It would be undoubtedly convenient in the city and in Westminster if it was Mervyn King. But whatever the case on both sides, and whether or not Mr King keeps his job I suspect he will, incidentally, but may not get his term in office renewed the real questions after this affair are not so much about the handling of it in the past three weeks, but about the handling of it in the past three years. I was really struck yesterday at the torrent of support for Mervyn King from readers of my blog — and those messages are still coming in. But I now fear that the briefing by the Bank to me last night — to the effect that the decision to offer three-month loans against the security of mortgage-collateral would not have been enough to help Northern Rock — was disingenuous.
Such a facility could have prevented the Rock hitting the rocks. And Northern Rock itself is absolutely persuaded that if these auctions had been available a few weeks ago, there would never have been the liquidity crisis which prompted it to go cap in hand to the bank for emergency help. Then the Bank changed its mind and said it could not be seen to be subsidising the deal.
The consequence was that the Rock then had to apply for succour from the Bank as lender of last resort. And the rest is the wrong kind of banking history. I have spoken to members of its "court" the equivalent of its board of directors and they are split on whether he will or should quit. One of the main functions of a central bank like the Bank of England is to provide liquidity - or funds - to banks to ensure the smooth running of the financial system and the economy. Banks became reluctant to lend to each other and would only do so at relatively high interest rates.
However, the Bank of England consistently said that its system for providing liquidity didn't need overhauling. It claimed that to do so would be to bail out banks which had lent or invested in an injudicious way - and it had no intention of doing that. If it had done this three weeks ago when banks were clamouring, Northern Rock might never have feared that it was running out of money. And there would never have been that infamous run on Northern Rock - the first run on a British bank for years.
The possibility that the flight of capital from Northern Rock could have been avoided is seriously embarassing for the Governor of the Bank of England, Mervyn King, one of whose functions is to maintain financial stability. It says that Northern Rock would have needed far greater funds - and that if this finance had been provided three weeks ago or so, the liquidity would not have eliminated the Rock's funding difficulties.
It is slightly odd that the Bank should divulge this to me now, because it failed to provide this detail or any answer at all when I asked this afternoon whether what it announced today could have provided succour to Northern Rock. So although the Bank of England has changed course in respect of the way it is prepared to tackle the crisis in the money markets, it is sticking to the position that it has no regrets about the way that it provided its initial support to Northern Rock.
The blame game has started. Who's to blame for the run on the Northern Rock - the management for their over-reliance on the money markets to fund their business, the regulators for not reacting quickly enough to guarantee the safety of depositors' cash, or the depositors themselves for panicking and ignoring the reassurances of the authorities? We have also seen on this blog , amongst other places that some people blame the BBC for its reporting of the crisis. From the moment the story broke - a terrific scoop by our business editor Robert Peston on Thursday night - we were clear we had to handle the story carefully.
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We talked internally about the need to be responsible in our coverage - not to provoke panic but to tell people straight what was happening see Peter Horrocks' blog on Thursday. We set out to be restrained and factual. We have given plenty of air time to Northern Rock, to the Chancellor and the FSA to reassure depositors and we have repeated those assurances throughout our coverage over several days.
But despite this, obviously we had a run on the bank - I think this is down principally to two things:. The power of the images of long queues forming and The fact that for many people this was indeed a 'rational' thing to do, if you were exercising the precautionary principle. So as one customer in a queue told us, "I'm not panicking, I'm being completely rational". Should we have carried images of the queues? Of course we should and everybody did. The public needs to know what's going on - but we had a responsibility to do it in a balanced way.
So the fears of those interviewed in the queues were set against the reassurances of experts from the financial services industry and the politicians and the regulators. It is not the fault of the BBC or the media in general that these assurances were not believed until the chancellor removed all doubt. What happened at Northern Rock, the first run on a British bank in living memory, has caused deep shame and embarrassment in the banking industry.
His refusal to flood the banking system with cash over the past few weeks is the cause of the humiliation of their industry, or so they claim. They replied that there was little the FSA could do, but it would be helpful if the Bank of England would widen the collateral it was prepared to accept from banks in return for providing short-term funds.
In a way, that is predictable. They are both former investment bankers, with a visceral understanding of markets. However King — a world-class economist with an intellectual grasp of markets rather than an emotional one — said no. He feared that he would in effect be bailing out some banks and financial institutions which — for the future safety of the financial system — ought to feel the pain of their imprudent lending and investments.
