Tuesday, 18 September 2007

Northern Rock crisis - oh the irony!

The run on the bank continues, despite the Chancellor's intervention. Since Northern Rock went to the Bank of England for a loan last Thursday, their customers have been queuing up to withdraw their money, convinced that the bank is about to sink, and their life savings with it. So far, over £2bn worth of deposits have been withdrawn - that's getting on for 10% of the total holdings.

There was a snowball effect. The more Northern Rock savers closed their accounts, the higher the chances of the bank going under, and the greater the temptation for their remaining customers to pull out too. The initial panic, sparked off by news of the Bank of England loan, could have been a self-fulfilling prophecy.

By this morning, the panic had started to spread to other banks, too. Alliance & Leicester, Bradford & Bingley and Paragon have seen large chunks taken out of their market value.

Enter the Chancellor. Alistair Darling has tried to calm things down by promising to underwrite all £28bn of Northern Rock's deposits with Treasury funds. To put it into context, he's promising to write a cheque for three quarters of our entire defence budget, or enough money to scrap university tuition fees for the next twenty-five years. It remains to be seen whether or not the people queueing outside the branches will now decide to leave their money where it is.

The irony is this: the Bank of England's job, as a lender of last resort, is to keep confidence in the system. Banking is built on confidence, and by promising to give credit to banks when they hit a crisis, the Bank of England is able to reassure savers that their money is safe. Northern Rock customers ought to feel secure in the knowledge that if their bank hits cashflow trouble, there'll be a loan to bail them out. That loan, however, has been taken by the media and the public as a sign of imminent insolvency - and the resulting run on the bank has precipitated a problem far worse than the original liquidity trouble that made Northern Rock ask for the loan in the first place!

It isn't the Chancellor's job to guarantee the funds in struggling banks - it's the Bank of England's - and I feel that this move from Darling is a mistake. Clearly, there are problems with the way in which the "last resort" mechanism works, the way the public understand it, and the way it was reported. But Darling's decision doesn't help that mechanism - it undermines it further. And if the crisis spreads, the Treasury could find itself writing many more cheques, and much bigger ones.

The beauty of the "last resort" system, when it works properly, is that it's predictable. Under certain clearly pre-defined circumstances, the Bank of England will step in to protect people's savings. By contrast, the Chancellor's intervention is a one-off and arbitrary decision. That introduces an extra layer of uncertainty and unpredictability into the banking system, and does more harm than good. The government needs to make the current system work properly, rather than change the system in this off-the-cuff, reactionary way.


monsterravingloony said...

Jonny, I think we're talking about two kinds of confidence. The Bank of England's role as lender of last resort is about underpinning the complex continuum of transactions that maintain liquidity in financial markets. It is important for the institutions involved in those markets to understand the Bank's role and have confidence in it. The typical man in the street will have no inkling of those machinations, nor any need to know.

In that regard, nothing has changed.

There is the quite separate matter of a run on a specific institution caused by public misunderstanding. It reminded me a bit of the scene in Mary Poppins where the boy elected to spend his tuppence on feeding the birds in Trafalgar Square rather than investing in the bank where his father works, making a scene and sparking a panic. I don't think the Bank's role as lender of last resort would have been much help in that situation either.

Alistair Darling's announcement is nothing more than a public relations exercise, aimed squarely at the public, to calm nerves and disperse the queues outside bank branches. The financial institutions will see it as such, knowing full well that Northern Rock was solvent to begin with and the Government Guarantee is purely for show.

Jonny Wright said...

Loony, sorry but I don't agree.

Wikipedia has this to say in the article "Lender of Last Resort":

The lender of last resort serves to protect depositors, prevent widespread panic withdrawal, and otherwise avoid damage to the economy caused by the collapse of an institution.

I think my argument is reasonable in that context.

monsterravingloony said...

Far be it from me to argue with the "wisdom of the crowds" which validates everything in Wikipedia.

Shame the crowds lining up to withdraw their savings from branches of Northern Rock did not have the wisdom to delve into Wikipedia before getting into a panic. They might have realised they had nothing to worry about.


Tristan said...

Lender of last resort however encourages risky behaviour from banks.

It also has other wider economic repercussions - if the money comes from the tax payer we're all keeping businesses which should have gone bust afloat - encouraging even worse behaviour.
If its funded by creation of new money it will cause inflation - which goes directly against the Bank of England's job.