A century of advancing regulation, bank consolidation and financial sophistication was thought to have put Dickensian bank "runs" behind us. Those queues outside Northern Rock branches said otherwise. And they spoke to a deeper fear: that what began as a complex financial crisis in America could degenerate into a slowdown or even recession here.
So what is the connection? How did some dodgy loans in the US mortgage market undermine the eighth largest British bank and apparently threaten several others? The link here is a financial mechanism which most of us never have to think about—the inter-bank market. At any one time, different banks have different requirements for short-term financing. The inter-bank market is the market between banks in which they can borrow from, or lend to, each other to meet their short-term needs. These transactions are secured against collateral such as government bonds. But the market has seized up because of uncertainty about the value of some of the collateral which institutions hold, such as instruments derived from US mortgages, whose value is now hard to determine. If Bank A is suspected of holding a lot of such debt, how can Bank B be sure that a loan to Bank A will be honoured?
Northern Rock fell victim because it depended more than most banks on the inter-bank market, rather than depositors, to fund its operations while also lending on highly attractive terms. In effect, the bank was borrowing short and lending long—the classic recipe for financial disaster. It raised funds by issuing short-term securities secured against its mortgages. This fuelled spectacular growth. But when the credit markets ground to a halt and interest rates rose, it could not raise the cash to fund its operations. Northern Rock's problem was liquidity, not solvency. Unfortunately, depositors did not understand, or did not believe, that this was the case. The financial seizure exposed the shortcomings of Northern Rock's business plan and sparked a textbook crisis of confidence.
For all the earlier tough talk about moral hazard, the Bank of England, the Financial Services Authority and the government had no alternative but to bail Northern Rock out. While Mervyn King, the governor of the Bank of England, could try to be resolute about the whole market, neither he nor the FSA and the government could countenance Northern Rock going bust.
But in other respects, this is a very modern disaster. Financial crises have usually reflected developments in the real economy. In this case, the causality may be reversed. Three things stand out. First, like generals fighting the last war, central banks have been obsessed with inflation. Monetary policy—basically manipulating interest rates—has paid too little attention to developments in the capital markets which have made it much harder for the authorities to influence the value of credit in the financial system. One aspect of this has been the use by banks of investment vehicles—often called "conduits"—which enabled them to play with exotic securities off balance sheet and avoid full regulatory scrutiny.
Second, these securities were the product of a hubristic conviction that computing technology, mathematical modelling and aggressive trading could divorce a financial security from its origin—for example, humble US domestic mortgages. Holders of these securities have discovered that ingenuity is no substitute for easily discernable value.
And third, the market is global. Its reach, which saw small German banks holding exposure to homes in Nevada, lulled people into a false sense of security. Didn't globalisation spread risk? Didn't it reduce the danger of a systemic crisis?
Obviously not. Conduits circumvented the regulation that was meant to keep banks on the straight and narrow. Technology and globalisation do not necessarily increase stability. On the contrary, they can spread and conceal exposure so that creditworthiness is uncertain and markets seize up. Central banks have been revealed to be as confused and divided as everyone else.
The ramifications of the crisis may become even graver. The problem of how much financial institutions owe to each other will take months to resolve. Central banks, regulators and financial institutions are trying to locate and estimate exposure without further undermining confidence in the system or particular businesses. It would be surprising if other institutions did not reveal heavy losses or even deeper problems. Optimists maintain that the world's banks have strong balance sheets and that intrepid speculators will buy debt at heavy discounts in the hope that its value will rise. But finding a new price level for the rogue securities will be difficult.
As a result, banks' capital is being stretched. When credit quality falls, a bank's capital requirements—the need for its own money—rises because the bank requires more resources to allow for bad debts. This hampers its ability to lend. In Britain, some borrowers, such as those wanting a 95 per cent mortgage, will have to pay more. In the market between financial institutions, only rock solid securities are being accepted as collateral.
Pressure for more regulation will grow. For some time, regulators have bemoaned the uncertainties created by the new financial terrain but done little about it. Now Jean-Claude Trichet, president of the European Central Bank, has called for unregulated entities to be brought to heel. American politicians, with an eye on next year's elections, will not pass up the opportunity to give a roasting to Bank executives who have been making millions in the good times.
In Britain, the fundamental point is that regulation failed because Northern Rock fell between the cracks of the tripartite arrangement between the FSA, the Bank of England and the treasury. The FSA is a regulator and cannot bail out a bank, although it should explain why it did nothing about the weaknesses in Northern Rock's business plan at an earlier stage. The Bank itself no longer has the power to arrange rescues behind the scenes, as it used to. And both are supposed to operate independently of the treasury. This was the first real test of the arrangement and it hasn't worked. The Memorandum of Understanding between the Bank, the FSA and the treasury, agreed when Gordon Brown gave the Bank independence, will probably have to be re-written. The announcement by Alistair Darling, that all deposits in Northern Rock would be safe—effectively guaranteeing all deposits in all banks in Britain—was politically unavoidable at the time, but may need to be replaced by a less sweeping option.
The consequences of tougher credit could have a big impact on house prices, jobs, investment and economic growth. US house prices have been falling for about a year and there are now signs that the British house price boom is ending. Finance for all manner of deals and investments will be harder to obtain.
There is a danger of recession, and Britain is not immune. But policymakers and central banks face a dilemma. On the one hand, cutting official interest rates —as the US Federal Reserve has done, and the Bank of England may soon do—would help to create a sense of the authorities being in control. On the other hand, cutting rates could stoke inflation just as the anti-inflationary effect of China's exports may be diminishing. Moreover, lower official interest rates run the risk of bailing out the knaves and fools in the markets without relieving the impact of widening credit spreads.
On balance, the inflationary risk is worth taking. But there are other dangers. Lower US rates could undermine the dollar, which in turn risks increasing inflation in the US and exporting recession to other countries, notably Britain, the eurozone and Japan, by reducing US demand for imports. Moreover, if house prices continue to fall, consumers will cut back their spending, especially in the US where it has been a sustaining force in the world economy. The response of policy makers over the next few months—and especially Gordon Brown, the architect of the tripartite arrangement—will be critical.
