How Mervyn King Got Northern Rock Wrong
The Governor of the Bank of England ignored the lessons of history and the UK’s reputation for financial competence may never recover
The starting point for any discussion of the UK banking crisis of 2007 and 2008 must be the events of May 10, 1866. The nation’s second-largest financial institution, Overend, Gurney & Co, announced that it could no longer repay creditors with cash. A few weeks later it was declared insolvent. The question for the Bank of England, the nation’s largest financial institution, was, “How should we respond?”
At that time the Bank employed no economists. It saw itself very much as a bank, if a rather special kind of bank because it was by far the dominant issuer of legal-tender notes and could freely expand these note liabilities. Strictly, it had to have enough gold to back the notes, but on a day-to-day basis it could do what it liked. That made it different from all other English banking institutions, which by law could not increase their note issues at all. It was a proto-central bank. It had this status even though at that stage the distinction between the central bank and commercial banks had not been clarified.
Since the Bank’s directors had let Overend, Gurney & Co go bust, they plainly did not see their job as being to rescue insolvent organisations. But the failure of that bank had wider ramifications, as it sparked “runs” on banks that were generally believed to be solid, well-managed and profitable. The Bank let it be known that it would lend notes freely to solvent banks. As its notes were the best-quality asset in the system, their injection into the economy restored confidence and the runs were brought to a halt.
There were two stings in the tail. The first was that, while the Bank made loans freely available, it charged heavily for them and demanded good collateral. The second was that, as Britain was on the gold standard, the Bank rate had to soar to 10 per cent to attract gold and maintain an adequate metallic cover for the Bank’s much-expanded liabilities. But life went on. According to statistics prepared more than a century later by the eminent economic historian Charles Feinstein, the UK’s gross national product fell by 1.5 per cent in money terms in 1867 and stayed down in 1868. But it moved ahead by 3.5 per cent in 1869 and surged by almost 8 per cent in 1870.
The Bank’s actions prevented the crisis at Overend, Gurney & Co from having too serious an effect on economic activity. In his celebrated 1873 book Lombard Street, Walter Bagehot, the first and most famous Editor of the Economist, said the Bank had “more or less” fulfilled its duty of making “enormous advances” in a “panic”. But he entered the caveat that it had not gone far enough.
According to Bagehot, not only should a central bank lend freely at a penalty rate against good collateral, it should also let its banking customers and the public at large know that this was its policy. By explicitly accepting a responsibility to lend in a crisis, the Bank could go a long way to ensuring that such crises did not happen at all. He warned, “Until we have on this point a clear understanding with the Bank of England, both our liability to crises and our terror at crises will always be greater than they otherwise would be.”
Bagehot’s doctrine was contested. The Bank’s directors did not like it, as it put them in the spotlight and carried the danger (the “moral hazard”, indeed) that they might be seen as a soft touch in a crisis. The most articulate opponent was Thomas Hankey, whom even Bagehot conceded was “one of the most experienced” of the Bank’s top brass. In Hankey’s words, “the Economist newspaper has put forward . . . the most mischievous doctrine ever broached in the monetary or banking world . . . Until such a doctrine is repudiated by the banking interest, the difficulty of pursuing any sound principle of banking in London will be very great.”
In the following decades the Bank behaved as Bagehot recommended. In that sense the arguments in Lombard Street, and in many trenchant editorials for the Economist, won the debate. The doctrine that central banks should lend freely to check a loss of financial confidence became textbook orthodoxy. The Bank’s reputation for crisis management was enhanced in the 1930s when not a single bank in the British Empire went under. The contrast with the United States, where thousands of banks closed in the Great Depression between 1929 and 1933, was obvious and compelling. For more than a hundred years Britain’s banks benefited from a central bank that understood their businesses and would help them to fund their assets when threatened by a run. When Northern Rock found it difficult to roll over inter-bank liabilities after the closure of the international money market in early August 2007, it took precedent and history as its guides. It immediately reported its problems to officialdom and expected assistance, not least because it had complied with regulations. Critically, its activities were audited every six months, and it deemed itself to have positive shareholder funds and to be fully solvent.
