At the height of the 2008 banking crisis, Mervyn King backed the wrong plan, which triggered a vicious deflationary shock in the UK
September 15, 2008 was an important date in financial history. It was then that bankers ceased to be regarded as acceptable representatives of the human race. Lehman Brothers filed for bankruptcy, with liabilities of potentially over $600 billion. Newspapers around the world said that the failure would be the largest in history, imperilling jobs, threatening small and medium-sized businesses, and risking economic collapse. According to the headlines, bankers were to blame for catastrophe.
More restrained words would have been sensible. Lehman’s losses were to total about $150 billion, equivalent to 0.2 per cent of American household net worth of $66,800 billion at the end of 2007. The losses fell in particular on Lehman’s commercial counterparties, including a list of widows and orphans with such names as Goldman Sachs, Bank of America and JP Morgan Chase. In the market turmoil and media hubbub no one noticed an obvious point: larger losses (relative to national output) had been reported by many companies and industries in America’s past, with no effect whatsoever on macroeconomic activity.
An amazing feature of modern life is that people believe what they read in newspapers. The headlines did their work. Bankers everywhere became the villains in a cops-and-robbers melodrama. The credit rating agencies, which had hardly been great heroes in the early phases of the crisis, decided to join the lynch mob. Hundreds of financial institutions in many countries received credit downgrades, undermining their ability to fund assets. One victim of this process was Bradford & Bingley, a Yorkshire-based mortgage lender with its roots in the Victorian mutual movement and self-help.
Despite having raised £400 million of new equity capital in July so that its solvency would not be in doubt, Bradford & Bingley’s downgrade meant that — like Northern Rock a year earlier — it faced a funding shortfall and might have to seek a loan from the Bank of England. UK officialdom did not want a repeat of the barrage of hostile publicity it had received in late 2007. Whereas Northern Rock’s nationalisation had taken some months and paid attention to due process, Bradford & Bingley was seized by the British state over the weekend of September 27-28. As with Northern Rock, no compensation was paid to shareholders.
Did government press officers tell the newspapers to report the story? The first paragraph of the Sunday Telegraph’s coverage read, “British taxpayers will be liable for more than £150 billion of potentially toxic mortgage debt following the nationalisation of Bradford & Bingley”; the headline was less circumspect, “Financial crisis: Bradford & Bingley nationalisation will cost taxpayers £150bn”. The Sunday Telegraph story has turned out to be drivel. According to its annual reports, Bradford & Bingley made a combined profit before tax of £2.4 billion in the period from January 2009 to March 2015. In addition, the government snaffled the company’s equity capital as it was in September 2008, which amounted to over £1 billion. Further profits will be earned on the rump of the business.
In a nation that prides itself on respect for the rule of law and property rights, the Bradford & Bingley expropriation was among the most outrageous acts of a British government in peacetime. There seems to be little doubt that the Treasury and the Bank of England conned journalists into magnifying a commercial organisation’s problems, thereby facilitating its theft. The behaviour of Her Majesty’s Government was little better than racketeering. Even today many people believe that in 2008 both Northern Rock and Bradford & Bingley were “ bust”, although their subsequent results and detailed audit information show otherwise. As their managements protested at the time, they were solvent and profitable businesses, but market conditions were such that they could not readily fund their assets.
Northern Rock and Bradford & Bingley were the salient tip of British banks’ funding iceberg. Over the decade running up to 2008, virtually all of the UK’s top banks had borrowed heavily on the wholesale markets, and used the proceeds to compete aggressively in lending to households and companies. The Labour government and the Bank of England knew full well that the credit boom had not been financed entirely from British retail sources. RBS, Barclays, HBOS and Lloyds had substantial wholesale liabilities, with enormous sums owed to foreign creditors. (HSBC was the exception, because it took a high share of its deposits from its Asian retail branch network.)
If the British government could nationalise Northern Rock and Bradford & Bingley without compensation, what did that mean for four giants of the industry that had also been reliant on wholesale money? They were soon to find out. Early in October 2008 RBS, HBOS and Barclays faced difficulty in rolling over inter-bank lines, while Lloyds was somewhat better placed because of its reputation for avoiding risk. Like the two former building societies that were now in government ownership, RBS, HBOS and Barclays might have to borrow from the Bank of England.
But Mervyn King, the governor of the Bank of England, did not want his institution to lend to them at all. In evidence to the Treasury Committee of the House of Commons on September 11, 2008 he had pronounced, “It is not the central bank’s job to lend to commercial banks on a long-term basis. That is a job only for the private sector or taxpayers, acting via the government.” As I discussed in my article “How Mervyn King got Northern Rock wrong” in the last issue of Standpoint, King had always loathed bankers and the City of London. His evidence to the Treasury Committee repudiated key principles established by Walter Bagehot in his 1873 Lombard Street. To recall Bagehot’s words, not only was it the central bank’s job to lend (at a penalty rate, of course) to solvent banks with a funding problem, but in crisis conditions the central bank should “lend as fast as” it can, because “ready lending cures panics, and non-lending or niggardly lending aggravates them”.
