Vince Cable on Northern Rock

The panic has been stabilised for the moment by the de facto nationalisation of Northern Rock and the promise to guarantee the value of deposits. It will be important to ensure that this guarantee does not become a crooks\’ charter in which any dodgy bank will be able to lure in depositors with attractive interest rates, expand rapidly using Northern Rock\’s business model and then call in the Government when it hits trouble.

Well, yes, that\’s the moral hazard part of it all, isn\’t it. By making xertain behaviours less risky you make them more likely.

The FSA also has much to answer for. It beggars belief that it failed to see any connection between Northern Rock\’s reliance on financial markets, rather than customers\’ deposits, and its frantic expansion into new mortgage lending with ridiculous multiples of incomes and loan-to-value ratios.

Well, those loans haven\’t actually gone wrong (yet!) so we\’ve no evidence that they were a bad idea. But yes, the FSA does seem to have been asleep at the wheel. They\’ve only been responsible since 2004 mind, so it might be that the system cooked up by El Gordo wasn\’t actually fit for purpose.

But the Government should not be allowed off the hook. Eddie George warned what could happen if the Bank\’s responsibility for systemic stability was separated from day-to-day banking supervision. Gordon Brown ignored him. When I asked who was responsible for the dangerous bubble in the housing market against which new mortgages are secured, I was told a tripartite committee. No one was in charge.

Quite so. This little dig is also worth savouring:

David Cameron\’s claim to have anticipated the personal debt problem didn\’t persuade even his supporters. Economic policy is not a branch of the public relations industry.

 

9 comments on “Vince Cable on Northern Rock

  1. A timely repeat. The Northern Rock saga is going to run and run.

    Vince Cable is absolutely right about the virtual nationalisation of the northern bank – and all its problems.

    The BoE is going to have to go on lending without stint to keep it going:

    “At least 12 of the UK and Europe’s biggest banks have now decided not to buy the Newcastle-based lender, according to the Sunday Times.”
    http://news.bbc.co.uk/1/hi/business/7009041.stm

    What could possibly be the cause of the hang up if Northern Rock and its mortgage book are as solid as those who champion it claim?

    For those who can remember the 1970s (shudder), it’s like old times have returned for a nostalgia fest with lashings of SOLD signals from northern places – for the young among us, in this case SOLD is not the past tense of the verb “sell” (would that it were) but the acronym for: Save Our Lame Ducks.

    Not to worry – some have been making big profits out of Northern Rock:

    “Hedge funds – as well as traders in some of the big City investment banks – have been betting heavily for months that Northern Rock was facing serious funding problems and its shares were on their way south. Their concerns proved well founded.”
    http://news.bbc.co.uk/1/hi/business/7007116.stm

    What took Alistair Darling and HMT so long to step in to sort out the problem if the tripartite system wasn’t working?

  2. IIRC, the U.S. savings & loan bail-out in the 1980’s ended up costing the US government about $125 billion. Times and products were simpler then, and it was a bit harder to get into deep trouble without anyone noticing. Northern Rock was obviously not carved from granite. Here’s hoping it does not prove to be the proverbial tip of the iceberg.

  3. Ronin – Many thanks for that hugely relevant reminder.

    I’ve long been familiar with scale of the Savings and Loan Association failures in America in the 1970s and early 1980s and the instrumental part that moral hazard and the standing deposit insurance (protection) scheme played in it:
    http://en.wikipedia.org/wiki/Savings_and_Loan_crisis

    The S&L debacle and the role of deposit insurance is widely cited in mainstream economics texts as an outstanding case of “moral hazard”, which is how I became aware of what happened and why – and I’ve remarked on it elsewhere within the last few days.

    One interesting insight to be gained from recent online debates about Northern Rock is that apart from economists few of my compatriots are apparently aware of either the scale of the S&L debacle in America or, more suprisingly, of the notion of “moral hazard” despite that being a notion familiar to insurance agencies centuries before its wider significance became apparent to economists.