Because of a foolish decision in 1997 by Gordon Brown to split bank regulation from central banking, the regulator with direct responsibility for Northern Rock was not the Bank of England. Instead, it was the Financial Services Authority. But the FSA was full of people who had served many years at the Bank and thought they knew how its executive team, including its Governor, would behave in a crisis. As recorded by Ivan Fallon in his recent book Black Horse Ride (Robson, £25), top FSA staff looked around for potential buyers for Northern Rock. They soon found one in the shape of Lloyds Bank, which had been conservatively managed in the credit boom of 2006 and early 2007, and was regarded as having good assets and adequate capital.
According to Fallon’s account, based on personal interviews, insiders estimated that “the business value of Northern Rock to Lloyds would be £2.5-3 billion”. This was well above Northern Rock’s then value in the stock market and gave a sound commercial basis for a deal. But even Lloyds relied on the inter-bank market for financing to some degree. Given that the money market was paralysed by a lack of confidence, Lloyds Bank’s board was not 100 per cent certain that it could obain sufficient retail deposits or an inter-bank line to fund the combination of its existing business and Northern Rock. For the deal to go ahead, Lloyds needed a standby loan facility which might have to be as large as £45 billion. With the money market closed, only the Bank of England could provide a facility of this sort. (Of course, if the money market were to return to normality, the Bank money might not be needed at all.)
What would Bagehot have recommended that the Bank do in these circumstances? To recall Lombard Street again, it was the Bank’s job not just to make “enormous advances” in a panic, but also to “lend as fast as” it can, because “ready lending cures panics, and non-lending or niggardly lending aggravates them”. By the end of the first week in September 2007 all of the FSA’s senior staff and Paul Tucker, the Bank’s senior executive for markets, wanted the Bank to provide Lloyds with a standby facility to facilitate its takeover of Northern Rock. Some haggling over the cost of the facility remained, but everyone close to the negotiations wanted to avoid an intensification of the banking crisis.
But there was an obstacle — the Governor of the Bank of England, Mervyn King. At a fraught meeting on the afternoon of Sunday, September 9, he said that the Bank would provide no help at all. When Hector Sants, chief executive of the FSA, set out the reasons that such help was essential to pre-empt worse funding strains at Northern Rock, King was belligerent. To quote Fallon, “‘No,’ he said decisively and abruptly, ‘I could not in any way support that. It is not our job to support commercial takeovers. I’m not prepared to provide any liquidity on that basis.’”
The next few days saw bad-tempered exchanges between King on the one hand and top FSA and Bank staff on the other. The antagonisms became bitter and personal. The truth is that King loathed bankers and the City of London. The crisis gave King an opportunity to translate the loathing into action. Fallon quotes one banker as saying, “Mervyn saw his job as being to teach the banks and the markets a lesson.”
The Chancellor of the Exchequer, Alistair Darling, was sometimes brought into the loop, but — under the terms of legislation his own government had passed — he could not overrule the Governor of the Bank of England. Darling’s version of events in his 2011 memoir Back from the Brink is consistent with Fallon’s. Although less hostile to King personally, he does say that in late 2007 he was being told “time and again” by bank chief executives that the Bank of England “did not understand the nature of the problem they were facing”. Britain’s banks were solvent and confronted only a “lack of liquidity”. Darling thought that King had some good qualities, but “the lack of relationship between Mervyn King and the bankers” became “a real problem”, not least because King was “incredibly stubborn” and “could be exasperating”.
For some days after the September 9 meeting it was hoped that something could be salvaged from the proposal that Lloyds might acquire Northern Rock. But, given King’s intransigence, these hopes came to nothing. Northern Rock still could not roll over wholesale liabilities to other banks and was running out of cash. It had no alternative but itself to seek a loan from the Bank of England, with an announcement due early on Friday, September 14. Unfortunately, Robert Peston, then the BBC’s business editor, somehow got hold of the story prematurely, but his scoop overstated Northern Rock’s weakness.
