LESSONS FROM THE NORTHERN ROCK EPISODE

1. LESSONS FROM THE NORTHERN ROCK EPISODE David G Mayes and Geoffrey Wood Auckland University Cass Business School University of Buckingham

2. MOTIVATION • First bank run in UK since 1866 Overend Gurney • How could it happen? • Strategy and risk well-known • Northern Rock thought solvent • UK had Lender of Last Resort/Emergency Liquidity Arrangements (home of Bagehot) • UK had extensive deposit insurance • Experienced central bank, unified supervisor, tripartite arrangements • Was theory or practice at fault? • Crises usually caused by something new • In this case drying up of wholesale markets with US sub-prime problems

3. ISSUES • Problems with LOLR/ELA • Why did deposit insurance not stop a run • Diamond-Dybvig • Why was there not more action earlier? • Keeping a failed institution open • Temporary nationalisation a solution not a problem • Problems of co-ordination • ‘Certainty’

4. CERTAINTY • People will rush for safety if they do not know what may happen. • Future is uncertain – cannot prescribe specific solutions • 4 general sources of certainty • Unlimited ELA against acceptable collateral • No taxpayer bailouts – closure or takeover by the authorities to keep critical functions operating/minimise the loss • Insured depositors have no material break in access to funds • Regulatory authority forced to act early accelerating scale of severity

5. CERTAINTY 4 general sources of certainty • Unlimited ELA against acceptable collateral • No taxpayer bailouts – closure or takeover by the authorities to keep critical functions operating/minimise the loss • Insured depositors have no material break in access to funds • Regulatory authority forced to act early accelerating scale of severity • None of these applied: ELA late cautious, viewed as penalty; government stepped in; major break in access to deposits and share of loss, lack of action (no PCA)

6. EMERGENCY LIQUIDITY ASSISTANCE • ELA has worked in the sense that there has been adequate collateral for the Bank of England to provide all the necessary liquidity to meet the withdrawal of retail deposits • The government should not lose money from nationalisation unless there is a problem with compensating shareholders – not a problem with ELA • However it did not prevent the run • Two main drawbacks highlighted • Transparency – could not put problem right quietly • Stigma – use of ELA interpreted as disaster not salvation

7. TRANSPARENCY • Ideally problem and solution are revealed simultaneously. • Is it possible to hold the discussions in secret? • Is it permissible? Duty to inform shareholders? • Are other switches in funding disclosed? • Is effect on share price different from takeovers? • Price of NR fell by 50% between Feb07 and Sept; fell by further third after news broke

9. TRANSPARENCY • Ideally problem and solution are revealed simultaneously. • Is it possible to hold the discussions in secret? • Is it permissible? Duty to inform shareholders? • Are other switches in funding disclosed? • Is effect on share price different from takeovers? • Price of NR fell by 50% between Feb07 and Sept; fell by further third after news broke • Creditors normally protect themselves if a company looks in trouble – banks different because funds are an essential input – cannot reschedule – safety net especially deposit insurance should reassure • Opacity only justifiable if it is in interests of creditors and depositors and all know there will be disclosure afterwards • Key is ability to close bank early before there are losses to creditors if recapitalisation fails

10. STIGMA • A dilemma • Should access to ELA be sufficiently frequent that it is not regarded as a signal of disaster? • If ELA is common then it may increase risk taking – moral hazard • Needs to be at an above market rate to enable the market to work first – should this be described as a ‘penalty rate’ – risk premia are common • No progressive structure – either using ELA or not • Difficult to match by general lending to the market • Is the problem unusual due to banks offloading the risk from normal borrower-lender relationship? Safety net not so well designed for market risk as idiosyncratic risk?

11. DEPOSIT INSURANCE • Issues • Does coinsurance help improve incentives? • Must all deposits be insured? • How long can access to funds be interrupted? • Does prefunding matter?

12. DEPOSIT INSURANCE • Issues • Does coinsurance help improve incentives? • UK unusual in having coinsurance after first £2000 10% of next £33000 others zero or 100% to limit • NZ experience suggests people do not check • NR shows exposure leads to a run • Theory OK but does not work if there is threat of loss • NR has killed coinsurance • Must all deposits be insured? • How long can access to funds be interrupted? • Does prefunding matter?

13. DEPOSIT INSURANCE • Issues • Does coinsurance help improve incentives? • Must all deposits be insured? • Current UK limit gives 100% coverage to over 90% of depositors. Are remainder well informed? Do they exit early before run? US experience suggests no. Can they afford the loss (not widows and orphans) • Raise to US levels? Already high by European standards – regime competition within single market? • NR shows that having no insurance is likely to result in a blanket guarantee – also Nordic crises • How long can access to funds be interrupted? • Does prefunding matter?

14. DEPOSIT INSURANCE • Issues • Does coinsurance help improve incentives? • Must all deposits be insured? • How long can access to funds be interrupted? • If there is any material break people will have problems – but Irish Bank strike example • Keep core functions operating – NZ approach • US tries to get full access within a week – EU 3 months permitted renewable twice • In NR people shifted banks rather than into cash – access is crucial • Implementation difficult – need considerable prior knowledge of banks’ computer systems. Bank systems must identify insured deposits on an ongoing basis (problem of aggregation) Must avoid netting. • Does prefunding matter?

