The financial system of the United Kingdom is considered to be one of the best in the world. In fact, it is where the system was born, nurtured and advanced to maturity, both in theory and practice.
The latest episode at Northern Rock, a small UK bank, however, suggests that despite the best safeguards, financial institutions cannot be totally immune to problems and the possibility of a crisis cannot be ruled out altogether. Northern Rock, in fact, suffered a funny sort of bank run. It did not make horrible lending losses - the usual trigger for bank runs in the past; indeed, its mortgage assets are thought to be prime and pristime.
But it relied on the commercial paper markets to finance itself, which subsequently were all but closed. Northern Rock had raised billions of pounds to fund an aggressive lending strategy but the liquidity dried up due to a squeeze on credit in the global money markets in the wake of a crisis in the US subprime mortgage sector.
Therefore, the problem, according to most analysts, was one of liquidity, not solvency. However, ordinary clients/depositors are not bothered by these finer distinctions. Queues to withdraw funds swelled when the news of impending problems at Northern Rock came to surface. A run on a financial institution cannot be avoided if credibility of a bank is in doubt or lost due to its perceived inability to honour its obligations.
Central banks are obliged to come into the picture in such situations. As the crisis worsened, Northern Rock was forced to apply to the Bank of England for emergency funds earlier this month.
Although the run on Northern Rock was a serious matter, it was the response of the overall system towards this crisis which seems to have attracted far greater attention of public and policy makers. As crisis of confidence was spreading to other financial institutions, Bank of England's Governor Mervyn King appeared to be double-minded.
In his letter to the Treasury Select Committee, the Governor was reluctant to offer financial assistance since it could sow "the seeds of a future financial crisis". Provision of such support, according to the Governor, undermines the efficient pricing of risk and encourages excessive risk-taking. Subsequently, however, the Bank of England was driven into a striking policy U-turn after a series of high-level meetings involving the Financial Services Authority (FSA), the Treasury and some of the largest financial institutions where concerns were aired that the crisis at the mortgage lender Northern Rock could spread to other lenders.
In an attempt to inject liquidity into the system, the Bank of England then had to offer billions of pounds on three-month terms to cash-strapped banks that provide mortgages, starting with an injection of ten billion pounds. Mervyn King, nonetheless, now stands accused of acting tough with UK banks in the beginning, only to step in later with emergency funding and finally agree to the action that bankers believe would have been enough to have headed off the debacle before it hit the high street.
He, however, gave a good account of himself in front of the cross-party Treasury Committee of MPs by defending the Bank's action but most of the analysts believe that his defence was uncompelling and the credibility of his institution remains dented. The British Government also stepped in to guarantee the savings of all customers of the beleaguered Northern Rock and any other bank that found itself in a similar situation.
Alistair Darling, Chancellor of the Exchequer, said that "people can continue to take their money out of Northern Rock. But if they choose to leave their money in Northern Rock, it will be guaranteed safe and secure". However, regulators are concerned that the approach for compensating bank customers in England is not robust enough to prevent them from rushing to withdraw their cash.
Under the scheme, the government guarantees all deposits below two thousand pounds and 90 percent of the amount upto thirty-five thousands pounds. Moreover, the British system does not make any special provision for handling banks that become insolvent.
The recent chaos at Northern Rock raises a number of questions about the workability of the system. It is obvious from the latest experience that central banks have to play a more active role and assume greater responsibility. The bank run afflicting Northern Rock shows that UK's tools for preventing such a crisis were not entirely foolproof. The turmoil at Northern Rock and difficulties in global financial markets are, in fact, a wake-up call for leading financial market centres to reassess their legal and regulatory frameworks in order to ensure more effective supervision.
Increasing use of off-balance sheet items, subprime mortgage lending, greater integration of global financial markets and certain other innovations in the banking industry definitely call for greater scrutiny of financial sector assets by the supervisors and regulators. Hitherto, the main goal of regulation has been to make sure that banks are solvent, that they have enough capital to cover potential losses on their lending.
Now the regulators have also to pay due attention to the liquidity risk which is not so easily measured and depends on the source of a bank's deposits and their terms, bank's capital, the open credit lines it has promised, the insurance it has bought, its emergency facilities with other banks and many other factors. In this connection, central banks could ask the banks to conduct stress tests - simulations of extreme market conditions - and devise contingency plans for funding in a crisis. However, there is a trade-off in the sense that banking regulation and supervision should not be tightened to the point where it squeezes the element of innovation entirely out of the system.
The overall handling of Northern Rock also suggests a breakdown in the relationship expected between the Bank of England, the FSA and the Treasury which were jointly responsible for overcoming the financial crisis. In the tripartite system created by Gordon Brown when he was Britain's Chancellor in 1997, the FSA supervises individual banks while the Bank of England has the balance sheet and acts as the lender of last resort.
At the time when FSA was created, many said that the split would prove unworkable in a crisis and so it has proved. An effective cooperation at all levels all the time is, of course, essential to ensure that the weaknesses of a financial institution are detected at the earliest so that the likely damage to the system could be reduced to the minimum.
It needs to be mentioned here that Pakistani authorities were also reported to be planning to appoint SECP as the sole supervisor of the financial system of the country, a job which has so far been done efficiently by the State Bank. Hopefully, the government would now rethink about this issue, keeping in view the Northern Rock experience and desist from such a move.