For all the talk – including by me (see my earlier comment, Rock or Crock) – about how Northern Rock must surely soon find itself under new ownership, I have learned that it cannot be taken over by another bank in the absence of a major policy shift by the Bank of England.
Here is why.
Bankers tell me that Northern Rock spent a good deal of the summer exploring whether any big bank was prepared to acquire it lock, stock and online accounts. It had appointed the leading investment bank, Merrill Lynch, to sound out possible buyers.
There was, I am told, interest in a possible deal from substantial international banks.
But – and here’s the important point – the seizing up of interbank markets proved an insuperable obstacle.
No other bank wanted to take on the responsibility for financing Northern Rock’s total assets of more than £100bn at a time when it is very hard and very expensive to obtain funds from the money markets and banks.
So it was the realisation on the part of Northern Rock’s board last week that selling the bank had become impossible in current market conditions which actually persuaded the board to approach the Bank of England and ask for access to emergency loans.
Plainly, a takeover would have been a less humiliating option. But it just couldn’t be done.
Here’s the great banking Catch 22 of our time.
The Bank of England under its governor, Mervyn King, takes a very purist line to exercising its role as lender of last resort.
It is prepared to bail out a bank like Northern Rock to prevent serious damage to the banking system and the wider economy, although only on condition that the Financial Services Authority deems said cash-strapped bank to be solvent.
However in their words and deeds, King and the Bank of England have made it clear throughout the crisis in credit markets that they are not prepared to make good the losses of those they think have behaved imprudently or injudiciously.
Mervyn King wants to spank banks and other financial institutions, in the hope that they’ll learn from their mistakes.
He is obsessed with moral hazard, and understandably so.
So the emergency lending facility can be used by Northern Rock as an independent bank to stop it from falling over while its worried depositors remove their cash.
But it cannot be used to prevent holders of Northern Rock’s bonds or shares suffering losses that stem from their decision to invest in a bank whose basic business model turned out to flawed.
What follows from that?
Well, the Bank of England would remove the emergency lending facility more-or-less the moment it was taken over by a bigger bank.
If it didn’t do that, the Bank of England could be accused of subsidising the sale of Northern Rock and propping up the value of Northern Rock’s shares and bonds, which is the last thing it wants to do.
But, as Northern Rock found out when looking for a buyer this summer, no bank has the confidence to buy Northern Rock and attempt to refinance its balance sheet on the money markets in the normal way.
The world’s biggest banks are finding it challenging even to fund their own assets in our malfunctioning financial markets. And if they didn’t want to absorb Northern Rock’s very substantial balance sheet just a few days ago, they are going to be even less keen now, after so much cash has been withdrawn by anxious Northern Rock customers from their branch, postal and online accounts.
As I said, it is the banking Catch 22 of our time: Northern Rock can’t be sold without a guarantee of funding from the Bank of England, but the Bank is refusing to provide such funding to facilitate a sale.
Maybe some kind of compromise, transitional arrangements can be agreed.
The Bank cannot have enjoyed witnessing the damage being wreaked to Northern Rock’s reputation by all those images of anxious and irate customers queuing outside branches.
Northern Rock’s brand is being tainted, possibly beyond repair.
For all the confidence of the Financial Service Authority’s confidence that Northern Rock is solvent, its basic long term commercial viability is being eroded. At some point, what starts as a liquidity crisis risks becoming something worse.
So here is the choice that may confront the Bank of England and the Chancellor of the Exchequer soon.
They could choose to continue along the path they have taken. This could see them injecting many many billions of pounds into Northern Rock for an indefinite period. They would in effect be choosing to enter the mortgage business and Northern Rock would almost be nationalised.
Over time, Northern Rock would probably wither as a business, to the detriment of its many employees.
Or the Bank and Chancellor could grit their teeth, swallow their pride and allow public funds to facilitate a takeover.
I cannot predict which way they will jump. When I interviewed the Chancellor Alistair Darling yesterday, he evinced great confidence in the actions of the Bank.
That said, in all the turmoil and uncertainty, Northern Rock’s share price is probably still heading in a direction that will not amuse its shareholders.
UPDATE 12:15 Withdrawals from Northern Rock are now just under £2bn, following yesterday’s withdrawals. In fact this is a bit less than the authorities – the Financial Services Authority, Bank of England and Treasury – had expected. They had been braced for £2bn on Friday alone. However, they cannot be sure much more will be withdrawn in the coming days, especially from holders of Northern Rock’s postal accounts (there was almost £10bn in these accounts as of June 30).
One piece of good news is that there does not appear to have been a loss of confidence in other mortgage banks or building societies. Much of the money withdrawn by Northern Rock customers has been put into other mortgage banks and former building societies, such as Alliance & Leicester and Bradford & Bingley, as well as the bigger banks. Although the risk of contagion has not been eliminated, so far there is no great sign of it.
I have also learned that Northern Rock was close to selling itself to another big bank before it finally asked for support from the Bank of England. There were two banks very interested in acquiring Northern Rock. They did a detailed investigation of Northern Rock’s business and determined that it was fundamentally sound (as it happens, the FSA has to an extent relied on their investigations in its subsequent determination that Northern Rock is solvent).
However these potential bidders were concerned about doing such a big deal at a time when there is turmoil in money markets, when it is difficult and expensive to raise money from other banks and financial institutions. They therefore sought guarantees from the Bank of England that it would supply facilities to fund Northern Rock’s assets, in the event that money was impossible to obtain on the market.
The Bank refused to provide such guarantees. As I've said, it did not want to be seen to be bailing out Northern Rock’s shareholders and bondholders. It feels they need to feel the pain and suffer the losses of their mistake in backing a bank, Northern Rock, whose strategy was flawed.
So the bidders walked away. And the Bank decided on a simpler strategy of simply providing emergency loans to Northern Rock as an independent entity.
UPDATE 19:31 The Bank of England tells me that the emergency lending facility would in fact be transferred to any new owner of Northern Rock. However once the facility expires (and the Bank will not give me the expiry date) there is no guarantee it would be extended for the new owner. So most bidding banks will remain nervous about taking on a balance sheet of Northern Rock’s size with the risk hanging over it of needing to refinance a large chunk of loans from the Bank of England at short notice in markets which may remain frozen. So negotiating a takeover of Northern Rock will not be easy. Even so, I detect a desire on the part of the authorities to see Northern Rock under new ownership sooner rather than later, so long as the strictures of good central banking are not thrown out of the window.
UPDATE 21:30 Sorry, I forgot to mention that - as the Sunday Times says today - Lloyds TSB was the bank which came closest to buying Northern Rock, before the Bank of England agreed the emergency facility. Right now, Lloyds TSB is no longer interested in buying the bank, but that could change.