Wednesday, 24 August 2011

Lessons for GFC2 from GFC1

The other day I read the National Audit Office's analysis of the events in the run-up to the nationalisation of Northern Rock. For a Government publication it's surprisingly readable and I strongly recommend it.

You may think this is ancient history. After all, Northern Rock collapsed over four years ago now. But I think there are still lessons to be learned from this and changes that need to be made to the way the Treasury does things. We still have not devised a method of managing bank failure that does not leave ordinary people - bank customers and taxpayers - on the hook for debts incurred by irresponsible bank management. And the banking sector is still desperately fragile. We urgently need a satisfactory way of dealing with banking collapse.

Lesson no. 1: The importance of planning
Northern Rock was the first of the major bank bailouts in the United Kingdom. It is very evident from the NAO's report that neither the Treasury nor the Bank of England were remotely prepared for this. The Bank of England at that time had no facility for extending emergency funding to banks suffering from lack of liquidity - which was initially all that was affecting Northern Rock. It had to get explicit permission from the Treasury to lend the money.  And handling of the media was inept. Why on earth was the emergency loan disclosed to the public? They didn't need to know, and all it did was cause panic. The run on the bank was a direct consequence of the disclosure of that loan to the public.

Once the run on the bank began it was evident that the Treasury had no idea how to deal with it. Their kneejerk reaction was to guarantee all bank deposits - including, eventually, wholesale deposits that should NEVER be subject to taxpayer guarantee.  The NAO's report makes it clear that the Treasury were winging it throughout, making decisions on the fly. Yet it appears that both the Treasury and the Bank of England had in fact been modelling disaster scenarios and considering emergency measures during the 6 months before the run on Northern Rock. But they hadn't put any of those measures in place. The necessary legislation to provide a stable rescue procedure for failing banks wasn't put in place until February 2009.

The lack of disaster planning for a business sector as key to the economy as banking was, and is, in my view negligent. Even now, we only have a legislated procedure for failure of individual banks. We have no plan for dealing with catastrophic collapse of the entire banking sector. Yet that is almost certainly what we face.

Lesson no. 2: Claim on your insurance!

One thing that struck me in the NAO's report was the fact that the Treasury appears to have totally ignored the existence of the Financial Services Compensation Scheme (FSCS), which already protected most deposits up to £50,000 (now extended to £85,000). This scheme was set up to protect savers and depositors following the near-collapse of Lloyds of London in 2000. Why did the Treasury choose to guarantee deposits and nationalise Northern Rock instead of informing depositors about the existence of this scheme and allowing Northern Rock to go into administration so that they could claim? Even now, bank depositors don't seem to know about the existence of this scheme. Banks don't tell them, and neither does the Government. What on earth is the point of having deposit insurance if no-one knows about it?

FSCS rules do say that a company must have ceased to trade in order for compensation to be paid. And the timescale is not immediate. But Northern Rock was not a clearing bank, so there was no risk to essential payments. What on earth was the tearing hurry in making funds available to depositors?  And if there were people who would suffer from not having deposit account funds available to them for months, why couldn't emergency lines of credit for those individuals have been arranged with other banks to cover them for that period?  If anyone has an answer to this, please let me know. It looks like a glaring omission to me.

Lesson no. 3: Stop the rot

The nationalisation of Northern Rock, and its separation into "good bank" and "bad bank" didn't happen straight away. During the time between its initial request for emergency funding and its nationalisation, Northern Rock received several infusions of taxpayers' money. But it carried on making bad loans during that period. The NAO's figures for the performance of TOGETHER loans are damning. Why on earth was Northern Rock allowed to continue making these loans? In fact, why did it continue lending at all? Surely if a retail bank is in sufficient difficulty to require continual funding transfusions, the first thing to do must be to stop it lending. After all, the main reason it requires funding is to settle lending.

The other reason it requires funding is to settle deposit withdrawals. I have already commented about Northern Rock's inept handling of its request for emergency funding. But would someone please explain to me why it didn't simply close its doors when the run began? Any commercial organisation can shut up shop for a day or two if it wants to. Of course, there may be some legal restriction specifically for banks that means they don't have this option available to them. If there is then for goodness'sake get rid of it. Banks must be able to close their doors.

