Tuesday, September 18, 2007

The final indignity

The Chancellor of the Exchequer Mr. Alistair Darling has guaranteed all of the deposits of Northern Rock. If the aim is financial stability, this makes no sense. Northern Rock had already been given an uncapped and open-ended credit line (‘Liquidity Support Facility’) at the Bank of England. Even if its depositors decided to withdraw all £24 bn worth of deposits Northern Rock held at the beginning of the crisis, it could simply have substituted Bank of England credit for the vanished deposits. The same holds for the threat of contagion to other banks. By making the same Liquidity Support Facility available to all solvent but illiquid banks, the Bank of England, the FSA and the Treasury could ensure that the UK banking system would continue to function even if all depositors ‘did a runner’.

As regards the preservation of financial stability and the health of the UK banking sector, the existence of the Lender of Last Resort Facility makes deposit insurance or other forms of deposit guarantees redundant. Even a run on the banks that drains the system of all its deposits will not force the hasty liquidation of illiquid bank assets.

Consider a system with a well-designed discount window, like the ECB’s Marginal Lending Facility or the Fed’s Primary discount window. Such a discount window accepts a wide range of collateral, including private assets, asset backed securities and illiquid assets, including non-marketable assets like pools of mortgages. It also provides credit for longer maturities than overnight (the Fed’s Primary discount window now can lend for up to one month). With such a well-designed discount window, accessible to all banks on demand, at a penalty rate over the official policy rate and against fairly valued collateral (and subject to an appropriate haircut on that valuation), the Liquidity Support Facility created for Northern Rock would have been redundant. The ECB would be wise, though, to extend its set of assets eligible as collateral to assets rated below the A category, including assets below investment grade (‘junk’). Northern Rock’s Liquidity Support Facility is what the Bank of England’s Standing (collateralised) lending facility should have been, and probably will become before long.

Until the UK’s Standing lending facility extends its list of eligible collateral and lends at longer maturities than it does now, I would encourage every UK bank to set up a subsidiary in the US and in the Euro Area, to be able to take advantage of the more generous definition of eligible collateral at the discount windows there, and the longer maturities.

Indeed, at the Fed’s Primary discount windows the list of eligible counterparties is, in principle, not restricted to banks. If the Board of Governors of the Federal Reserve System determines that there are “unusual and exigent circumstances” and at least five out of seven governors vote to authorize lending under Section 13(3) of the Federal Reserve Act, the Federal Reserve can discount for individuals, partnerships and corporations “notes, drafts and bills of exchange … indorsed or otherwise secured to the satisfaction of the Federal Reserve bank…”. This means that, should it decide to do so, the Fed can accepts cats and dogs as collateral at its discount window, and from any US-based individual, partnership or corporate entity. I would hurry to register my UK-based or Eurozone-based SIV or conduit in the US, to take advantage of this unique (discount) window of opportunity for liquifying the illiquid.

So if the chancellor’s decision to provide blanket cover for all UK deposit holders, free at the point of delivery but at a potential cost to the tax payer, was not about financial stability and safeguarding the UK banking system, what was it about?

It was about three things – two bad reasons for this intervention and one good one, in indeterminate proportions. (1) Protecting depositors for its own sake, that is, without any material benefit as regards financial stability; (2) Covering political posteriors; (3) Preserving consumer confidence and minimising the risk of recession.

The chancellor decided that the 100 percent guarantee for deposits up to £2,000 and the 90 percent guarantee for the next £33,000 worth of deposits provided by the Financial Services Compensation Scheme (that is £31,700 per person) was not enough. (Note that, even as unsecured creditors, the depositors holding deposits over the £35,000 FSCS limit could have expected to receive back something for their ‘uninsured’ deposits in the even of insolvency and liquidation of the bank).

As distributive justice, the chancellor’s blanket extension of the deposit guarantee seems bizarre. There are many persons in the UK that are much poorer than the depositors who will benefit from the chancellor’s largesse. Is it now the job of the state not just to prevent poverty, but to compensate for any decline in a person’s standard of living, or even to intervene whenever a person’s standard of living falls below the level (s)he hoped for or anticipated? I sense a deeply moralistic distinction being made between the undeserving poor (those who have no savings) and the deserving not-so-poor who have savings. We will compensate the bees but not the crickets. The deposit guarantee of course also benefits shareholders, but this is unlikely to have been a major consideration, as there were no long queues of shareholders outside the stock exchange, trying to dump their shares.

There is a ‘fixed cost of monitoring financial institutions’ efficiency argument for providing limited deposit insurance. Clearly, it makes no sense for everybody who has a deposit account with an average balance of a few thousand pounds or less to do extensive due diligence on the solvency and liquidity of the institution. Such information is a public good (it is ‘non-rival’) once it has been acquired by anyone; however, it is hard to disseminate. So it makes sense that not every small account holder goes through the cost and effort of verifying the safety of his account. The current FSCS limit of £35,000 seems quite adequate for the purpose of making sure that resources are not wasted doing due diligence for small accounts. Anyone holding more than £35,000 in a single bank account deserves to lose it if (s)he does not bother to find out whether the institution is safe.

As regard the covering of posteriors, it is clearly not an election winner to have the opposition in a position to put up posters picturing long queues outside some bank or building society, of people desperate to get their money out. The fact that depositors simply did not believe/trust the troika of the chancellor, governor and chair of the FSA to safeguard their money, even after they set up the Liquidity Support Facility, is deeply embarrassing for all members of the troika.