The first big retail run on a British bank since 1866 — since, indeed, the crisis of Overend, Gurney & Co that had inspired Bagehot to write his classic Lombard Street — began on the morning of September 15, 2007. With depositors’ “terror” fanned by the Peston story and overblown newspaper headlines, cash withdrawals ran into the tens of billions. The Bank of England had to lend the full amount of those withdrawals to ensure that depositors did receive cash, with its loan peaking at more than £40 billion. The UK’s reputation for high-level competence in finance and banking was badly dented, and may never recover to what it was before autumn 2007.
When asked a few weeks later by the Commons Treasury Committee whether a Lloyds takeover of Northern Rock would have avoided the disaster, King claimed that no meaningful discussions had ever take place. His evidence did not deny that the Lloyds proposal had been on the table, but dismissed it as consisting of “one pretty vague phone call which came to Bank officials and then passed to me, originating in the FSA”.
A fair interpretation of Fallon’s book is that King’s statements to the Treasury Committee amounted to an outright lie. They were certainly misleading. Fallon writes: “For his part, Hector Sants still boils with anger at the way things worked out.” Sants is quoted as saying (evidently on the record), “I believe to this day that the Bank of England’s decision was one of the biggest mistakes made in the UK in this period. If we had stopped Northern Rock failing in a disorderly fashion, we would have been seen as the leader by the rest of the world and in control of the situation.”
On February 17, Northern Rock was nationalised by the British state, with no compensation for its shareholders. The lack of compensation contrasted sharply with Lloyds’ preparedness to pay £2 a share some months earlier, which would have given a valuation of almost £1 billion. It is now more than seven years later, and most of Northern Rock’s loan portfolio has either been sold off or run down. What has happened to all those allegedly dodgy mortgages? Was Northern Rock indeed a bank that had behaved so recklessly as to be worthless?
It is now official that the British state has made a thumping profit, into the low billions, on its seizure of the business. On June 10 this year, the Treasury published a report from Rothschild on The UK investment in Royal Bank of Scotland. The report showed that, overall, UK Asset Resolution had made a net profit of £9.6 billion for the taxpayer. UKAR contains two businesses, Northern Rock and Bradford & Bingley. The Northern Rock part made pre-tax profits in the six years to end-March 2015 of almost £5 billion. By implication, it contributed at least half of the £9.6 billion of the state’s booty. (What was that a famous novelist once wrote about Robbery Under Law? Wasn’t that sort of thing meant to happen only under Latin American caudillos? Or in Putin’s Russia?) I was myself a shareholder in Northern Rock and gave expert witness advice on behalf of the sharholders. In 2008 I correctly predicted Northern Rock would eventually make the government a profit.
The key issue in the whole sorry saga was the subject of the Bagehot-Hankey dispute almost 150 years ago: does the central bank have a responsibility to lend — at a penalty rate on good collateral — to a solvent commercial bank that has trouble funding its assets and is vulnerable to a run? And should that responsibility be spelt out formally in legislation? Bagehot’s answer was yes, Hankey’s was no. For many successful decades the Bank of England behaved as if Bagehot was right. In 2007 and 2008 its Governor apparently deemed Thomas Hankey, who was after all one of his predecessors on the Bank’s Court, the greater authority on the purpose and functions of a central bank.
Ivan Fallon’s Black Horse Ride is a lively, readable, necessary and outstanding book. Fallon has done an important public service by putting on record the views privately held by nearly all the prominent players at the time, although — it has to be said — he seems not to have interviewed Mervyn King himself. By his behaviour in early autumn 2007 King repudiated Bagehot’s intellectual legacy, with results that were catastrophic for both the Bank of England and the British banking system as a whole. Bagehot’s ghost might perhaps be chuckling about the September 20, 2007, front cover of the magazine which he had edited during the Overend, Gurney & Co crisis in May and June 1866. Its headline was “The Bank that failed”. Quite so.