Lender of Last Resort

by Scott B. Wilson October 16 2007, 23:33

     The New York Times headlines exclaimed, "Terrible and Disastrous Financial Panic in London...Lombard Street Blockaded by a Tumultous and terror Stricken Mob...The Panic without Parellel in the Financial History of England..."[1] Meanwhile, on the streets of London, what began as a slow trickle of people gushed into a torrent pouring on to the streets in order to line up outside the reputable bank. Hours earlier, the aforesaid bank had posted a notice on its premises that attracted some attention, "We regret to announce that a severe run on our deposits and resources has compelled us to suspend payment, the course being considereed under advice the best calculated to protect the interest of all parties..."[2] The crowds' focus was not just limited to the ailing bank, "the tumult became a rout...The doors of the most respectable banking houses were besieged and throngs heaving and tumbling about Lombard Street made that narrow thoroughfare impossible."[3] Even outside of the City "country bankers found their halls besieged by anxious depositors trying to withdraw money and begged their London agents to send them gold and cash."[4]

     In order to clear Lombard from the clamoring crowds, the Lord Mayor was forced to call in a platoon of police.[5] News of the panic spread throughout the countryside and the bank crisis precipitated the closing of merchants' shops and freezing of banks and discount houses.[6] The reputable bank at mention was known as "the greatest instrument of credit in the Kingdom", virtually by perception unshakable.[7] Its holdings and financial influence were immense, second only to the Bank of England.[8] Aside from the odd mention of gold reserves, you might have concluded that such were the events resulting from the recent bank run on the British lender Northern Rock PLC. In fact, the aforementioned events are cumulatively known as "Black Friday" and occurred on May 10, 1866 when the well known bank Overlend & Gurney could not cover its payments, collapsed, and nearly brought down the entire British financial system. Prior to September 14, 2007, it was the last bank run on a British bank in over 140 years. This article will briefly restate the events leading up and subsequent to the September 14th bank run on Northern Rock as well as discuss the laws and policy at work.

     On September 14, 2007, Northern Rock issued an official statement announcing the "extreme conditions" have led to it seeking a line of credit from the Bank of England, the U.K.'s central bank and "lender of last resort."[9] Upon learning that the lender Northern Rock may need a bailout from the Bank of England, customers including pensioners and others who had deposited their life savings in the bank lined up outside branches in Newcastle and throughout the United Kingdom. At on Newcastle branch, bank staff attempted to reassure customers by even asking for deposits, yet the announcement was met with predictable bursts of laughter from the queues of patient customers.[10] Other customers inquiring into their accounts and financial statements using the Internet were blocked from logging into the website.[11] In the course of the day, Northern Rock's shares plummeted 31%, knocking £846.7 million off its market value.[12] Customers withdrew in a matter of days about 4% (£1 billion) of the bank's more than £25 billion of deposits.[13]

     Prior to its financial crisis, Northern Rock was the U.K.'s fifth-largest mortgage lender.[14] In fact, less than two months prior to the September crisis, Northern Rock reported its business outlook as "very positive."[15] Contrary to many major banks worldwide currently suffering under the subprime mortgage milieu, Northern Rock primarily lent to borrowers with good credit.[16] Two parts of the bank's business model, however, created substantial risk that led to its eventual financial demise. First, Northern Rock relied more heavily than other U.K. lenders on investors in its securitized mortgages, who of late have become risk-averse as a result of the U.S. subprime loan crisis.[17] Second, and perhaps more critical to its demise, Northern Rock depended heavily on short-term loans from other financial institutions, as opposed to relying primarily on customer deposits.[18] In fact, according to analysts, Northern Rock's borrowings from other banks exceed customer deposits "by more than three times."[19] This compared with other U.K. lenders whose ratios average around one and one-half and were projected to face funding shortages.[20]

     What happened in turn was that once the money markets dried up and banks became unwilling to lend to one another for periods longer than overnight, Northern Rock was faced with borrowing ever-larger amounts amidst its inability to cover its own outstanding debts.[21] In early September, Northern Rock began talks with the Bank of England in lieu of its dire funding needs.[22] On September 13th, the BBC reported[23] that the Bank of England had promised Northern Rock emergency financial support, and the very next day Northern's CEO Adam Applegarth was forced to admit as to its holdings, "There are no funds available...It's an astonishing thing to see."[24] As word of the bank's sorry state spread, the Financial Services Authority (FSA), Britain's financial regulator, attempted to reassure the public, "If we believed Northern Rock was not solvent, we would not have allowed it to remain open for business."[25] Nevertheless, customers continued to withdraw their deposits while shareholders dumped their securities, so by Tuesday September 18th, the share price had plunged an additional 35%.[26]