I know that both of these measures - temporary closure and cancelling new lending - would have caused a massive loss of consumer confidence. But if depositors want to remove their money they should be allowed to - and if the bank goes down as a consequence, well, tough, really. All the closure should do is buy time for funding to be provided to meet depositors' demands.  And Northern Rock's funding problems concealed a much deeper issue. It was very highly leveraged and a growing proportion of its assets were highly risky or actually in default. Why the FSA ever let it get into this state is a mystery, but allowing it to continue lending once this had come to light was ridiculous. Cancelling offers of new lending would have been tough for people trying to buy houses, but as a lot of this lending was to people who couldn't really afford it and for far more than houses were worth, it would have been better for them in the long run.

Lesson no. 4: Who is more important - depositors or taxpayers?

Once it became apparent that Northern Rock was not viable, the Treasury considered various options which are detailed in the report. The main driver behind the decision to nationalise appears to be the belief that depositors couldn't wait for their money. I've already commented on that above, so I won't address it again here. However, given that belief, the Treasury's analysis was reasonable and full nationalisation was indeed the best option for Northern Rock and its depositors. I question though whether it was the best option for taxpayers - and this question becomes even more serious when we look at the part nationalisations of RBS and Lloyds TSB.

For nationalised companies, the validity of the Treasury's assumptions about value to taxpayers depends on the market value of the company.  This is unrealised, of course, until the company is sold or floated. At present banking shares are taking a beating: both RBS and Lloyds TSB shares are trading at well below their nationalisation value. If sold now both banks would deliver a loss to taxpayers. Recently the Chancellor actually proposed selling the "good" part of Northern Rock - which is currently making a loss. There is no way that this sale in the current climate would generate any kind of decent return for taxpayers.  So at present the Treasury's assumptions about "best value" for taxpayers look very dodgy indeed. Nationalisation may prove to be a simply rotten deal for taxpayers.

Although the Treasury believed it was acting in the best interests of both depositors and taxpayers, therefore, in fact it placed the interests of depositors (and other creditors) ahead of the interests of taxpayers. This principle has applied in all the bailouts of banks worldwide. But is it reasonable? Should depositors (and other creditors) really be regarded as more important than taxpayers?

I don't think so. In fact I think this is a simply dreadful attitude. You see, taxes are paid by people who can't afford to save, as well as those who can. So in nationalising banks, the Government put the taxes paid by the poorest at risk. In effect, those who are too poor to save protected the savings of those who could afford to save.  Nationalisation of banks to protect depositors (and other creditors) is therefore an INCREDIBLY regressive action. I am astounded that anyone on the Left regards this as a good thing to do.

Lesson 5: What do we REALLY need to protect?

From everything I have seen and read so far, the nationalisations of Northern Rock and Bradford & Bingley were driven by a misguided belief that depositors must be protected at all costs. I don't agree with this, and therefore I believe these nationalisations were both unnecessary and harmful to taxpayers.

But in the case of Lloyds TSB and RBS, current accounts were also at risk - and these are the lifeblood of our economy. Just about everyone in society has a current account now, even the very poorest. These are the accounts from which essential bills are paid and food is bought, and into which wages are paid. If people can't access their current accounts, they suffer - and the poorest people suffer the most, since they seldom have funds in other accounts. Protection of these accounts is therefore essential. But that's no reason to protect deposit accounts as well.

The problem is that in the banking world, all forms of bank deposits including current accounts are "at risk". You may not think your wages are lent to the bank when they are paid into your current account, but they are. And banks can lose that money through risky activity - particularly excessive lending, which is what caused the failure of Northern Rock, Bradford & Bingley and HBOS (Lloyds TSB). I believe this is wrong. I think that current account balances should be regarded as in safe custody and not available to banks for lending or speculation. And it is sensible in my view for government to guarantee current account balances up to a reasonable limit. Obviously if banks can't use current account balances for lending or speculation they won't make any money on them, so there would be no interest paid on current accounts and there may be fees. But the interest paid on current accounts is pathetic, and we are already beginning to see fee-based current accounts anyway.