So the Bank stuck to its own rulebook of how much it would lend into the banking market and how it would do so. There was no recovery in banks willingness to lend to each other and - with a grim inevitability - Northern Rock started to fear it would run out of cash. So Northern Rock had no option but to request an emergency loan from the Bank of England — which it was duly given last Thursday night. What followed has been a shocking new chapter in the annals of banking history, as images of queues of anxious customers flashed across the world.
The Government too has been humiliated. All its reassurances to Northern Rock depositors were ignored, until - with all the appearance of panic - it ditched its existing limited insurance scheme for depositors by promising that no Northern Rock depositor would lose a penny. The Chancellor, Alistair Darling, was bounced by the crisis into pledging that in a worst case of Northern Rock running out of funds, it would be nationalised.
Again, that is just not the sort of thing that is supposed to happen in a well-functioning economy. And it is unclear precisely how much the seizing up of the money markets will slow down the wider economy. More germanely, few would dispute that the Bank must take enormous care not to reward foolish lending or investing — because that would only encourage foolhardy institutions to behave even more stupidly next time, to the detriment of all our future wealth. That said, top British bankers — who met the FSA again yesterday — are sickened that their industry, the very heart of the economy, should have been tarnished by those pictures of anxious depositors scrambling to withdraw funds.
Their anger at the Bank of England shows no sign of easing — and it is shared by one or two members of the Government. The trouble started in the US, and the Federal Reserve's decision to cut interest rates had been awaited for weeks as one potential solution to it. Indeed, there are worries the US might have become overly dependent on the Fed coming to the rescue at times of financial difficulty - if Superman is always there to save the day, then doesn't Lois Lane let herself get into trouble?
But at the moment, such concerns are not bothering Wall Street. They got what they wanted - the authorities to shift their recent preoccupation with inflation, and to ease the pain of those that have been suffering from their lending decisions. As it is, the US is adjusting to a slowdown - from growth rates of about three per cent, to those of about two per cent.
That adjustment is probably inevitable, as Americans move to more sustainable levels of borrowing and saving, and not even Superman can prevent that. But the goal is simply to prevent a slowdown turning into a recession, particularly given falling house prices. However - in the UK, where similar issues arise, the heroic job of steering the economy through current stresses is being made far easier by falling inflation. If the Bank of England doesn't have to worry about that, it has more room to manoeuvre to deal with other problems, perhaps sometime following the US with lower interest rates.
No really, it has.
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Or so says the chief executive of the Financial Services Authority. In four words he inadvertently captured the gap between the regulators and the public. You might think that the sight of people queuing through the night to get their money out of the bank was a sign that the system had not worked. Or, indeed, you might point to the dramatic policy U-turn which produced a guarantee that every penny in every account in every single solvent bank would be underwritten by the government. The regulator would reply that Northern Rock stayed open, no saver lost money and the integrity of the banking system was preserved.
Sure, shareholders may have lost cash though rather less if they sold today than yesterday. And, perhaps most worryingly the North East of England stands to lose not just jobs but a source of regional identity, pride and charitable funding if Northern Rock is lost as an independent institution. Ah, the regulator might reply, it is not our job to worry about share prices, job prospects or regional economies.
However, if this was not policy failure it clearly wasn't a triumphant success. In the past few days Whitehall insiders have described the scenes of the past few days as illogical and irrational and called it a psychological or social problem. They have been baffled by the public's unwillingness to accept the Bank of England's guarantee that all would be well. Policy will clearly have to change. What though will be the political fall out? My hunch is that it will be more like the fuel strikes of than Black Wednesday.
In other words, a short term knock to confidence in the government's economic confidence. The thing that could change that is if voters associate falling real incomes and falls in the value of their house with the sight of queues outside the bank. The decision is without precedent.
The theory is, of course, utter nonsense in complex modern capital markets — where even the specialist watchdog, the Financial Services Authority , has difficulty understanding the precise risks being run by individual banks as we have seen in recent weeks. And in practice the puritanical theory that everyone has to lose something has led to the near-collapse of Northern Rock. Because when Northern Rock was singled out as a vulnerable bank after it was given emergency support by the Bank of England, the one thing the Blogginses remembered was that the official deposit protection scheme only guaranteed that a portion of their savings would be safe — and they may also have recalled that it would be months before they received even this limited compensation, in the event that Northern Rock collapsed.