     Beginning in 1997 with the then Chancellor of the Exchequer, Gordon Brown, the U.K. stripped regulatory authority from the Bank of England and went to a three-tier system.[27] This system divided responsibility between the Bank of England, which primarily ensures the stability of the monetary system by setting interest rates; the FSA, two of its main duties being the "prudential supervision of banks"...and the "conduct of operations in response to problem cases" outside the Bank's role; and the Treasury, which is responsible for the "overall institutional structure of financial regulation."[28] Within this system both the FSA and Bank of England gather distinct information about the financial system and are expected to freely exchange such information with each other.[29] In crisis situations, the system calls for the three entities to come together and coordinate a support operation, keeping in mind that the Bank of England as the central bank can provide "liquidity assistance" as the lender of last resort.[30] The FSA is specifically tasked to "monitor the health of institutions that fall within its regulatory remit and ensure...continuing compliance with regulatory standards."[31]

     Criticism on the government's role in the Northern Rock crisis has mainly focused on the FSA and the Bank of England. The FSA, as the main financial regulator, has been accused of being asleep at the wheel for failing to call attention to possible problems within its regulatory purview.[32] Moreover, the FSA's role was critical because it is the "guardian of the public scheme of deposit insurance"[33], which in the U.K. covers 100% of the first £2,000 and 90% of the next £33,000, for a possible total of £31,700.[34] As of late, the FSA has admitted its shortcomings.[35] However, the bulk of the criticism has focused on the Bank of England. There are two main arguments. First, the Bank broadly detected problems affecting the financial money markets many months previous to the Northern Rock crisis, but failed to timely act when a particular case demanded it. For instance, the Bank of England warned in April of the aforementioned funding gap between the levels of actual bank deposits and loans, which it contended stood at £530 billion.[36] With both investors and financial institutions tightening up because of the tumultuous credit markets, banks are having a difficult time borrowing, leaving the stark possibility of "A temporary glitch in the banking payment system or an unfounded rumour could leave an otherwise sound bank short of cash at the closes of business, forcing it to ask the Bank of England to tide it over--which may imperil its future health."[37] Thus, the Bank should have seen the Northern Rock crisis coming and pro-actively instituted preventative measures. This last point, concerning the secondary reliance on the central bank, leads to the second criticism of the Bank of England's response.

     For months previous Mervyn King, the governor of the Bank of England, had criticized the American and European central banks' policies of injecting billions into the interbank-lending markets in response to the tightening credit.[38] Rather, Mr. King proposed that investors should bear the costs themselves of risky investments.[39] Mr. King was in essence worried about moral hazard, which "can occur if lenders make high-risk loans (normally the loans offering the highest returns) because they known they will be bailed out by a third-party if the loan fails."[40] This can cause two problematic results. First, the promise of a third-party bailout encourages lenders to act reckless by offering loans that have a high probability of failure, such as subprime mortgages.[41] Second, a big borrower is more apt to take on larger amounts of debt with higher interest rates on the notion that the central bank will prevent its insolvency.[42] Nevertheless, Mr. King did respond with at least a promise of emergency funding to Northern Rock, and many have argued this encourages moral hazard as well as being sheer hypocrisy.[43] In his defense, Mr. King could argue that in fact Northern Rock was not insolvent, it just suffered from temporary illiquidity, thus minimizing moral hazard.[44] Moreover, he could argue that such a response was justified to prevent a broader impact on Britain's financial system, which is within his role as governor.

