Jeremy Warner's Outlook: Reluctant Government reappoints King

Muddled thinking on deposit insurance; Another panic rate cut from the Fed
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The Independent Online

To reappoint Mervyn King as Governor of the Bank of England for a second term may have been the right decision, yet the Government will almost certainly have done it through gritted teeth. Behind the scenes, the recriminations have been heated and vitriolic over the disaster of Northern Rock, with the Bank of England, the Financial Services Authority and the Treasury all blaming each other for the first run on a British bank in more than 100 years.

For choice, the Government would have gone for someone else by way of punishment for the Bank of England's supposed role in undermining Labour's hard-won reputation for financial and economic competence.

In practice, this was never an option, for you don't counter a banking crisis by sacking the Governor of the Bank of England in the midst of it. Think of the way it would have played in the press. "King made scapegoat for the Rock", the headlines would have read. More damning still, Gordon Brown would have been accused of knocking away one of the cornerstones of his economic policy – an independent Bank of England.

Perversely, the Northern Rock debacle made Mr King much more difficult to sack than he would otherwise have been. Even if the Government had wanted a change at the Bank for wholly unrelated reasons, the fiasco of Northern Rock made it virtually impossible. To have changed the Governor would have been tantamount to admitting that a key element of the Government's institutional arrangements for macro-economic stability had failed.

Besides, Mr King's record on monetary policy has, on the whole, been exemplary, and even on the Rock there is a good case for arguing, as indeed Mr King has, that it was the system, rather than any errors of judgement on the Governor's part, that was the main cause of the mischief.

With yesterday's package of proposed reforms to banking regulation, these failings are now being addressed. Even so, in the heat of the crisis, tempers became more than a little frayed, particularly after Mr King's radio interview in which he appeared to accuse the Government of dithering on legislative reform and of failing to grasp the opportunity of a rescue takeover bid by Lloyds TSB.

This latter allegation was, in fact, a case of misinterpretation of Mr King's comments, but the damage to relations had been done, and, at one point, the Chancellor and the Governor were said to be barely on speaking terms. Bridges have since been mended.

Yet the Bank hasn't got off entirely scot-free. Yesterday's consultative paper makes some worthwhile suggestions for much-needed governance chang-es. The Court, as it stands, performs the role of little more than a gentleman's dining club, with a few honorary females to pep up the conversation.

The Governor is, meanwhile, said to rule the roost with an iron hand. It is not that he is intolerant of dissent; it is just that no one dares challenge such a formidable intellect. He is also said by critics to be stubborn, with few even willing, let alone able, to sway him. If this is true, then it is obviously not entirely healthy. The Court needs to be made smaller and more effective. It also needs greater powers of oversight and an independent chairman to counsel and advise Mr King, the chief executive.

By the time Mr King became involved in the Rock debacle, the die had already been cast, and, as far as I can see, his advice and actions over the matter given the constraints under which he was operating cannot reasonably be faulted. Yet on the wider issue of moral hazard, and the Governor's unwillingness to provide the banking system with the liquidity it craved, he almost certainly got it wrong, and indeed has as good as admitted so by subsequently reversing his previously hair-shirted approach.

At the World Economic Forum in Davos last week, there was implied criticism from Jean-Claude Trichet, president of the European Central Bank, of his counterparts both at the Fed and the Bank of England. The Fed was challenged for its panic cutting of interest rates in apparent response to turmoil in the financial markets. The purpose of monetary policy, M. Trichet insisted, was solely that of keeping the lid on inflationary expectations. Yet when the money markets are sick, they have to be treated with injections of liquidity if unnecessary economic damage is to be avoided. People in high office don't usually get a second chance. Mr King can no doubt be relied upon to use it wisely.

Muddled thinking on deposit insurance

The Government's proposals for replacing the present pay-as-you-go arrangements for deposit insurance with a beefed-up, pre-paid, scheme beg more questions than they answer. The absence of an adequate deposit compensation scheme was one of the primary reasons for the run on Northern Rock, so something plainly has to be done. But it is not yet clear precisely what.

The proposed bar is set at the existing £35,000, which is better than many countries but not nearly as good as France, Canada, the US, Japan and Italy. Well over 90 per cent of all deposits by number are below this figure and therefore stand to be fully compensated, but around 50 per cent by value are above it, and would be unprotected. The case for a rather higher figure seems on the face of it to be unarguable.

Yet the higher the number, the bigger the cost, and the real concern among bankers is the proposed pre-paid nature of the compensation fund. Admittedly, the consultation document refers only to "an element" being pre-paid, with the rest borrowed from the Government or the Bank of England, but there is no attempt to quantify the size of the pre-paid pool.

Even for a smallish insolvency, it would have to be substantial. To cover a larger one, it would need to be very big indeed, while heaven forbid that one of the bigger deposit takers went under. No pool could realistically be made large enough to cover such a calamity. To attempt to do so would be wholly disproportionate, with the costs to the banking system and therefore customer far outweighing any supposed benefit.

To point to the US as a model for deposit insurance is misleading, as banking in the US is still highly fragmented with quite frequent smaller insolvencies. In Britain, such insolvencies are extremely rare, with the vast bulk of deposits concentrated in just five big players. The existence of the insurance may encourage a welcome proliferation of smaller competitors, but it would also create moral hazard and could thereby end up being extremely costly to the customer. These concerns would only be partially answered by making the levy on banks risk-based, so that payments are made according to prudential assessments of a bank's creditworthiness. Should National Savings, with 10 per cent of all UK deposits, be made to pay the levy too? The questions multiply.

Another panic rate cut from the Fed

Last night's 50-basis-point cut in interest rates by the US Federal Reserve was wholly predictable, not because of the dire state of the US economy, but because of the Fed's increasingly muddled relationship with the financial markets.

When the Fed cut rates by 75 basis points last week, it was a bit bigger than the markets had been expecting, but even so the Fed failed to discourage expectations of another 50 points at this week's meeting. It then transpired that at least part of the market turmoil which may have helped instruct the emergency rate cut was caused by the antics of SocGen's rogue trader.

Ergo, if the Fed had cut by just 25 points last night, it might have been seen as an admission that the size of the first cut was a mistake. The Fed therefore became tied into cutting by the previously planned 50 basis points. Too conspiratorial an explanation?

There was no hint of this line of thinking in the Open Markets Committee's statement last night, nor will you read about it in the minutes when they are published. Yet given the Fed's apparent state of blind panic, it seems to me as good an explanation as any.