So even though Northern Rock was not bust, it was not rational for the Blogginses — and all those other savers — to keep their money in Northern Rock, once even the faintest question was raised about its viability. What the Northern Rock panic demonstrated is the huge potential for there to be runs on banks, when savers have so many banks to choose from. However, there is no point in providing this protection for simply Northern Rock or any other bank that faces a funding shortage in the current market turmoil the chairman of the FSA, Sir Callum McCarthy confirmed to me last night - you can watch the interview here - that such protection was being extended to all other British banks.
The Bank of England would like elements of the US model to be imported, such as a provision for all small depositors to receive their money within days of a bank going bust. In the current crisis, the Treasury is saying that no depositor will lose his or her money, no matter how big the deposit. That is not sustainable as a general approach, because it would create a serious moral hazard issue. It would effectively be extending protection to sophisticated professional money-market players — which would have the effect of reducing the pressure on banks not to take excessive risks, because they could take comfort that the Government would pick up the tab if it all went wrong.
The pressure on banks not to take excessive risks must come from the substantial providers of capital, those who buy their shares, purchase their bonds or finance them in other ways through the wholesale money markets. Make no mistake, Alistair Darling has bailed some or all of them out in the Northern Rock case.
And that is a very unfortunate precedent. If it became the general rule that all deposits were protected, well the financial system would soon go to hell in handcart. As one bank after another took stupid risks to inflate profits, they would all end up in public ownership.
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That may push up the cost of borrowing for all of us. But in the long term, it should put the economy on a more sustainable footing. You can watch the interview in full by clicking here. Economic stability is the rock on which New Labour's election victories have been built. No wonder then that their opponents - in both the Tories and the Liberal Democrats - could not hold back their excitement at the possibility that that reputation might be destroyed by the sight of people queuing up to take their cash out of the bank.
And yet in the speech David Cameron has just delivered, he pulled back from repeating - let alone escalating - the suggestion he made yesterday that ministers were somehow to blame for the Northern Rock crisis. Just to remind you, the Conservative leader wrote in the Sunday Telegraph that, "though the current crisis may have had its trigger in the US, over the past decade, the gun has been loaded at home. Today, though he repeats his criticism of economic growth "built on a mountain of debt", there is not the slightest hint of a direct connection between the government's economic policies and Northern Rock's problems.
There is a lively debate about whether the regulatory regime set up by Gordon Brown - which, remember, includes the Treasury as well as the Bank of England and the Financial Services Agency - have got their response right see my colleague Robert Peston's latest blog for an admirably clear summary of the case for and against. There is another lively debate about whether Britain and Britons are too heavily indebted and, if so, what to do about it. I struggle to find anyone who believes, however, that Northern Rock's troubles result from government action or inaction. Of course, if Northern Rock's problems spread to other institutions, if they are seen to be the beginning of economically turbulent times, few voters will study the economic arguments.
Alastair Darling himself recognised this in an interview this morning when he was asked if his reputation was on the line. I had to chuckle when I heard Will Hutton on Today this morning you can listen to the interview here. Here was the leftish head of the Work Foundation making the same arguments about the need for the Bank to pump money into the financial system that I have been hearing from the uber-capitalists of the investment banks and the commercial banks for weeks. The bankers want the cash from the Bank to ease the pain they are feeling from the injudicious way they invested their capital over the past few years.
And, funnily enough, Hutton feels their pain too and thinks the Bank should have provided an analgesic weeks ago. There is an important debate to be had about the response of the Bank, the Financial Services Authority and the Treasury to the crisis in financial markets. Simplifying slightly, the bankers and Hutton believe that some weeks ago all banks should have been allowed to borrow from the Bank of England more-or-less in the way that Northern Rock has been allowed to — and via a generalised special lending facility, rather than as an emergency loan to ward off imminent collapse.
What they argue is that if banks had been allowed to pledge all manner of assets of questionable value as collateral for Bank borrowing — Hutton mentioned the asset-backed commercial paper that no one wants to hold any longer — then there would have been enough liquidity or cash in the financial system to reverse the rise in market interest rates and also to encourage banks to lend to each other in the normal way. Just possibly, Northern Rock would not then have faced a strike by the institutions that normally lend to it and would not have had to go cap-in-hand to the Bank.
That might be right. There is, for example, some evidence that conditions in the eurozone and US money-markets, where the central banks have been a bit freer with their injections of liquidity, have not been quite as tight as here. Another possible argument against the way that the Bank used its lender-of-last resort powers to bail out Northern Rock is that the very act of saving it in this way also damaged it, possibly beyond repair.
