Bank chief defends money market cash injection

Bank of England governor Mervyn King today defended his decision to inject £10 billion into the money markets in the wake of the Northern Rock banking crisis.

Mr King told the Commons Treasury Committee that yesterday's operation by the Bank had been "carefully designed and judged".

He said the Bank had been making such judgments "almost daily" in the febrile circumstances of the markets.

Only last week, Mr King was resisting such a move, arguing that it would mean bailing out institutions which had made risky or reckless lending decisions.

In a letter to the committee, he warned that this would "sow the seeds of a future financial crisis".

Mr King said the Bank was not offering "ex-post insurance" to institutions which had made unwise investment decisions.

"It is limited in size, it is limited in amount to each individual bank and that provides a strict limit on the extent to which there is some ex-post insurance," he said.

"So we have balanced the concerns about 'moral hazard' against the concerns that arose at the beginning of this week about the strains of the banking system."

Mr King rejected the view that he should have stepped in earlier, as the European Central Bank (ECB) and the Federal Reserve in America had.

He said Northern Rock had suddenly found itself unable to borrow against its assets and it was "natural" to turn to the central bank as lender of last resort.

Mr King told the MPs: "After the events of August, which essentially closed the markets in asset-backed securities, Northern Rock was then a company with a highly illiquid set of assets."

They consisted of market-backed securities and mortgages.

"Northern Rock tried to sell some of these assets, without a great deal of success," said Mr King.

"The asset side of its balance sheet suddenly became highly illiquid.

"At that point it was clear that, in one form or another, Northern Rock required as a backstop a lender of last resort."

Mr King said the market could not have been the lender of last resort in current circumstances, until the lending markets returned to normal.

To achieve that would have required a "massive" injection of funds into the market, something way beyond what the ECB and Federal Reserve had done.

"In those circumstances it's natural to regard the central bank as the lender of last resort," added the governor.

Committee chairman and Labour MP John McFall said the actions taken to rescue the bank were "the equivalent of screaming fire in a crowded cinema.

"Everybody rushes for the door and there is sheer and absolute panic, all as a result of one company maybe having a bad business model."

Mr King accepted his concerns but said that to have announced a massive liquidity injection or a guarantee for depositors in every bank "would undoubtedly have been a signal that the authorities were deeply concerned about the entire UK banking system.

"That is wholly unfounded.

"To have announced measures on that scale, that would have suggested that we didn't have that confidence, would have been irresponsible."

He complained that he had been prevented by legislation from keeping the rescue package secret.

"The way I would have wanted to do it on this occasion is to have acted covertly as lender of last resort."

Details could then have been published afterwards for public scrutiny, he said.

"As a result of the Market Abuses Directive in 2005, we were unable to carry out a covert... operation in the way we would have done in the 1990s."

Mr King said there now needed to be a "serious reform" of the existing system, including the insurance to depositors in the event of a bank failure.

Mr McFall expressed exasperation at some of the answers he was receiving.

"I am not getting much comfort from the answers I am getting here. There is an obfuscation going on," he said.

Mr King denied he had been "leant on" and said the Bank had worked out all the details of the support operation.

He insisted he had wanted to conduct a "covert" support operation which would not have led to a run on Northern Rock, but "strong legal advice" had been that that was not possible.

The Governor called for "speedy" action to overhaul the complex legislation which had inhibited him from taking the action he wanted.

He said the present operation was not sustainable.

Mr King told the committee: "When it comes to decisions which might involve taxpayers' money, it's right and proper the Chancellor has to approve any move that might involve taxpayers' money."

But he conceded: "People outside the financial system must regard what has happened with utter bemusement."

That was because Britain has a strong economy and this was not a banking crisis caused by macro-economic problems.

Asked directly if he had been "leant on", the governor replied: "No. I can assure you that the operation we carried out was designed in the Bank.

"Of course, in these circumstances I have to discuss it with the Chancellor.

"I give you my personal assurance I would never do anything unless I thought it was the right thing to do.

"Independence of the central bank is not just about legislation, it's about having people in the central bank who will do what's right for their job, not what other people ask them to do."

He said he had been hampered by the "unintended consequences of different pieces of legislation coming together".

He went on: "I think this needs to be acted on speedily".

The arrangements put in place to support Northern Rock "cannot be a permanent solution", said Mr King.

Mr King said he had first been made aware of the problem with Northern Rock on August 14, five days after the "market disturbance" began.

He said it was "concerns about the banking system as a whole" that had prompted yesterday's move, which was first discussed by all sides over the weekend.

Deputy Governor Sir John Gieve, who is in charge of financial stability, told the committee he had not read an interim statement published by Northern Rock in July.

But he insisted that the Financial Services Authority would have had the bank under close scrutiny and that no-one foresaw the way the crisis would develop.

"In April, we identified that there were vulnerabilities in the system but we didn't see exactly the path that they would lead back to Northern Rock. I don't think anyone did," he said.