[DEBATE] : How Bank of England was compelled to rescue Northern Rock

[Riaz K. Tayob]

   How Bank of England was compelled to rescue Northern Rock

	

Submitted by cpowell on 09:47AM ET Sunday, September 23, 2007. Section:
Daily Dispatches <http://www.gata.org/node/5552>

Did the Bank of England
Cave In to Political Pressure?

By Iain Dey
The Telegraph, London
Sunday, September 23, 2007

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/09/23/ccbank...
<http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/09/23/ccbank123.xml>

It was late on Tuesday afternoon when Mervyn King summoned the chief
executives of Britain's top five banks to a meeting that night at the
Bank of England.

The Governor's problem was obvious. While the queues outside Northern
Rock branches had begun to die down, Britain's financial system was
still creaking. HSBC, Royal Bank of Scotland, Barclays, Lloyds TSB and
HBOS were still refusing to lend to each other to any great extent,
clinging on to their piles of cash instead. Only the previous day, a
hedge fund whispering campaign had wiped 30 per cent off Alliance &
Leicester's shares. Fear of contagion was real.

King shepherded John Varley, Sir Fred Goodwin, Eric Daniels, Andy Hornby
and Michael Geoghegan round the table. The mood was already tense. He
then revealed his astonishing U-turn: the following day he would
announce plans to pump some liquidity into the markets through a £10bn
money market auction.

The reaction was fierce. The banks had been demanding such action for
more than a month. King had been resisting on the grounds of principle.
Only six days earlier he had sent a letter to the House of Commons
Treasury Select Committee explaining the dangers of "moral hazard".

Goodwin and Varley in particular wanted to know why King had suddenly
changed his mind. If he'd done this when they'd asked him the Northern
Rock crisis could have been avoided, they argued.

This was no longer about principles, but pragmatism. For weeks King had
been behaving like King Canute, trying to hold back a flood of liquidity
that the market believed could bring the banking system back to life.
But the tide had overcome him.

He may have been right on principle. But his successive U turns prove
that King made some bad judgment calls.

"There have always been a lot of people who disagree with King," says
one banker. "But they still respected him. Is that still the case? We'll
have to wait and see."

Of all the major figures at the heart of the British financial system,
no one has been more critical of the excesses of recent years than King.
The Bank of England's quarterly publications have warned time and again
of excessive leverage, the poor pricing of risk in the system and the
dangers that could be posed by a freeze of liquidity. These warnings
were spelled out in long explanatory documents rather than bold red
letters. And no one paid much heed.

King made his point more explicitly in his speech to the Lord Mayor of
London's banquet at the Mansion House on June 20. It was the first half
of his speech that caught the imagination -- an appeal to the banks to
help him round up the nation's tatty old fivers, so he could replace
them with the shiny new ones in the vaults at Threadneedle Street. But
the real meat came later:

"Excessive leverage is the common theme of many financial crises of the
past," he said, after detailing again the dangers inherent in complex
financial instruments. "Are we really so much cleverer than the
financiers of the past?"

Just one week later Northern Rock issued a profits warning. It was
already apparent that the financiers of today were cursed with the same
hubris as their forebears.

Paul Tucker, the deputy governor of the Bank responsible for the money
markets, was increasingly worried. In early July he sent a memo to the
Treasury and the Financial Services Authority warning of the potential
dangers of a liquidity freeze. In the Bank's eyes, it had just passed
the baton to the FSA, which should now start hunting out the individual
banks with potential problems.

On July 25 Northern Rock flashed on to the radar screen again, with
another profits warning and an admission that some of its hedging
strategies were a bit off the mark. Two weeks later, on August 9, the
market for commercial paper -- short-term money market loans -- ground
to a halt. Northern Rock's reliance on wholesale funding had turned from
an inconvenience into an impending disaster.

It took five more days for the FSA to raise the prospect of Northern
Rock's imminent collapse with the Treasury and the Bank of England. All
the investment banks that had ever had a relationship with Northern Rock
began pitching bailout ideas. JP Morgan, for one, offered a rescue
financing deal. But Adam Applegarth, Northern Rock's chief executive,
and his board balked at some of the terms.

King wanted to do a covert deal, providing Northern Rock with emergency
funding behind closed doors. He argued that this was the easiest way to
save the Rock without spreading panic. But lawyers kept telling him that
he could not do this -- it would breach the EU's market abuse directive.