The tension reached its height during the evening and night of October 7. As King was adamant that the Bank of England would not lend on a long-term basis to any British bank, and as the international inter-bank market had been paralysed since August 2007, the only way that RBS, HBOS and Barclays could fund their assets was by raising new equity or bond capital. But their share prices had collapsed. The package proposed to the banks was that, if they wanted further loans from the Bank of England, they would have to accept the government’s money in a major recapitalisation.
In other words, they would have to become nationalised, at least in part. Could the banks have said no? One of the revelations in Ivan Fallon’s important and recently-published book Black Horse Ride (Robson Press, £25) is that the government did have a fall-back plan of sorts. If the banks refused to issue new capital on the government’s terms and still could not finance their businesses from market sources, their outcome would be the same as it was for Northern Rock and Bradford & Bingley. The businesses would be taken from shareholders without compensation. Since RBS was, at the time, the largest bank in the world in terms of assets, the potential public relations implications were alarming, even terrifying. Alistair Darling, the Chancellor of the Exchequer, is quoted by Fallon as saying, “It crossed my mind that the banks . . . might be daft enough to take up the option of suicide — and I simply couldn’t afford a row of dead banks in the morning.”
In the event RBS and HBOS had no alternative. They had already started to borrow from the Bank of England (on a short-term basis, of course), although the full extent of their plight was not to be disclosed until much later. Barclays instead sought help from Qatar, which had surplus funds in the Western banking system because of its considerable natural gas exports. The Qatari sovereign wealth fund was persuaded to lend Barclays sufficiently large sums on inter-bank terms and to subscribe for enough newly-issued equity that it could comply with UK regulatory demands. Vitally, Barclays achieved this without taking British government money. In that sense, it remained independent and in control of its own destiny.
But there was a catch. Given the crisis conditions in which the discussions were held, the Qataris could drive a hard bargain. Suggestions were later made that Barclays received its money only after bribing top Qatari officials, a matter which led to a still-unresolved investigation by the Serious Fraud Office. At the time the Prime Minister of Qatar, Sheikh Hamad bin Jassim, was in cordial discussions with none other than the Prime Minister of the UK, Gordon Brown. (According to Brown’s memoirs Beyond the Crash, he was “urging” the sheikh “to consider investment in recapitalisation of our banks”.) The fact is that Brown and Darling, unable to overrule King on emergency liquidity assistance to Britain’s top banks, welcomed Qatar’s intervention.
In due course the Qatari sovereign wealth fund made a nice turn on the transactions. A Reuters story published about four years later put its profit at £1.7 billion, a sum that was at the expense of Barclays’ other shareholders, most of whom are British. A fair comment is that, if the Bank of England had been prepared to lend to Barclays to tide it over its liquidity strains in late 2008, possibly for a period of a few years, this loss to Britain would not have occurred. The source of the trouble was Mervyn King’s pronouncement that long-term loans to British banks were not part of the Bank of England’s remit. Suppose that a large four-year loan on commercial terms, plus a penalty, had been extended by the Bank to Barclays in October 2008. Then not only would the Bank of England rather than the Qatar sovereign wealth fund have made a profit from the interest margin, but all the dubious negotiations with an Arab sheikdom and the allegations of bribery would have been avoided.
King might insist that the Bank of England’s job is not to help banks out of trouble. Instead its statutory priority is to conduct monetary policy in order to meet the inflation targets, and that is all. He might reiterate the arguments he gave to the Treasury Committee in September 2008, possibly adding that the European Commission regarded the state support of Northern Rock in late 2007 as an artificial subsidy that would become illegal after a mere six months.
King’s problem is that his position has been refuted — decisively and comprehensively — by the actions of the European Central Bank in the last few years. Not only did the ECB extend large credit lines to eurozone banks at the start of crisis in August 2007, but it later renewed them on an uninhibited and massive scale. The first big decision taken by ECB President, Mario Draghi, in December 2011 was to institute so-called “long-term refinancing operations” (author’s italics) or “LTROs”, by which any Eurozone bank could borrow from the ECB for as long as three years at an interest rate of only 1 per cent. The arrangements were repeated and expanded in February 2012, and eventually hundreds of banks took advantage of them.
