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Northern Rock and moral hazard

The rocket scientists led to the first run on a British bank in 100 years.

Banks attract the brightest talents and employ them to the full.  In the City they are referred to as ‘rocket scientists’.  Therefore we should not be surprised that banks regularly find new and exciting ways to run into trouble.  No crisis is like the last for banks and regulators are similar to stereotypical generals, always fighting the last war.  Yet, like architects of military defeats, failing banks have usually forgotten longer term lessons of history.  Such was the case with Northern Rock.

Queues of customers outside Northern Rock branches seemed to echo different times and CBI Director General Richard Lambert even declaimed that the scenes mirrored those we might find in a ‘banana republic’.  Ignoring the insult to the many developing countries not experiencing runs on their banks, we can say that financial markets do seem to be on unfamiliar territory.

Emergency funding for Northern Rock and government intervention to protect depositors has not ended the credit crunch in markets.  Confidence has not been totally restored.

In addition to measures to protect Northern Rock, the crisis in credit markets prompted the Bank of England to change policy and adopt a more flexible approach to injecting money into the markets.  This has raised the question of whether such a bail-out of markets has increased the probability of moral hazard occurring.  In other words, has the Bank’s action made more Northern Rocks possible?

What went wrong

The money markets have been afflicted with a crisis of confidence since the beginning of August.  Sub prime mortgages in the United States had begun to go sour as borrowers began defaulting.  The US mortgage market had been carried away, with loans made to people who were unable to keep up payments.  Many were hit by penal rates of interest.  The US faces a serious social justice issue as a result, since people on low incomes have been further impoverished.  This is a big challenge facing the Democrat-run Congress and the next President.

The payment streams from sub prime mortgages had been packaged up and sold on as financial securities around the world.  Derivatives (complex financial instruments linked to an underlying asset such as a bond or share) were constructed around them.  As the sub prime market suffered, the effect was multiplied by borrowing.  Banks in Europe discovered they had commitments to make payments on behalf of off-balance sheet vehicles they had developed linked to the sub prime crisis.  The problem was that they could not easily work out their exposure, since there was suddenly no trade in the derivatives these vehicles held.

Confidence dropped in the money markets (the markets for short term loans).  Banks, worried about their own exposure (and unable to quantify it properly) became reluctant to lend to each other, fearing other banks may be worse off.  Debt markets froze.  The banks kept high levels of cash to themselves.  The interest rates for lending money over night and for three months rose considerably, to counter any risk of a bank having problems.

While most mortgage banks take deposits from savers and lend off that foundation, most Northern Rock loans worked differently.  Northern Rock borrowed money in the money markets, lent it to homeowners, and sold the resulting mortgage payment streams as bonds to financial institutions.  Unlike the US sub prime lenders, Northern Rock did not have a problem with its mortgage holders.  They continued to make their payments as normal.  However, with the money markets charging high interest rates for borrowing, Northern Rock’s profit margins were squeezed.  Finally, when no one would lend money to Northern Rock it had to approach the Bank of England for emergency funding through a well-established mechanism.

Unfortunately, as news emerged that Northern Rock was seeking funding, a panic ensued and savers rushed to withdraw their money.  So began an old-fashioned run on a bank as people concluded their savings were at risk.  Northern Rock had been hit not by mortgage holders defaulting but by a dramatic drop in liquidity, to which it was especially exposed.  Historians have had to go back to 1866 and the collapse of Overend, Gurney and Co for the last UK bank run, though they have occurred elsewhere in the world in more recent times. 

Moral hazards?

When Chancellor of the Exchequer Alistair Darling acted to guarantee deposits he stemmed the run on Northern Rock.  The existing deposit insurance scheme had only guaranteed 100% of the first £2,000 and 90% of the next £33,000.  This provided some essential breathing space.  The Chancellor, Alistair Darling, who was instrumental in calming the situation initially, has now announced plans for all bank deposits to be guaranteed up to £100,000.  There is some moral hazard risk here because savers may look less at the quality of the banks they save with, resting in the knowledge the government will rescue them and thereby increasing the costs of such a rescue.  The government probably has to take this risk but may want to offset it with stricter regulation.

A potential moral hazard arose from the Bank’s actions.  The Bank of England had been strict in only providing emergency funding overnight and at 1% above the bank rate of 5.75%.  Bank governor Mervyn King believed that injecting money in at lower rates encouraged banks to be reckless because they would rely on being bailed out.  In this he disagreed with his counterparts at the US Federal Reserve and the European Central Bank, who had been pumping money into the system during the summer.  Mr King worried about moral hazard.  However, as other banks began to suffer, the Bank of England changed policy and announced it would lend money for three month periods, again at 1% above base rate but in exchange for mortgage securities.  No bank asked for such a loan during the initial offer, perhaps because of the stigma attached to borrowing from the Bank of England.  The announcement however helped ease the pressure in money markets.

Has the Bank increased the risk of these troubles repeating themselves?  A little maybe, but the banks will not wish to make the same mistakes for some time at least.  The large losses announced by Citigroup and UBS demonstrate that banks worldwide are paying for their earlier enthusiasms.
Of more significance perhaps was the sense of indecision, before the policy change, coming from the tripartite regulatory system of the Bank, the Financial Services Authority, and the Treasury.


While we must guard against moral hazard, the intervention was not unique.  Most financial crises end with intervention from authorities to restore confidence and limit losses.  Bankers who would protest at government subsidies to industry have no qualms about demanding government support when they get into trouble.  Financial markets, which appear more than any others to resemble economic models of perfect competition, in fact require state support and intervention.    While moral hazard must be prevented, this laudable aim must not prevent intervention where necessary otherwise the impact on the wider economy and peoples livelihoods could be severe.

The economic ramifications of the credit crunch are not yet clear.  There could be an impact on consumer confidence, companies may find borrowing more expensive, and City activity may slow.  This could translate into slower economic growth, and lower tax revenue, which would limit spending plans.  The UK economy remains comparatively robust however.  The conditions of economic stability so hard won by Labour should enable our economy to weather a credit crunch better than in previous decades.  Predictions of gloom following the Asian currency crisis in the late 1990s did not come to pass, for example.  Still, while May 2008 has appeared to be an attractive date for a general election, economic conditions next year now appear much harder to predict.  Gordon Brown alone has had to judge election prospects in the light of that known unknown.

This article previously appeared in Tribune magazine.
Stephen Beer, October 2007
Tribune October 2007, 01/10/2007

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