King spent the next nine days arguing his legal case, picking over the
wording of the relevant legislation. But it seems that lawyers from the
Bank, the FSA and the Treasury were all telling him that it couldn't be
done. Bizarrely, the European Commission disputes this interpretation of
its law. But obviously no one asked its opinion before forcing King into
submission. There was to be no secret bailout of Northern Rock.

In the meantime, Northern Rock was touting itself round the City, with
some help behind the scenes from King and Tucker.

All the major banks operating in Britain were approached. Lloyds TSB was
the only one to show serious interest. But it wanted assurances that the
Bank of England would provide emergency lending facilities to tide it
through. In testimony to the Treasury Select Committee last week, King
said he was asked about rolling over the emergency credit line to a new
owner only a week ago, on Sunday August 16, when Callum McCarthy, the
chairman of the FSA, called him. But according to sources close to the
situation, King did hold talks with Lloyds TSB on whether emergency
funding would be available if it were to press ahead with a bid.

Eric Daniels, the Lloyds TSB chief executive, was pushing for this
facility to be made

available without a penalty rate of interest. He wanted emergency funds
for the Rock priced at Libor, the interbank lending rate, as a favour
for solving the problem. The deal that was made available to Northern
Rock later that week was priced at 1.5 percentage points above base rate.

These talks were apparently taking place one week before that
conversation with McCarthy. So while King may have been willing to offer
a funding line to a new buyer, he wasn't prepared to do so at a price
that was acceptable.

In any case, Northern Rock's board was still reluctant to accept that
the Lloyds deal was the best offer on the table. A bailout would be the
only option.

In an attempt to set the tone, King sent an open letter to John McFall,
the chairman of the Treasury Select Committee, on September 12. He
railed against the dangers of flooding the market with liquidity,
warning that it "encourages excessive risk-taking and sows the seeds of
a future financial crisis".

King was clear in his own mind. If Northern Rock needed a bailout, it
would have to pay dearly. As for everyone else, it was not up to him to
ensure that the money markets allowed them to make profits. Hector
Sants, the chief executive of the FSA, still disagreed. In daily
conference calls he pushed for more liquidity to the system as a whole.

The bailout of Northern Rock was announced. King had been clinging to
the hope that this would reassure the public, not alarm them. The queues
outside Northern Rock branches all over the country proved him wrong.

Alistair Darling, the Chancellor, attempted to reassure the public that
their money was safe. But now that the run on the bank had begun, none
of this was enough. Meetings continued over the weekend between King,
Darling and McCarthy.

On Monday morning Darling pledged to guarantee the nation's bank
deposits with taxpayers' money. That helped reassure the public, but did
little to solve King's problems. The interest rates that banks charge
each other were climbing again in view of the panic.

Sants was making desperate attempts to persuade the UK's big banks to
make a co-ordinated move in the money markets to free up the system.
They told him they simply couldn't do that. There were still too many
potential demands on their balance sheets that had yet to be drawn down.
It was not in their interests to do so.

Sants turned again to King. If the banks wouldn't help themselves, it
was up to the Governor to pump money into the system. King was still
protesting his stance on "moral hazard". The FSA chief said it had gone
beyond that point. Darling and his Treasury officials agreed.

Even within the bank, there may have been an element of pressure on
King's position. Some sources believe that Paul Tucker was also trying
to persuade the Governor to change his stance. Tucker is known to have
been more open to intervention than King.

All in all, King began to realise that things had gone too far. Bank
officials began drawing up plans for the L10 billion emergency lending
facility. By the time he called in the five bank chief executives to
Threadneedle Street, he had already made the decision. He would have to
go back on his word.

To the outside world it looked as if he had caved in to political
pressure. Senior City sources thought he had been made to look like a
fool. From King's perspective, it seems that he just realised he had
been proved wrong. The way things had panned out, he had no option but
to move. The chain of events had overcome him.

His brush with the Treasury Select Committee last Thursday proved King
to be a man of principle. But those principles helped contribute to the
first run on a British bank in 140 years.

Even now that he has ceded ground, it is unclear whether King has made
the right decision. Britain's major banks are this weekend in talks to
try to work out a way to use his L10 billion liquidity line. Whispers
about who has had to take part in the Bank's auction could simply lead
to more disturbing rumours about banks in trouble.

"People have been debating whether the governing structure of the Bank
of England needs to be reformed," says one senior City source. "That's
not the issue. The problem lies with decisions made by certain
individuals involved."