Rocky Road Ahead

Philip Booth on the Northern Rock Crisis in the Yorkshire Post

The problems at Northern Rock are still making the headlines several days after the Bank of England stepped in to lend to the troubled bank. Queues of people are forming outside the bank to withdraw their deposits. At the time of writing about £2bn had already been withdrawn, although to put this in context it only represents about 2% of the value of Northern Rock’s mortgage book. In an extraordinary attack by David Cameron, even the government is being blamed for the crisis.

Such party political interventions by politicians do nothing to alleviate one notable aspect of this crisis: the fact that nobody believes the politicians. The Chancellor of the Exchequer and others have told depositors that they have nothing to worry about. They are broadly correct. Even if Northern Rock were to have serious, structural solvency problems customers’ losses would be limited by the deposit insurance scheme to which all banks have to subscribe. Yet the more the politicians reassure depositors, the more depositors ignore the politicians! It is a warning to those who respond to crises by proposing more and more regulation in financial affairs by politicians that trust in politicians is probably rather lower than trust in banks.

How did this all happen? Northern Rock is well known for providing mortgages at high multiples of income and at a very high proportion of a property’s value. They funded such mortgages, many of which were tied to the Bank of England’s lending rate, by borrowing funds at an interest rate which can, and did, rise significantly above the Bank of England’s rate in times of financial turmoil.

In my view, with one or two caveats that I shall mention later, this problem has been dealt with correctly from the point of view of policymakers and regulators. But what about Northern Rock? It is not for me to comment on its business model. As long as appropriate, risk-adjusted rates of interest are charged, it is not unreasonable for a bank to lend high multiples of salary or high percentages of property values. Like many critics, I have a distaste for spending too much beyond my income. But, unlike other critics, I recognise that one cannot make judgements from an ivory tower about the borrowing needs of people who need to get onto the property ladder or who are trying to sort out their financial affairs after a separation or divorce. The important thing is that those who make the decisions bear the cost when things go wrong. There should be no bail out of borrowers; there should be no bail out of shareholders; and any assistance given to savers must be strictly limited to the terms of the statutory deposit insurance scheme. Any assistance given by the Bank of England should be at least at commercial rates of interest and the Bank of England must have first call on Northern Rock’s assets.

We cannot have a trouble-free financial system, but we should not turn a drama into a crisis. In fact, this crisis has been generally well handled so far. No doubt, the Bank of England will wish to review, in retrospect, whether its actions have been entirely consistent as the problems in the money markets have developed. It may also wish to review whether it should simply have allowed Northern Rock to go to the wall. However, we should not react with more calls for regulation and government enquiries. This is what happened in the pensions industry. From Maxwell onwards, every little blip in the pensions system was followed by regulatory action. The result has been a private pensions system that was the envy of Europe turning into a fiasco. What should happen is exactly what happened when some building societies lost money in the early 1990s. Banks should reassess their business models, the level of interest rates they charge for different levels of risk and review how they fund their lending. Some will change the way they do things – a case of once bitten twice shy. That is how markets work. Businesses make mistakes, everybody learns from them and those with the best practices survive.

We may not be at the end of the problems in the financial markets yet. Indeed, it is difficult to see precisely how the problems at Northern Rock will end. I fear particularly for those organisations with complex balance sheets. There may be some rocky times ahead. But the best way to guarantee reasonable calmness in financial markets is for regulators and politicians not to over-react and to ensure that those who take decisions bear the cost of those decisions: however uncomfortable that might be in the short term. Politicians should keep their mouths shut unless they have something useful to say.

Author's note: this article was written hours before the government bail out. The author still believes that, even though the bail out has averted this particular panic, it is wrong to use taxpayers' money to assist depositors beyond the terms of the deposit insurance scheme. Inevitably, this will lead to more moral hazard, more regulation and, in the long run, more expensive mortgage rates.