Bank on the Rocks?
I had to chuckle when I heard Will Hutton on Today this morning (you can listen to the interview here). Here was the leftish head of the Work Foundation making the same arguments about the need for the Bank to pump money into the financial system that I have been hearing from the uber-capitalists of the investment banks and the commercial banks for weeks.
The bankers want the cash from the Bank to ease the pain they are feeling from the injudicious way they invested their capital over the past few years. And, funnily enough, Hutton feels their pain too and thinks the Bank should have provided an analgesic weeks ago.
It’s is wrong of me to be flippant. There is an important debate to be had about the response of the Bank, the Financial Services Authority and the Treasury to the crisis in financial markets.
Simplifying slightly, the bankers and Hutton believe that some weeks ago all banks should have been allowed to borrow from the Bank of England more-or-less in the way that Northern Rock has been allowed to – and via a generalised special lending facility, rather than as an emergency loan to ward off imminent collapse.
What they argue is that if banks had been allowed to pledge all manner of assets of questionable value as collateral for Bank borrowing – Hutton mentioned the asset-backed commercial paper that no one wants to hold any longer – then there would have been enough liquidity or cash in the financial system to reverse the rise in market interest rates and also to encourage banks to lend to each other in the normal way.
Just possibly, Northern Rock would not then have faced a strike by the institutions that normally lend to it and would not have had to go cap-in-hand to the Bank.
That might be right. There is, for example, some evidence that conditions in the eurozone and US money-markets, where the central banks have been a bit freer with their injections of liquidity, have not been quite as tight as here.
Another possible argument against the way that the Bank used its lender-of-last resort powers to bail out Northern Rock is that the very act of saving it in this way also damaged it, possibly beyond repair. There is a huge stigma attached to requesting emergency funds in this way: Northern Rock was identified very publicly as a victim which therefore created the very anxiety among depositors that has led to the mass withdrawal of funds we’ve seen since Friday.
So the Bank may end up giving more financial help to replace the Rock’s lost deposits than it would have had to do if it had been less uptight up pumping cash into the banking system more widely and generously.
That’s the case against the Bank of England.
And I can understand why Hutton and the bankers are quite emotional about it: the pictures of those queues outside Northern Rock branches are quite shocking; they’re not really the sort of thing that ought to happen in one of the world’s largest and strongest economies.
There is however a powerful argument in the Bank of England’s favour.
The first is that the Northern Rock was an accident waiting to happen. It was far too dependent on the money markets to finance the growth in its lending. And if the Bank had pumped a ton of money into the system to allow Northern Rock to weather this particular storm unscathed, there is a significant risk that Northern Rock would have faced bigger, uglier and scarier problems in the months and years ahead.
The second is that if the Bank had allowed all the banks to dump asset-backed commercial paper and mortgage assets on it in return for loans priced at the base rate plus a bit, a mountain of dodgy assets might have ended up on its books – and with no certainty that normal service in the money markets would have resumed.
In the process, the investment banks and commercial banks would have learned a dangerous lesson, which is that so long as their foolish lending and trading is on a big enough scale, the Bank will rush in to prevent them suffering undue losses.
At least in the case of the Northern Rock bailout, the Bank knows there is an upper limit of how much cash it would have to pump in – which is probably around £20bn in the highly unlikely case that every retail depositor were to take out his or her last penny.
To be clear, I am not yet arguing that the Bank and FSA handled this crisis in an optimum way.
Much will depend on what happens to Northern Rock over the coming days – and also whether there is contagion in the form of a loss of depositors’ confidence in other lending banks.
Northern Rock’s woes are a bit worse than just a little local difficulty. But it is premature to say that the Bank of England’s conduct has turned a crisis into something a good deal worse.
UPDATE 17:15 According to well placed banking sources, this afternoon’s massive Alliance & Leicester share price fall does not reflect any run on the bank’s deposits, either by ordinary customers or by other banks and financial institutions.
Like all banks, A&L is suffering from the illiquidity of the inter-bank market, but is much less dependent on other banks and institutions for funding than Northern Rock.
A&L itself believes simply that it has been targeted by hedge funds looking to profit from identifying the next banking victim, which have been short-selling the stock.
It and other small banks – like Bradford & Bingley, whose shares are also down sharply, though not as much – will remain vulnerable to this kind of negative speculation unless and until the Bank of England succeeds in restoring confidence to wholesale money markets.