Northern Rock: Assessing the Damage to the Bank of England’s Credibility

In today’s Financial Times, Willem Buiter, professor of political economy at the London School of Economics, and and Anne Sibert, professor of economics at Birkbeck College, University of London, take stock of the impact of the Northern Rock bailout on the Bank of England’s reputation.

The article points out various dimensions on which the Bank’s action was misguided. It goes beyond the widely-cited observation that the rescue was an abrupt reversal of the bank’s policy of intervening only to counteract threats to financial stability. Northern Rock, the UK’s fifth-biggest building society, is too small to pose any systemic danger.

The authors argue that had the Bank had collateral policies similar to those of the ECB, the crisis might not have occurred. Similarly, they criticize the Bank for failing to intervene in the three month money markets (It now is operating only in overnight markets). Its own policies call for a flat money market yield curve, yet the one month rate recently was nearly a full point higher than the overnight rate, which Buiter and Sibert attribute mainly to a liquidity risk premium.

The writers believe the stakes for the Bank are high, since credibility is key to the Bank’s effectiveness in implementing monetary policy. The lack of disclosure about the terms of the deal are only making public perceptions worse.

The FT’s Lex column also notes (as we did yesterday) that Northern Rock is under considerable time pressure to close a deal:

Northern Rock’s options are nevertheless narrowing as each day passes. Selling itself to a trade buyer anxious to beef up its own mortgage business seems unlikely – it would, after all, presumably have explored this before resorting to the drastic measure of going to the Bank. Its brand, sadly, has probably now been irrevocably tainted.

It is also clear that funding itself from the Bank’s facility can only be a temporary measure. Not only does the money come at a high cost – at least 7 per cent – but the Bank also requires a significant haircut on collateral offered. This varies according to its quality but suggests that, should Northern Rock require more funding, it will get it on progressively more punitive terms. The Bank, after all, has a responsibility not just to minimise the hit to taxpayers but also to avoid moral hazard. And its responsibility is not to save the bank itself but to protect depositors.

If Northern Rock fails to agree on terms with a buyer soon, the bank will be liquidated, which is what would have happened in the absence of a rescue, making the bailout look even more misguided.

From Buiter and Sibert:

The Northern Rock bail-out was formally a joint decision of the UK Treasury, the Financial Services Authority and the Bank of England. However, their Memorandum of Understanding (MOU) states that “ultimate responsibility for authorisation of support operations in exceptional circumstances rests with the chancellor [of the exchequer]”. This makes sense: the taxpayer is on the hook when public resources are put at risk. Unfortunately, it is the Bank’s reputation that is damaged. It had to provide credit after the governor took a strong public stand against bail-outs.

Following rapid expansion financed by high-risk funding, Northern Rock depended on the government to survive. Three-quarters of its funds came from the wholesale markets instead of depositors. When global financial turmoil hit, Northern Rock could no longer refinance its maturing obligations. It had engaged in reckless borrowing; it gambled and lost. Now it must find itself a buyer with deeper pockets. That the government bailed it out is hard to understand. The MOU states that a bail-out should only be undertaken if there is, “a genuine threat to the stability of the financial system”. The demise of the fifth-largest UK mortgage lender would hardly be a systemically significant event.

The Bank’s primary role is to ensure price stability. For this, it needs credibility. The Northern Rock debacle damages this credibility. Restructuring Lender of Last Resort responsibilities is necessary. The Bank should support key financial markets and institutions such as the payments and clearing and settlement systems. Bailing out individual banks should be left to the FSA, which has the expertise, and the Treasury, which has the power to tax. Ending the active role of the Bank as a lender of last resort would require only that the FSA have a credit line with the Bank, guaranteed by the Treasury, and a change in the MOU.

The Bank is not blameless in the Northern Rock debacle, however. A bail-out might not have been needed if the Bank had a more sensible collateral policy for its open-market operations and discount-window borrowing. The ECB accepts private securities rated at least A-; the Bank should too. If Northern Rock had a eurozone subsidiary, it could have borrowed from the ECB, using its high-grade mortgages as collateral.

The Bank should also intervene in the three-month, as well as the overnight, money market. Its own money market Objective 1 says: “Overnight market interest rates to be in line with the official Bank Rate, so that there is a flat money market yield curve . . . out to the next MPC decision date”. In early September, a month before the next MPC meeting, the one-month (unsecured) interbank rate should have been close to the policy rate of 5.75 per cent; instead, it was 6.68 per cent: just below three-month Libor. As the policy rate is unlikely to rise, this spread must be some combination of a pure term premium, a counterparty risk premium and a liquidity risk premium. We believe it reflects primarily liquidity risk.

Currently liquid banks are reluctant to make interbank term loans today, even at nearly 7 per cent, because they fear they and their borrowers may be illiquid three months from now. The Bank should inject liquidity with a three-month maturity to reduce the liquidity premium and kick-start lending. Accepting a wider range of eligible collateral – punitively priced – would enhance the effectiveness of this.

We know that the chancellor authorised the Bank to support Northern Rock. But is the support uncapped and open-ended, as Northern Rock informs us? What is the premium? Exactly what collateral will be offered and how will it be priced? Taxpayers’ money is at risk. The chancellor should make public this information and if he does not, parliament should insist.

The Bank’s credibility is being sacrificed for a bail-out of a systemically insignificant mortgage lender that looks at least partially politically motivated. The chancellor wants to protect depositors and does not want a bank failure on his watch. Depositor protection, however, is the job of the FSA and the Financial Services Compensation Scheme. Redistribution of income is the Treasury’s province. If the Bank is part of the inevitably political bail-out of individual banks, its independence in the realm of monetary policy could be compromised.

Update 9/17, 10:45 AM: Bloomberg’s story “King, BOE Face `Crisis of Confidence’ After Rescue ” suggests that critics are increasingly taking the line that had the Bank of England acted earlier, Northern Rock might not have had to be rescued:

Bank of England Governor Mervyn King has spent the past month trying to stay above the fray as the U.S. subprime-mortgage collapse roiled credit markets. Now he’s getting dragged in, whether he likes it or not….

“It’s a crisis of confidence, and the bank is confused,” said Patrick Minford, an economics professor at Cardiff University who advised former Prime Minister Margaret Thatcher. “They want to be hands-off, but in this situation they can’t be. I don’t think this has done King any good.”

King’s credibility is in question for his refusal to emulate other central banks and take early action to help cash-strapped lenders. With Northern Rock’s failure, he is finding himself subject to the same charge of excessive caution being leveled at U.S. Federal Reserve Chairman Ben S. Bernanke….

“There’s no doubt that had the Bank of England acted early, Northern Rock would not have had the same problems,” said Stephen Bell, chief economist at hedge fund GLC Ltd. in London. “The idea they can’t do anything about it is clearly wrong.”….

King’s defenders say the Bank of England’s stance on the credit turmoil, which he outlined in testimony to U.K. lawmakers last week, will be proven wise over time. “King is an intellectual colossus, and I’d have no qualms about reappointing him,” said Geoffrey Dicks, chief U.K. economist at Royal Bank of Scotland Group Plc in London. His statement “was almost a gem.”

King, an architect of the bank’s inflation-targeting strategy, has won plaudits for helping end the U.K.’s decades-long fight with rising prices. He became chief economist in 1991 and was named governor in 2003.

“King has faced lots of tests and come out of them very well,” said Minford. “He’s done a good job. But on this one he’s made a wobbly call and will have to retrieve it smartly.”