This was the lifeblood of liquidity that revived the eurozone from a near-death experience, and was a particularly important transfusion to the banking systems of Spain, Ireland, Portugal and Greece. It must be emphasised that the facilities were — explicitly, almost brazenly — long-term. Were Draghi and the ECB keen to distance themselves from Mervyn King and his repudiation of long-term central bank lending? Did they want banking organisations around the world to believe that the ECB was open for business, while the Bank of England was closed?
The rights and wrongs of the British banking crisis of 2007 and 2008 will be debated for decades to come. Let it immediately be conceded that most of the UK’s banks had taken inappropriate risks in the run-up to the crisis, and their managements and shareholders deserved much of the pain. RBS was over-trading, with a balance sheet that was grotesquely large relative to its true capital resources. HBOS’s assets included investments that could not, on any sensible regulatory criterion, be deemed safe and appropriate banking assets, and was insolvent. Barclays was better placed, but its senior executives could not make up their minds about how to mix commercial banking operations with the racier world of investment banking. Lloyds had been prudent by traditional banking standards, but it had sold its customers billions of pounds’ worth of payment protection insurance (PPI) policies that were later judged worthless and semi-fraudulent.
The banks had sinned and many of their top executives were the sinners-in-chief. Nevertheless, the key question for UK policy-makers throughout the crisis ought to have been, “What is in the nation’s best interests from now on?” The banks may have done silly things in the credit binge of the early and mid-noughties, but they had complied with regulations, paid taxes and on the whole obeyed the law. (The deplorable rigging of market benchmarks was not public information in October 2008, while a case is sometimes argued that the PPI policies were legitimate products.) RBS, Barclays, Lloyds and HBOS were entrenched in British banking, with their branch networks and settlement capability. Well-timed rights issues, management changes and astute handling ought over time to have restored them to health.
Above all, official measures to deal with the banking problem had to be structured so as not to cause a recession and damage innocent bystanders. In the critical weeks in September and October 2008 the key movers and shakers often gave the impression of not knowing where events would take them or what they should do next. Most fundamentally, they knew from the mess around them that banks mattered enormously to macroeconomic outcomes, but they lacked a coherent theory of how banking fitted into the economy, and why it affected spending and output. Both Mervyn King and Ben Bernanke, then chairman of the Federal Reserve, endorsed bank recapitalisation because they saw it as a way of restoring confidence to the banking system, and so unfreezing the inter-bank market and stimulating new bank lending to the private sector.
But was it not obvious that the demands for banks to have higher capital/asset ratios would slow the growth of assets or even cause bank assets to contract? In late 2008, in Britain, the USA and most of Europe, banks’ assets were dominated by loans to the private sector. A contraction of banks’ assets therefore meant a contraction in their loan portfolios. Since banks like to be gentle to existing customers and not to pull credit lines when loan conditions are being met, a contraction in loan portfolios implied a drastic restriction of the availability of new credit. Far from stimulating extra bank lending to the private sector, the recapitalisation programme of October 2008 was followed in the UK by an intensification of the credit crunch. (Similar programmes elsewhere had similar consequences.)
When a customer repays a bank loan, he or she uses a bank deposit. A sum in the deposit is paid to the bank, and both the deposit and the loan are cancelled. Nowadays bank deposits are the principal form of money. More generally, if officialdom instructs banks to sell their riskiest assets and “to tidy up their balance sheets”, loan repayment causes the destruction of money balances. Whereas in early 2007 the quantity of money had been growing in the UK at a double-digit annual rate, by early 2009 the rate of money growth had collapsed and was liable soon to go negative.
Bank recapitalisation was a vicious deflationary shock to the British economy, at just the wrong moment in the cycle. The Great Recession of late 2008 and early 2009 was the UK’s most severe setback in private sector demand since the inter-war period. (Government spending carried on growing.) Officialdom punished the bankers, but in the process it punished everyone else too. The squeeze on money balances, due to banks’ shrinkage of their businesses, exacerbated the weakness of demand. Job losses occurred throughout the economy, affecting millions of people unconnected with finance, and remote from the squabbling in Whitehall and Threadneedle Street.
The downward spiral could have been checked, easily and quickly, if the Bank of England and the Treasury had taken the right decisions in autumn 2008. First, the Bank should have extended LTROs, on Draghi’s December 2011 model, to British banks. Second, policy-makers were and remain too obsessed with banks’ capital. They need to be told that no recognised economic theory proposes that national income is a function of banking system capital. The standard and traditional view, that national income and wealth are determined by the quantity of money, is correct. Large-scale money creation by the state, as in “quantitative easing” programmes, can always stop a demand downturn. If QE had been announced on the morning of October 8, 2008, instead of the misjudged and mistimed bank recapitalisation, the Great Recession would not have happened.