To the Chancellor's evident relief, the Government's decision to underwrite Northern Rock's £24bn of retail deposits seems to be working. The queues are abating, share prices are recovering, and the sense of panic that gripped the banking system just a few days ago seems to be easing.
Final judgement on whether the authorities did the right thing will have to await the longer-term verdict on its effectiveness. If Alistair Darling's actions succeed in stabilising the situation without cost to the taxpayer then this unseemly episode – and, as I wrote yesterday, terrible precedent in essentially agreeing to nationalise a major mortgage bank – will quickly disappear into the mists of time.
The Chancellor might even emerge from it quite well. After a slow start in recognising the gravity of the situation, he gripped it when all around him were behaving like rabbits frozen in the headlights of an oncoming car, and, at considerable risk to his own and the Government's position, did what was necessary to stem the panic. Of course, this will not be the verdict of history if the Chancellor's actions fail. Then very likely he'll be dog meat. On current evidence, though, it looks as if his gamble might pay off. Mr Darling gets full marks for decisiveness, at least.
The same cannot be said of financial regulators and particularly the Bank of England which emerges from the crisis visibly damaged. The Bank's high-minded adherence to the principles of moral hazard are now shown to be peculiarly unsuited to the seriousness of the crisis it was charged with addressing.
In one of the myriad interviews given by Alan Greenspan to launch his new book, the former chairman of the US Federal Reserve says that central banks should not be too discriminating about whom they offer money to when tackling financial crises. Bailing out the "greedy and the egregious" is part of the price that sometimes has to be paid for financial stability.
Mervyn King, the governor of the Bank of England, might have heeded this counsel. Mr Greenspan's reign at the Fed is certainly not without fault, but on financial crises he's as wise an old bird as they come, having dealt with more of them first-hand than anyone else on the planet.
Part of the job of a central banker is to communicate a sense of calm and quiet authority to the markets and the public. Through carefully managed signals and actions, the central bank must give the impression that everything that can be done is being done. This quality has been absent from the Bank of England throughout the current credit crisis. To the contrary, what the Bank has said and done has only further fanned the flames. The Governor first refused to lend to markets. Then he was forced to bailout Northern Rock. Worse, he chose to lecture the markets on why they couldn't expect any relief at a time when he already knew he would have to provide emergency funding to Northern Rock. The impression was of things being out of control and a consequent series of grudging volte-faces.
It is not just the Bank of England's reputation which has been harmed by this clumsiness. The chaotic scenes outside Northern Rock branches has made Britain seem more like a Third World country than the mature, post-industrial society it pretends to be. How could an economy that houses the most successful international financial centre in the world have allowed itself to sink so low?
There were plenty of excuses yesterday, and some of them not half bad. One key weakness thrown into sharp relief by the run on Northern Rock is Britain's arrangements for deposit insurance. They have been shown to be wholly unequal to a crisis of this magnitude.
The compensation scheme run by the Financial Services Authority guarantees only the first £2,000 of any monies on deposit, and then just 90 per cent of the next £32,000. In an insolvency, depositors stand to lose everything above that figure. What they do get back may take six months or longer to be paid. In circumstances where there is any risk whatsoever to the future of the mortgage bank, it is therefore perfectly rational for depositors to dash for the exit.
The Bank claims to have been worried about this fault line in the system for some years, but has been unable to persuade policymakers in Government or the Financial Services Authority to pursue reform. It ought to be said, however, that if there has been a debate on this matter, then it has not been a public one. I'm not aware of any authority, never mind the Bank of England, raising deposit insurance as an issue before the Northern Rock debacle.
Nor are Britain's arrangements for deposit protection notably worse than anywhere else other than America, France and, oddly, Italy. Yet it is the absence of the gold-plated deposit protection they have in the United States which lies at the heart of the muddle the Bank of England has got itself into on when it is appropriate to bail out distressed banks.
There is no point in applying the principles of moral hazard to ordinary depositors. Most of them won't understand them and nor is it fair. Savers put their money in a deposit account rather than the stock market because they believe it to be risk- free. It is unreasonable to expect retail depositors to distinguish between the creditworthiness of banks regulated by the FSA.
Their deposits must therefore be underwritten 100 per cent, up to an agreed ceiling to prevent reckless or fraudulent deposit-taking. In the US, which has a long and proud history of banking failures, deposit protection on this grand scale is achieved by ranking depositors first in the line of creditors. In an insolvency, deposits are immediately removed from the bank and placed with safe rivals. The banking industry is thus persuaded to fund more generous deposit protection. In so far as shareholders and other creditors are concerned, the principles of moral hazard are also upheld. These creditors will likely lose everything.
One positive outcome of the present crisis should therefore be better deposit insurance. On almost every level this would be a desirable development, for it ought also to encourage the creation of a greater number of smaller banks. The consolidation of British banking into a small number of notionally well-capitalised behemoths doesn't seem to have made it notably safer.
Criticism has focused on the Bank of England, but the FSA cannot be allowed to escape without at least a few pellets in its derrière. Its system of solvency regulation is plainly not up to dealing with the loss of confidence that has gripped credit markets these past two months. Banking crises normally occur when borrowers get into trouble. There is not much evidence of that at Northern Rock, or indeed in the wider banking crisis we have been experiencing. Rather the problem is that no-one will lend. This is something new for regulators, and they have been found wanting in attempting to address it.
Both the Bank of England and the FSA have found themselves powerless in organising an ordered rescue of Northern Rock. Is that because of the dispersed, irreverent and global nature of modern-day capital markets, or is it because the separation of monetary policy from banking supervision which took place under Labour has diminished the authority and effectiveness of regulators when dealing with a crisis?
The Fed last night showed how it should be done by cutting interest rates by a full half a point. No hint there of the moral hazard that the Bank has so fretted over, to the exclusion of almost all else. The economy demanded liquidity and it got it. Now it's got the hoped-for half-point rate cut too. The Fed is cutting not because it thinks the risks of inflation have gone but because it fears for the damage that disruption in financial markets might do to the wider economy.
As Alan Greenspan has remarked, you cannot calibrate liquidity to help only the deserving. When the livelihoods of Joe Public are at risk, you have to act. The authorities in Britain have been slow to grasp this point.Reuse content