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Political Hazard

Cameron may struggle to make capital from Northern Rock

What can we say, after Labour Conference week, on the financial crisis that has engulfed Northern Rock? What we saw on Friday, September 14 was an old-fashioned run on a British bank. We have to go back to the 1800s to find the last such drop in confidence. Last month, the UK’s systems for regulating the financial system were severely tested. Yet the signs had been there for some weeks.

As a bank, Northern Rock borrows (often for three month periods) from other banks, money market funds and other financial institutions. Following the sub-prime mortgage crisis in the US, some European institutions were exposed because of the type of complex financial products they had traded in. These proved difficult or impossible to price accurately after the trade in them dried up. That meant many financial institutions could not determine the size of their exposure; if market confidence revived it could turn out to be relatively small but if things had changed permanently, the exposure to loss could have been much higher.

As a result, the interest rates on three-month loans climbed higher throughout August. Banks were reluctant to lend to each other, particularly to those banks that relied on the money markets. Northern Rock was exposed because its business model relied on larger scale borrowing than other mortgage banks. When it emerged that it had received support from the Bank of England, confidence collapsed. As customers withdrew their savings the government intervened to guarantee retail bank deposits. Later, the Bank agreed to relax its hardline stance and offered to lend money for three-month periods in exchange for mortgage securities.

The lessons we can learn are as follows:

Trust and risk are often overlooked factors in government policy

The financial system, indeed the whole market system, including the money we have in our pockets, relies on trust. A key role for government is to maintain confidence. In the past, one way governments undermined this confidence was to borrow excessively and encourage inflation, devaluing the currency. On this occasion there was a liquidity crisis and the responsibility to act rested with the Bank of England, the FSA, and the government. The episode also showed that we cannot always take risks without being exposed to financial loss. This is the case in the housing market, the financial markets, and even seemed to be the case for simple bank deposits until the government intervened.

Rules are essential but must not blind us to the realities of new situations

Most regulation is based on past crises and errors. This summer saw a new situation, with markets near to failure. The Bank obviously aimed to be clear in its approach but in retrospect appeared to have been inflexible with regard to the pressures banks faced.

Moral hazard should be avoided – unless it is better to risk that rather than significant loss of confidence now

It is generally accepted that if investors expect to be bailed out by the authorities, they will take more risks and therefore make it more likely that a crisis will occur. However, intervention is necessary on some occasions, as we have seen. The move by the Chancellor to guarantee retail deposits stemmed the flow of money from Northern Rock, thereby stabilising the situation.

Hindsight is overrated

When the problems began in financial markets, in August, it was not clear to those active in markets that the conditions would prevail for so long. There had been a drop in confidence but it appeared that action by the Federal Reserve and others might be sufficient to restore confidence, especially as people returned from summer holidays. However by the end of August it was apparent the situation was more serious and might affect the wider economy. The Fed cut interest rates by half a point in mid September. Following the emergency Northern Rock funding, we are now reading accounts of how it was obvious that new bank business models were riskier and should have been avoided. Some did make the correct call. But few if any predicted the US-led financial turmoil that we have seen.

In a financial crisis, political manoeuvre is limited

David Cameron found that making political comments in the midst of a financial crisis can rebound. Only an established long-term record – like Labour’s on prudent finance – will really reap political rewards.

Economic policy that provides a stable economic environment is essential

Any sign that government commitment to sound finance is slipping runs the risk of exacerbating a financial crisis. Equally, the Northern Rock episode showed that even advanced financial markets rely on institutions in society to function properly. Markets do not simply require a legal framework to operate but constant vigilance by government and, history shows, often rely upon government intervention to keep operating.

The challenge now is to monitor the ‘real’ economy for any impact the financial turmoil may have had on the confidence of companies and consumers.

This article previously appeared on the Progress Online web site.
Stephen Beer, Monday 1 October 2007
Progress 1 October 2007, 20/10/2007

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