So current accounts should be protected. But interest-bearing deposit accounts are a different matter. The FSCS is effectively backstopped by the taxpayer, and has the additional problem that it is funded by a levy on all financial institutions, which means that "good" institutions end up bailing out "bad". I would rather people understood that money placed in interest-bearing accounts is AT RISK, not in safe custody. If they want their money to be safe, safe custody could be made available - for a fee, and no interest would be paid on it. If they want interest then they either need to accept the risk that they will lose their investment, or pay for insurance to protect it. I am sure that private sector insurers would be very happy to offer voluntary insurance to those prepared to pay a premium to protect their cash....with protection against mis-selling, of course. This is how I think deposit-taking should operate in the future.

However, we have a banking crisis approaching in which large amounts of very dodgy debt will put everyone's money at risk. It is all very well saying that ideally people should manage their own risks and abandon banks they regard as taking unacceptable risks with their money. But that's in the future. The present situation is that savers - of all kinds - need protection from the approaching crisis. FSCS is essential, with backstop and if necessary top-up from government. By using FSCS, with additional emergency credit and if necessary payments facilities from the Bank of England, we can ensure that PEOPLE are protected in the coming storm, not the banks that need to be allowed to fail. For that was what went wrong in the first financial crisis. Instead of compensating depositors directly, government supported failing banks such as Northern Rock.

 Lesson 6: What if it all goes pear shaped?

I don't know if the Treasury has done any planning for the possibility that the entire banking system may collapse. I hope it has. Because mass nationalisation of banks would be appalling for taxpayers. Not only would taxpayers end up owning a wonderful collection of zombie banks with no guarantee that they would ever come to life again, but they would also own all their assets. And if the banks collapse en masse due to, for example, sovereign debt defaults, quite a high proportion of these assets will be either highly risky or actually in default. Northern Rock on a simply gigantic scale.

There is a cautionary tale here. Ireland bailed out its entire banking sector when the property construction bubble burst. In so doing it bankrupted the country, destroyed the future of an entire generation and reduced its population to penury. It is now massively in debt and its banks are worthless. Do we want to go there? Surely not!

Let's develop plans NOW to allow all banks - including retail and clearing banks - to fail safely, while protecting taxpayers, current account holders and savers from the consequences. And let's work towards a more responsible attitude to lending by banks, creditors and depositors (who of course are also lenders). That way we may survive the coming banking crisis with our economy intact.

3 comments:

  1. I am immediately moving all my 'excess' savings into a current account, just in case someone takes you up on your suggestion!

    Does this also apply to ISAs, used instead of risky pension schemes (see Equitable Life and almost any unit-trust based pension) and abysmal annuities?

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  2. I never understood why Ireland and Iceland nationalised their banks when their banks' liabilities were greater than the annual GDP of the countries. Mind you, as you say, if we nationalised all our banks we'd have the same problem on a much larger scale.

    Good piece as usual Frances.

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  3. “We still have not devised a method of managing bank failure that does not leave ordinary people - bank customers and taxpayers - on the hook for debts incurred by irresponsible bank management.” I suggest that a “method” HAS BEEN devised.
    You’ll find it in the Positive Money / New Economics Foundation submission to the Independent Banking Commission. This “method” consists of the following.

    Those making deposits at banks are given a choice. First they can go for 100% safe deposits, in which case their money is deposited at the Bank of England and earns little or no interest. Second, they can let the bank lend their money on to borrowers – commercial loans, mortgages, etc. But in the latter case there is no compensation if the bank goes belly up.
    And that is fair enough. The current system offers 100% security on money which is lent to commerce, which is a subsidy of commerce. The latter constitutes a mis-allocation of resources.

    See: http://www.positivemoney.org.uk/wp-content/uploads/2010/11/NEF-Southampton-Positive-Money-ICB-Submission.pdf

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