“…the moral hazard inherent in the provision of ex post insurance to institutions that have engaged in risky or reckless lending is no abstract concept”.
On September 13, 2007, we received the announcement that the Bank of England, as part of a joint action by HM Treasury, the Bank of England and the Financial Services Authority (according to the Memorandum of Understanding between these three parties), had bailed out Northern Rock, a specialist mortgage lender, by providing it with a short-term credit line. Without this, Northern Rock, which funds itself mainly in the wholesale markets, would not have been able to meet its financial obligations.
It will be interesting to see how this reported credit line is secured, or how any draw-downs of this credit line are collateralised. If Northern Rock had sufficient collateral eligible for rediscounting at the Bank of England’s Standing (collateralised) Lending Facility, it presumably would have done so, rather than invoking this emergency procedure involving the Bank, the FSA and the Treasury. Collateral eligible for rediscounting at the Standing Lending Facility consists of sterling and euro-denominated instruments issued by UK and other European Economic Area central governments, central banks and major international institutions rated at least Aa3 (and, exceptionally, US Treasury bonds). Such assets are said to be scarce on the balance sheet of Northern Rock. The severity of the penalty rate (relative to the policy rate of 5.75%) charged Northern Rock will also be important in determining the long-term damage to financial stability caused by this operation.
The Bank’s September 12 Paper recognises conditions when this kind of bail out is justified:
“…, central banks, in their traditional lender of last resort (LOLR) role, can lend “Against good collateral at a penalty rate” to any individual bank facing temporary liquidity problems, but that is otherwise regarded as solvent. The rationale would be that the failure of such a bank would lead to serious economic damage, including to the customers of the bank. The moral hazard of an increase in risk-taking resulting from the provision of LOLR lending is reduced by making liquidity available only at a penalty rate. Such operations in this country are covered by the tripartite arrangements set out in the MOU between the Treasury, Financial Services Authority and the Bank of
. Because they are made to individual institutions, they are flexible with respect to type of collateral and term of the facility”. England
The MOU states in paragraph 14:
14. In exceptional circumstances, there may be a need for an operation which goes beyond the Bank’s published framework for operations in the money market. Such a support operation is expected to happen very rarely and would normally only be undertaken in the case of a genuine threat to the stability of the financial system to avoid a serious disturbance to the
It is clear that the conditions for a justifiable bail out, as specified in the MOU and reiterated in the Bank’s September 12 Paper, were not satisfied.
First, it is by no means obvious that Northern Rock (total assets £113 bn as of
Second, it is hard to argue that the survival of Northern Rock is necessary to avoid a genuine threat to the stability of the
No doubt its depositors (of which there are rather too few) are covered by the Financial Services Compensation Scheme to the tune of £31,700 per person (100% of the first £2,000 and 90% of the next £33,000). If most of its mortgage assets are good (albeit unprofitable, given Northern Rock’s funding costs), they will find willing buyers among the remaining viable mortgage lenders. Northern Rock’s shareholders would, of course, lose everything and the remaining creditors (including depositors with balances in excess of the deposit insurance limit) would have to wait to see how much the realisation of the assets generates. Top management would lose its jobs. All this is as it should be. What would happen to staff below the strategic decision-making levels would depend on which parts of the business remain viable after the financial restructuring following the insolvency.
Following the bail out of Northern Rock, I can only conclude that the Bank of England is a paper tiger. It talks the ‘no bail out’ talk, but it does not walk the talk. It does not matter whether the decision to bail out Northern Rock was initiated and/or actively supported by the Bank, or whether the Bank was bullied into it by the Treasury and the FSA. Moral hazard has received a boost in the