    I’m sure most readers will be familiar with occasional news reports of failing businesses burning down to enable the owner(s) to recover the (possibly inflated) insurance value. Reducing moral hazard is why insurance companies often offer no-claims bonuses and will typically offer to insure only losses in excess of some loss which has to be borne by the insured.

  4. Concerning bail-outs of banks by the central bank, underwritten by the government: wasn’t one of the arguments against joining the euro the fact that the European Central Bank was not underwritten (implicitly or explicitly) by a government? In the event of a run on a bank in the euro-zone, there would be no process for bailing them out.
    If true – and I am not sure of the precise details – then either it is a dangerous gamble with the savings of millions of people, or it is a clever move to enforce discipline on banks. There is no safety net.

  5. The national government can still bail out a bank – the concern surely is the central bank wouldn’t be ameniable to political pressure to ease the bailout, though so far the ECB seems to have not required political pressure.

    “Well, those loans haven’t actually gone wrong (yet!)” – that’s true to some extent, but presumably that other banks wouldn’t lend to NR or take it over must reflect concern, even if only indirectly.

  6. For economists only:

    I first learned of the scale and suggested moral hazard causation of the Savings and Loan Association debacle in America in the 1970s and early 1980s from reading (years ago) an extensive discussion in the first edition of Donald Campbell: Incentives (CUP, 1995). This book is now in a recent second edition (CUP, 2006) and highly recommended but it is about graduate level for economists and will be verging on incomprehensible to readers without the necessary priors in economics and maths.

    As Mervyn King, governor of the Bank of England, first injected the notion and relevance of moral hazard in this public debate, we can be suitably reassured that he keeps up with the professional literature. But there seems to be no corresponding reassurance about the other two parties in the tripartite system who have so far maintained much lower profiles in the debate. Also, the BoE had solid reasons for not intervening earlier to prop up Northern Rock as the BoE had no prior remit to rescue NR from the downstream consequences of its own business model, consequences which were plainly evident for months to the hedge funds and the like which made profits through taking short positions in its shares. The extent of the fragility of Northern Rock can be judged from the absence of buyers willing to take over an institution that is reported to have provided as much as 19 per cent of UK home mortgages.

    Kindly overlook this interruption.

  7. Alert: The really dedicated must read Lawrence Summers in Monday’s FT on: Beware the moral hazard fundamentalists.
    http://www.ft.com/cms/s/0/5ffd2606-69e8-11dc-a571-0000779fd2ac.html

    There is much of wide interest in the piece on nuanced analysis of the different dimensions of moral hazard and the implications but the main intent is to argue that moral hazard considerations should not preclude measures to prevent contagious loss of confidence in financial institutions which are basically solvent.

    The consequences of systemic bank failures are hugely costly to economies. That point is well made and taken but there is curiously no reference to the S&L Assoc. debacle in America during the 1970s and early 1980s and the motivating role of deposit insurance (guarantees) in that debacle.

    A systemic loss amounting in the end to $125 billion or so that was ultimately covered by American taxpayers cannot remain overlooked as some passing, minor glitch. Just try dividing the number of taxpayers in America into $125 billion.

    Lawrence Summers is an economics prof at Harvard and was first US Deputy Treasury Secretary and then US Treasury Secretary in the Clinton administration.

  8. For the archive here because this is just what moral hazard theory would predict in the presence of bank deposit guarantees if there are no effective sanctions against institutions and their agents generating sub-prime mortgages:

    “A BBC investigation has found evidence of serious mis-selling in Britain’s sub-prime mortgage market. Industry insiders have described how people have been advised to lie about their incomes to take out loans far bigger than they can afford.”
    http://news.bbc.co.uk/1/hi/programmes/file_on_4/7010415.stm

    Apart from jeopardising the systemtic stability of financial institutions and stoking the likelihood of house repossessions and downstream personal bankruptcies, boosting the numbers of sub-prime mortgages helps to further inflate an unsustainable house-price bubble.

    Above citations in the thread here show that the moral hazard effect of deposit insurance in the home mortgage market was well recognised in the professional literature years ago.

    We are entitled to ask what all those “special advisers” in government were doing to earn their taxpayer financed crusts in those years.

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