For the FSA, on whose regulatory watch Northern Rock and other mortgage lenders began to access the wholesale markets as a source of funding, and which did nothing to prevent the excesses that began to crop up in the mortgage contracts on offer (up to 125% loan-to-value ratios; loans up to six times annual household income etc.), the visibility of a bank run is a deeply embarrassing event even if, because of the Liquidity Support Facility, it does not threaten the viability of any bank. The Bank of England is, of course, not responsible for the regulatory and supervisory failings of the FSA. It has some responsibility, as an advisor to the government, for present and past chancellors’ failures to create a proper legislative and regulatory environment for the banking sector. Inevitably also, it will take a credibility hit, however unfairly, because ‘its’ Liquidity Support Facility did not suffice to stop the run on Northern Rock.

Maintaining confidence, especially consumer confidence, is the one good reason for the chancellor’s decision. People get scared when they see 1930s style queues outside banks of depositors wanting to put their money under the mattress rather than keeping it in the bank. This is the stuff of banana republics and countries in the early stages of transition, not what you expect to see in the country that hosts the financial capital of the world.

Some slowdown in consumer demand would be a good thing. A panic-and-fear-induced collapse of consumer demand (more than 60% of final demand) could cause a recession.

So the chancellor’s decision to guarantee all Northern Rock depositors (and by implication to guarantee all deposits in all UK banks and building societies) was motivated by (1) the political desire to pander to depositors, (2) political posterior covering and (3) the desire to prevent a collapse of consumer confidence and consumer demand. It would be interesting to know the weights attached to these three motives in reaching the decision.

Finally, by effectively granting 100 percent deposit insurance free of charge to all depositors in the UK, the UK banking system has been de-facto socialised to a significant extent. It would have been much cleaner to have used the US approach to this kind of problem. In the US, the Federal Deposit Insurance Corporation could have taken into full public ownership a bank in a position similar to Northern rock, and could have done so overnight. It would have re-opened immediately for existing business commitments and activities.

Once markets had become orderly again, and the value of the bank's assets and liabilities had been established with some degree of confidence, the bank could have been privatised again as a going concern, sold to another bank or broken up and sold in bits an pieces. Unsecured creditors, including depositors with deposits above the deposit insurance limit (who in the US have priority over other unsecured creditors), would have to see how much the re-privatisation of the bank or the sale of its assets would yield. The old management would not be expected to play a role under public ownership. The former shareholders might get something back if the re-privatisation more than covered the cost of the operation, after all the other creditors had been paid.

Such a temporary transfer into full public ownership, which should be part of the competencies of the FSA, would be socialism in support of the market. It presents a sharp contrast with the chancellor's socialism for the (richer) depositors and for the shareholders of Banks at risk of a run.


Anonymous said...

The whole situation springs from the questionable justification for the credit line in the first place.

I fail to see how net borrowers confidence would collapse because of pictures of depositors actions. No as long as they can access their credit they will continue borrowing to spend. In fact sensing the end of their spree the sight of queues might spur them to have a last fling. Consumer confidence has nothing to do with it. The condition of the equity markets on the other hand. Ahh much dearer to my heart!

Anonymous said...

We still do not know the exact mechanics of the Northern Rock episode and unfortunately it appears no one wants to dig. the run the action precipitated has cme to justify the action. 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 but they plainly need a push. Derek Wanless was director responsible for risk oversight and contacting the authorities. The company is still planning a dividend payout.

Matthew Bailey a blogger diagnoses the funding origins of the crisis. These have important implications

"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, and the timing of the recognition of the problem and the amount of time that elapsed between the two are key. For it is obvious that until 3 months ago Northern Rock wrote business at an accelerated rate, magnifying the risks in their financing. Northern Rock then say they secured the BOE credit line for future use. This gives a clue to the potential funding gap. Northern Rock sold 470m pounds of mortgages to Lehman on August 20th. So we begin to get some idea of the amount of mortgages IF ANY.. not funded.

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

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

If this is so the only systemic risk around was that NR would 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!!!

DorsetDipper said...

Prof, this article clearly demonstrates why you are a Professor of Economics not Chancellor of the Exchequer.

Your approach to depositors requires them to have the ability to assess the risk of financial institutions, something most people are not qualified to do.

Instead, collectively we pay our taxes and elect MP's to act on our behalf, in this instance to regulate banks and building societies so our deposits are safe. To argue that in fact £32,000 is the limit of efficient regulation is simply not acceptable, and as a good Labour Chancellor Darling has instinctively grasped this. I will guess that as a consequence of this episode the insured limit will increase, regulation will be tighter, and heads will roll at NR.

Finally, i think you are confusing socialism with welfarism. The socialist creed was born when Britain was a class-bound restrictive society and people's prospects were determined by their social status at birth. Clearly much has changed since then, and I don't think you'll find many socialists who think that individuals who have accummulated wealth as a direct result of their own efforts should be denied the fruits of their labours by a failure of regulation.

Eric Rasmusen said...

The relevant limit is really the 2000 pounds, not the 32,000 pounds. If you can avoid a 10% tax on your investment by waiting a couple hours in line to take it out for a week, you'll do it. And 2000 pounds is pathetically low. No wonder there was a run. I'm surprised it hadn't happened earlier.

Are you saying that the Bank of England line of credit solves the problem because runs would still occur, but runs aren't a problem if Northern Rock can survive on BE money? That position needs fleshing out. It seems to me, too, that the BE credit line will make runs much worse, because it reduces the assets available to general creditors such as depositors in case of bankruptcy. If Northern Rock did turn out to be insolvent in the end, the effect of the BE line of credit would be that the BE would foreclose on all the bank's assets, which would have been used as collateral, leaving zero for the depositors. Am I missing something?