Bank Bailout Mistake

Bank of England

The government’s guarantee of all deposits held by Northern Rock is an astonishing move.

Turmoil in the market was affecting Northern Rock’s ability to operate given it’s mortgage-heavy business model. To protect UK financial markets and consumers, measures were put in place. This included financing from the Bank of England at a ‘punitive rate’. In other words Northern Rock could access money to tide it over, but profits would suffer due to the rate they would have to pay. Northern Rock didn’t actually use the facility, just arranged for it to be available as a precaution.

Somehow this was worked up into a media frenzy which saw queues forming _at some branches_ as customers tried to withdraw their money lest it get lost in some kind of catastrophic financial implosion. This ignored the fact that the Financial Services Compensation Scheme guarantees the first £2k and 90% of the next £33k. For the vast majority of customers this more than covers their savings.

It seems to me that not only did many savers not understand what was going on, but that some journalists didn’t either. Some did and chose to whip up a frenzy whilst a few remained calm. Not an unusual state of affairs.

The government, in an attempt to calm fears and stop panic withdrawals, offered to guarantee all existing deposits in Northern Rock. Whilst very thin on specifics, this was an extraordinary thing to do and in my view a huge overreaction. Suddenly taxpayers were liable for all deposits in the bank, and the precedent was set so that by implication any other bank appearing to fail (even if not failing in reality) would be provided such guarantees at taxpayer expense.

It’s quite astonishing that the government felt such a huge intervention in the market was necessary, with so little attention to detail or the implications of the precedent it set. Will no bank be allowed to fail, no matter how poor its management?

The government overreacted and have created a situation which could essentially nationalise any failing bank. The question then becomes… was it Alistair Darling who got the jitters or Gordon Brown?

Public reaction to the Northern Rock story has also shown the low level of trust people seem to have in financial institutions and the system at large. This is an issue the Financial Services Authority and the Bank of England will need to urgently address.

*UPDATE* I was flabbergasted by the BBC’s 1 o’clock news coverage of Bank of England Governor Mervyn King’s appearance before the Finance Select Committee. Suddenly the entire problem was his and the Bank of England’s fault, plus the British banking regulatory system was flawed. Rather it was coverage by outlets such as the BBC which stirred up the trouble, including their incessant presentation of a queue outside one branch when I hear other branches had no queues at all. I’m finding the heavily lopsided presentation of the facts increasingly disturbing.