15. DEPOSIT INSURANCE • Issues • Does coinsurance help improve incentives? • Must all deposits be insured? • How long can access to funds be interrupted? • Implementation difficult – need considerable prior knowledge of banks’ computer systems. Bank systems must identify insured deposits on an ongoing basis (problem of aggregation) Must avoid netting. • Can transfer all deposits to another bank, can take over bank and keep deposits in ‘good’ bank, bridge bank in US • Does prefunding matter?

16. DEPOSIT INSURANCE • Issues • Does coinsurance help improve incentives? • Must all deposits be insured? • How long can access to funds be interrupted? • Does prefunding matter? • Without prefunding cannot payout in a hurry or offer other quick solutions • Funding increases credibility of the fund • If problems occur in a downturn rest of banking system not in good shape to provide funds in a hurry. • Cost of prefunding small particularly if pay interest after cost recovery

17. GETTING EARLIER ACTION • Prompt Corrective Action • In US a required series of increasingly harsh interventions within a timetable as capital falls ending in closure before capital is exhausted. • However NR shows that intervention must occur before capital falls – risk taking and liquidity problems. Need Pillar 2 and Pillar 3 to require action • NR share price falling; FSA clear that reliance on wholesale market a risk. • How is this turned into clear rules? PCA limits discretion • NR shows that authorities hold off in the hope of achieving a less difficult solution

18. GETTING EARLIER ACTION • Prompt Corrective Action • Prompt action requires intervention by the private sector well before regulatory limits are breached • Midland and National Westminster are UK examples • Can only be encouraged not compelled – main encouragement is that failure to act will be unattractive • Action on risk needs to be based on quantitative assessment – NR shows standard approaches can be underestimates

19. GETTING EARLIER ACTION • Prompt Corrective Action • The authorities must have the power to step into a troubled institution should it get too close to failure • They have to be capable of forming a rapid judgement about the extent of the losses and the sensible action • They have to be capable of acting fast enough to be able to assign the losses and keep the bank operating without a material break • Furthermore if the bank does close the authorities have to be able to act fast enough to ensure that insured depositors have access to their funds without any significant break. All these must be believed to apply in advance

20. KEEPING CORE FUNCTIONS OPERATING • In general banks that cannot perform to the rules should be closed and closed early before there are losses • However, some banks are too important to be allowed to close because of the disruption it will cause to financial markets and the wider economy • Not simply too big to fail but too important in certain functions – market maker for example • NR shows this applies to smaller institutions than previously thought • US have good way of achieving this through ending legal personality and reopening in whole or essential parts as a bridge bank under temporary government control without a break – time limit laid down • UK does not have legal power but recommended by BoE/FSA/HMT paper – avoids costly litigation and taxpayer being exposed to full extent of losses

21. COORDINATION FAILURE • Government by committee • Cross-border arrangements

22. COORDINATION FAILURE • Government by committee • 3 players in the UK – BoE, FSA, HMT • In US FDIC has clear lead role – UK deposit insurer FSCS has none – others only involved if Systemic Risk Exemption invoked – never used • NR showed some problems with each being reluctant to act • Treasury Committee recommends Office of Deputy Governor in BoE to lead • Cross-border arrangements • Much worse when more countries involved • Who should lead? ECB? Has possibility under the Treaty. European Deposit Insurance Corporation only for banks with systemic implications - 30-50 • How shall different interests be balanced? • Whose jurisdiction applies

23. COORDINATION FAILURE • Government by committee • Cross-border arrangements • Much worse when more countries involved • Who should lead? • How shall different interests be balanced? • Whose jurisdiction applies? • Need agreement about how joint arrangements shall run in normal times to avoid recrimination if things go wrong • Lead of consolidating supervisor of college of supervisors, with single database, able to exercise similar powers (single rule book) • Agreed PCA – respecting all countries’ financial stability • Closure at positive capital before any losses to argue over • Currently do not have power to take account of other countries’ interests

24. LESSONS • deposit insurance needs to be designed so that • the large majority of all individuals’ balances are fully covered • depositors can all have access to their deposits without a material break • the activation of emergency liquidity assistance arrangements needs to give confidence that those being assisted will survive, and should be seen as the system working as it should, rather than signalling some breakdown • there needs to be a regime of prompt corrective action for supervisors whereby prescribed actions of increasing severity are required within short time periods according to a set of triggers based on capital adequacy and risks of failure

25. LESSONS (2) • there needs to be a legal framework such that the functions of systemic importance in banks that fail can be kept operating without a material break • such ‘failure’ should occur before the bank becomes insolvent so that there is little chance of losses to the taxpayer • this will normally involve a special insolvency regimes for banks • some designated institution needs to be in charge of intervention in failing banks to ensure rapid and concerted action • At a European level far greater coherence among the legislation and authorities of member states is required if these provisions for the handling of problems in domestic banks are to be equally successfully handled in the case of large cross-border banks

26. REMARKS • If 1 to 5 had been in place there would have been no run on Northern Rock • But if NR had been a more complex cross-border bank the problems could have been much worse • This unfortunate and unnecessary incident will help authorities not just in the UK but round the world avoid much greater threats to financial stability • If distinguished and well thought out authorities have a problem so will others • No safety net can be completely successful