Obama’s Speech on Wall Street on Monday.)

    “Extraordinary” Says The Economist

    The world’s top business magazine The Economist noted:

    A Century ago, the depth of a banking crisis was measured by the length of the queue outside banks. These days, financial panics are more likely to be played out through heavy selling in share, bond or currency markets than old-fashioned bank runs. That makes the sight on the morning of Friday September 14th of a queue of people waiting (patiently in most cases) to take their money out of Northern Rock, a wounded British mortgage bank, all the more extraordinary.

    Yes, folks, “extraordinary” is the word, as this crisis becomes frighteningly global.

    The People In The Know Know….

    Bankers know how bad it is. Here’s Jim Glassman of JP Morgan: ‘The credit-market storm is a far more dangerous thing that anything we’ve seen in memory.” More and more news reports are glum.

    Here’s the Sydney Morning Herad in Australia reporting on “How Bad Debt Infected the World.”:

    “The foreclosure butterfly flapped its wings in smalltown USA and the hurricane built and tore through world banking.”

    Here’s the Independent on Sunday drawing a parallel with the Great Crash of 1929:

    “In his classic work The Great Crash: 1929, J K Galbraith put the decline down to the bad distribution of income; the bad corporate structure; the bad banking structure; the dubious state of the foreign balance; and the poor state of economic intelligence. He might have been writing about George W Bush’s world rather than that of Herbert Hoover.”

    Remember: you can’t rely on what officials are saying to calm us. One financial website noted: “the time to panic is when officials say, “don’t panic.”

    Remember Andrew Mellon, Hoover’s Treasury Secretary who said famously: “I see nothing in the present situation that is either menacing or warrants pessimism.”

    The comment was made on 31 December 1929, just after the Wall Street crash and ahead of the Great Depression.

    No, I am not expecting or hoping for a depression. Who would? But the parallels are eerie, and I am not the only one making them.

    Will The Interest Rate Cut Help?

    On Tuesday, The Federal Reserve bank cut the interest rate for first time in four years, seeking, they said, to prevent a housing slump and turbulent markets from triggering recession.
    Bloomberg’s Financial News explained the Fed’s “dilemma:”

    While a quarter-point reduction in the federal funds rate may not be enough to bolster growth and investor confidence, a half-point cut might fan inflation and be perceived as giving in to pressure from Wall Street firms that made bad bets, especially in the market for securities backed by subprime mortgages.

    (NOTE: The cut was a half point deal. What do you think that means? ….Yup, the current crisis is scarier to them than future inflation which rich people can handle and yes, they did give in to pressure.)

    Bernanke and fellow policy makers “are really caught,” said Robert Eisenbeis, a former research director at the Fed’s bank in Atlanta who attended meetings of the rate-setting Federal Open Market Committee before retiring early this year. “The Fed needs to avoid the perception of bailing out the markets, lenders or borrowers.”’

    “Needs to avoid”?? Huh? No it doesn’t. It is not in the PR business and in the air cared not a whit about image, but at the same time, it is all a “perception game.” It looks like something good was done. It wasn’t.

    Look at what the experts were saying before the Fed overacted:

    The Wall Street Journal: “Too Much Hope May Be Pinned On Rate Cut”

    They say the rate cut “would offer little immediate help for the fundamental problems weighing on the country’s economy and financial markets.”

    The Economist: “In the short term, lower interest rates will not achieve all that much.”

    So why all the hype?

    Perhaps because symbolically this looks like the government is coming to the rescue. The cut will help stock sales, as it already has when the market soared. It will bail out bankers, but not the people who are suffering under the burden of debt and foreclosures.

    No one is talking about how to create economic inequality, lower prices, control gas and food cots and raise wages for working people. No one.

    I wonder why. “Don’t be naive, a friend said, the FED is not there to help us. It is run by bankers, for bankers. It’s part of the problem, not the solution.” True-but what will we do to help ourselves or is it already too late.

    That is shocking!


Comments are closed.