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Wild Parties and the Bank of England

Aug 12, 2008
Mervyn King, Governor of the Bank of England, is normally noted for his restrained and diplomatic language in statements concerning interest rates and the general performance of the UK economy.

However, this reserve and restraint appears to be changing. During the Northern Rock banking crisis in the summer of 2007, he justified his reluctance to intervene and save the bank by reference to 'moral hazard'. By this he meant that banks, like every other private sector organisation, should be subject to normal commercial forces. If the directors act wisely, the bank will grow and prosper. If they act foolishly, they will make losses and risk takeover or even bankruptcy.

Several commentators made light of his remarks and suggested that he may have been visiting lap dancing clubs frequented by younger City traders. The amusing comments lasted for several weeks, but before the story ended, the Governor had performed a spectacular U turn. The threat of moral hazard had been overshadowed by the lines of depositors outside Northern Rock branches who were waiting to withdraw their funds.

The Chancellor of the Exchequer, Alistair Darling, described the action of depositors as irrational and felt obliged to stop the panic by guaranteeing all deposits at Northern Rock. The bank was subsequently nationalised or taken into public ownership.

In the US, the pattern was repeated. On the one hand, the Fed wished to respect market forces and let poor performing banks fail, but at the same time was mindful of the wider implications of such failures.

Eight banks have been closed in the US during 2008 by state and national regulators. The most significant casualty being IndyMac of Pasadena, California and this was the second largest collapse in US banking history. Although, the Federal Deposit Insurance Corporation is expecting to payout some US$ 7 billion to depositors, this will only cover the first US$ 100,000 of each account. It is estimated that some 30,000 of IndyMac's customers have deposits in excess of this guaranteed sum.

However, the Fed has not implemented this policy across the board. When the investment bank, Bear Stearns, was in trouble, the Fed quickly arranged for JP Morgan to take over the bank. The irony is that Bear Stearns did not hold the life savings of small depositors, but managed investments for corporations and wealthy speculators. The Fed felt that Bear Stearns was simply too big to fail and that its dealings were complex. The failure of Bear Stearns would lead to a contagion and drag many other large players to the brink. The international dimension of Bear operations, also meant that the global standing of all US financial institutions would be adversely affected.

The action by the Fed has drawn criticism from many quarters. It has bailed out an investment bank which managed funds for wealthy clients and has let a bank which specialised in mortgage lending fail. This sounds like public support for the wealthy and privileged while poorer people have to face the cold wind of capitalism.

Both the Bank of England and the Fed are trying to devise prudent and coherent policies in response to criticism and public concern. This is an urgent process as the fallout of the credit crunch is far from over and other banks remain fragile.

The behaviour of banks during the years of easy credit was akin to herd instinct behaviour. Financial derivatives, based on the packaging of US subprime mortgages were popular bank investments. They were also given top ratings by agencies such as Standard & Poor's and Moody's.

However, these rating were flawed. The imaginative and complex way in which mortgage debt was sliced, diced and repackaged meant that credit rating became based on guesses and not hard facts. When these ratings were downgraded the repercussions were immediate and significant. For example, the UK buy-to-let mortgage lender, Bradford & Bingley, suffered a serious reversal when Moody's revised its rating. This led TPG, formerly Texas Pacific Capital, to withdraw from the proposed purchase of 23% of the bank's shares.

Mervyn King, in a speech on 10 June 2008, commented on the increasingly risky behaviour of banks. He said 'If banks feel they must keep on dancing while the music is playing and that at the end of the party the central bank will make sure everyone gets home safely, then over time the parties will become wider and wilder.'

If the adverse effects were limited to hangovers by party-goers, this may be of little consequence. But when the party ends, unfortunate and innocent people have their houses repossessed and some elderly folk lose their life's savings.

Not only are banks cushioned against the implications of disastrous investments, their top management seem to be immune from criticism. In the UK, Sir Fred Goodwin, Chief Executive of RBS defended his position after his bank revealed a GBP 5.9bn loss while Michael Geoghegan of HSBC, after indicating a possible US$ 6bn loss, asked shareholders for 3 years to sort matters out.

At the same time, all major banks are calling in loans to small and medium size business in an effort to boost their cash holdings. These loans can be called in on demand and the borrower does not need to default before this takes place. This action understandably causes outrage in the wider business community and will lead many small firms into bankruptcy.

The problem of bank failures and public bailouts is now a matter of serious concern. The party is indeed over, and the party goers are back in the office actively foreclosing on mortgages and calling in loans to small companies. The challenge is too great for the Bank of England and the Fed to handle without direction and support from their respective governments.
About the Author
Leslie Hardy is a noted writer on North Cyprus Property
and the UK Chairman of Wellington Estates Ltd. Read more about Banking & Finance
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