     However, the facts will bear this defense out. Particularly, the Northern Rock bank crisis highlights the potential ramifications of moral hazard and more broadly calls into question the role that the central bank has in the market.[45] No doubt Northern Rock, and by implication its competitors, realize their virtual guaranteed continued existence as is evident from a recent bold statement on Northern's website: "Your funds are safe at Northern Rock" [because]..."The Chancellor has made it very clear that all existing savings accounts with Northern Rock are safe and secure during the current instability in the financial markets."[46] Thus, by implication it is the financial markets that led to Northern's crisis, not its own mismanagement and high risk activities. This exemplifies the broader point that much government intervention in the market system distorts market behavior, encourages reckless risk-taking, increases costs, and generally causes unintended costly consequences. As of October 3, 2007, Northern Rock is up for sale to the  highest bidder, which probably will be a private equity firm.[47] As for the future role of the central bank in the financial markets, well that is unfortunately at this stage far more guaranteed.

[1] Geoffrey Elliott, THE MYSTERY OF OVEREND AND GURNEY 1, (Methuen 2006).

[2] Id. at 180.

[3] Id. at 181.

[4] Id.

[5] Id.

[6] Id. at 182.

[7] Id. at 2.

[8] Id.

[9] Timeline: Northern Rock Bank Crisis, BBC NEWS, Sept. 24, 2007, http://news.bbc.co.uk/2/hi/business/7007076.stm.

[10] Hit by a Rock, ECONOMIST.COM, Sept. 14, 2007, http://www.economist.com/finance/displaystory.cfm?story_id=9821067.

[11] Joe Bolger and Marcus Leroux, Northern Rock Savers Rush to Empty Accounts, TIMESONLINE, Sept. 14, 2007, http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article2451069.ece.

[12] Carrick Mollenkamp et al., U.K. Lender is Latest to Join Mortgage Crisis, WALL ST. J., Sept. 15-16, 2007, at B1, available at http://online.wsj.com/public/article/SB118975103917427544.html.

[13] Carrick Mollenkamp and Jason Singer, A Weekend of Worry Tests Big U.K. Lender, WALL ST. J., Sept. 17, 2007, at C1, available at http://online.wsj.com/public/article/SB118998688873529222.html.

[14] The Bank That Failed, THE ECONOMIST, Sept. 20, 2007, at 16, available at http://www.economist.com/opinion/displaystory.cfm?story_id=9832838.

[15] Timeline: Northern Rock Bank Crisis, supra note 9.

[16] Id.

[17] Id.

[18] Id.

[19] Id.

[20] Id.

[21] The Great Northern Run, THE ECONOMIST, Sept. 22, 2007, at 92, available at http://www.economist.com/finance/displaystory.cfm?story_id=9833685.

[22] Mollenkamp, supra note 12, at B1.

[23] Timeline: Northern Rock Bank Crisis, supra note 9.

[24] Mollenkamp, supra note 12, at B1.

[25] Mollenkamp, supra note 13, at C1.

[26] Carrick Mollenkamp, Northern Rock's Crisis Jangles Nerves in U.K., WALL ST. J., Sept. 118, 2007, at C3, available at http://online.wsj.com/public/article/SB119004858354329943.html.

[27] The Bank That Failed, surpra note 14, at 16.

[28] Memorandum of Understanding Between HM Treasury, the Bank of England and the Financial Services Authority, (Mar. 22, 2006) (on file with author), available at http://www.bankofengland.co.uk/financialstability/mou.pdf.

[29] Id.

[30] Id.

[31] Id.

[32] Great Northern Run, supra note 21, at 92.

[33] The Bank That Failed, supra note 14, at 16.

[34] Mollenkamp, supra note 13, at C1.

[35] Adam Bradbery and Simon Kennedy, Credit Crunch: U.K. Regulator Admits Missteps, WALL ST. J., Oct. 10, 2007, at C3, available at http://online.wsj.com/public/article/SB119197708192054169.html.

[36] Great Northern Run, supra note 21, at 92.

[37] Id.

[38] Mollenkamp, supra note 12, at B1.

[39] Id.

[40] Samuel Gregg, Central Banking's Hazardous Ways, ACTON INSTITUTE, Sept. 26, 2007, http://www.acton.org/commentary/commentary405.php.

[41] Id.

[42] Id.

[43] Mollenkamp, supra note 12, at B1.

[44] Gregg, supra note 39.

[45] Gregg, supra note 39.

[46] Northern Rock, http://www.northernrock.co.uk/index2.htm (last visited Sept. 27, 2007).

[47] Jason Singer, U.S. Firms Circle Northern Rock, Oct. 4, 2007, WALL ST. J., at C3, available at http://online.wsj.com/public/article/SB119145077260448208.html.

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