The way the UK government and Gordon Brown in particular have dealt with the liquidity crisis at Northern Rock has become a huge embarrassment. The new Prime Minister has always talked about what he did as Chancellor of the Exchequer from 1997 to 2007, while he waited for Tony Blair to leave office. But in just a few days, his reputation as a good manager of the economy has been hurt.
The problems at Northern Rock and other banks did not appear out of nowhere. The crisis in the US subprime loans market and the fact that this bad debt was repackaged and sold to banks in the UK and EU were both well known. There are rumours that major banks in Germany and Barclays Bank in the UK have a lot of these risky assets.
Northern Rock is an active UK mortgage lender that gets about 73 percent of its money from the wholesale market and only 27 percent from private depositors. Because of the subprime banking crisis, these funds could no longer come from other major UK banks and financial institutions.
What made the UK different from the US and the EU was how their governments and central banks reacted. During the summer of 2007, the Federal Reserve and the EU central bank did a lot to ease liquidity pressures on the financial markets. The Bank of England took a "let it be" attitude and said that financial institutions shouldn't expect the Bank of England to protect them if they make bad decisions.
When the Northern Rock crisis became public and the Bank of England said it would help, the UK government and Alistair Darling, the Chancellor of the Exchequer, agreed with the Bank of England. But the Chancellor's bland assurance that Northern Rock was solvent didn't convince regular investors, and there was a run on the bank.
With the Financial Services Compensation Scheme, savings of up to GBP2,000 are fully protected, and savings of up to GBP33,000 are protected at a rate of 95%. There is no protection after £35,000. People waiting in line outside Northern Rock branches usually had more than GBP50,000 in the bank.
The news stories about panicked depositors who didn't listen to the Chancellor of the Exchequer's reassurances must have made Prime Minister Gordon Brown angry. On September 17, 2007, the government said that all Northern Rock savings would be safe. This worked as planned, and the rush to the bank was stopped.
The Governor of the Bank of England did a big about-face on September 19. Just a week ago, he said that central banks should only step in when there are "economic costs on a scale large enough to ignore the moral hazard of the future."
In simple terms, this means that the Bank of England will only step in if nothing else works. It should only happen in the worst of times. If the Bank saves a financial institution that got into trouble because of its own stupidity or lack of foresight, it could be seen as endorsing or even rewarding bad behaviour and could encourage other institutions to take too many risks in order to make money.
Now, the Bank of England has announced a set of measures that will help all UK banks get through the current crisis, whether they have acted recklessly or not.
This has taken the attention away from Northern Rock's problems and made people wonder how well the Bank of England is handling the crisis.
This U-turn makes me wonder a lot of interesting things. First of all, would the crisis at Northern Rock have been stopped if these steps had been taken two weeks ago?
Even though this is a hypothetical question, the likely answer is "yes." Most likely, the answer to the question of whether this would be good for the UK economy is "no."
Second, could there have been a better way to deal with the problems at Northern Rock? Without a doubt, the answer is yes. Northern Rock would have been an appealing company to take over. But the damage to the brand name is now too great to fix, and a takeover is not likely to happen soon. In any case, the brand name is more likely to be a weakness than a strength.
Third, could it be the Bank of England's fault? The Governor of the Bank had to do an embarrassing U-turn, but the government's hidden hand is easy to find. There haven't been many UK banks that have failed in recent times. Even though London and County Securities and some other small banks went out of business in 1973, none of them were as big as Northern Rock. But in 1973, the Bank of England did start a lifeboat plan to stop a chain reaction. At the time, it was said that Nat West Plc was in danger.
Staff at the Bank of England today have to know about the lifeboat plan from 1973. One could assume that the Governor and his staff were at first ready to let Northern Rock go into receivership and have a stronger organisation take over its mortgage loans. The depositors' money would be safe, but no one would have slept well for a long time.
It seems like the Bank of England is not controlled by the UK government when it is trying to do what the government wants. But if it follows policies that it thinks are good for the UK economy but go against what is politically convenient in the short term, then this independence is a lie.
The Bank of England is now stuck on Northern Rock because it sent out a lifeboat.