There is a huge stigma attached to requesting emergency funds in this way: And I can understand why Hutton and the bankers are quite emotional about it: The first is that the Northern Rock was an accident waiting to happen. It was far too dependent on the money markets to finance the growth in its lending. And if the Bank had pumped a ton of money into the system to allow Northern Rock to weather this particular storm unscathed, there is a significant risk that Northern Rock would have faced bigger, uglier and scarier problems in the months and years ahead.
The second is that if the Bank had allowed all the banks to dump asset-backed commercial paper and mortgage assets on it in return for loans priced at the base rate plus a bit, a mountain of dodgy assets might have ended up on its books — and with no certainty that normal service in the money markets would have resumed. In the process, the investment banks and commercial banks would have learned a dangerous lesson, which is that so long as their foolish lending and trading is on a big enough scale, the Bank will rush in to prevent them suffering undue losses.
For all the talk — including by me see my earlier comment, Rock or Crock — about how Northern Rock must surely soon find itself under new ownership, I have learned that it cannot be taken over by another bank in the absence of a major policy shift by the Bank of England. Bankers tell me that Northern Rock spent a good deal of the summer exploring whether any big bank was prepared to acquire it lock, stock and online accounts. It had appointed the leading investment bank, Merrill Lynch, to sound out possible buyers. The Bank of England under its governor, Mervyn King, takes a very purist line to exercising its role as lender of last resort.
It is prepared to bail out a bank like Northern Rock to prevent serious damage to the banking system and the wider economy, although only on condition that the Financial Services Authority deems said cash-strapped bank to be solvent. However in their words and deeds, King and the Bank of England have made it clear throughout the crisis in credit markets that they are not prepared to make good the losses of those they think have behaved imprudently or injudiciously. So the emergency lending facility can be used by Northern Rock as an independent bank to stop it from falling over while its worried depositors remove their cash.
But when the sub-prime mortgage market turned sour, the darling of the financial markets became the Black Hole equation, sucking money out of the universe in an unending stream. Anyone who has followed the crisis will understand that the real economy of businesses and commodities is being upstaged by complicated financial instruments known as derivatives. These are not money or goods. They are investments in investments, bets about bets. Derivatives created a booming global economy, but they also led to turbulent markets, the credit crunch, the near collapse of the banking system and the economic slump.
And it was the Black-Scholes equation that opened up the world of derivatives. The equation itself wasn't the real problem. It was useful, it was precise, and its limitations were clearly stated. It provided an industry-standard method to assess the likely value of a financial derivative. So derivatives could be traded before they matured. The formula was fine if you used it sensibly and abandoned it when market conditions weren't appropriate. The trouble was its potential for abuse. It allowed derivatives to become commodities that could be traded in their own right.
The financial sector called it the Midas Formula and saw it as a recipe for making everything turn to gold. But the markets forgot how the story of King Midas ended. Black-Scholes underpinned massive economic growth. By , the international financial system was trading derivatives valued at one quadrillion dollars per year. This is 10 times the total worth, adjusted for inflation, of all products made by the world's manufacturing industries over the last century.
The downside was the invention of ever-more complex financial instruments whose value and risk were increasingly opaque. So companies hired mathematically talented analysts to develop similar formulas, telling them how much those new instruments were worth and how risky they were. Then, disastrously, they forgot to ask how reliable the answers would be if market conditions changed.
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Black and Scholes invented their equation in ; Robert Merton supplied extra justification soon after. It applies to the simplest and oldest derivatives: There are two main kinds. A put option gives its buyer the right to sell a commodity at a specified time for an agreed price. A call option is similar, but it confers the right to buy instead of sell. The equation provides a systematic way to calculate the value of an option before it matures. Then the option can be sold at any time.
The equation was so effective that it won Merton and Scholes the Nobel prize in economics. Black had died by then, so he was ineligible. If everyone knows the correct value of a derivative and they all agree, how can anyone make money? The formula requires the user to estimate several numerical quantities. But the main way to make money on derivatives is to win your bet — to buy a derivative that can later be sold at a higher price, or matures with a higher value than predicted. The winners get their profit from the losers.
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The world's banks lost hundreds of billions when the sub-prime mortgage bubble burst. In the ensuing panic, taxpayers were forced to pick up the bill, but that was politics, not mathematical economics. The Black-Scholes equation relates the recommended price of the option to four other quantities. This worked as long as the international money markets wanted to buy the bonds. Its warehousing model meant it had to sell bonds every three months — and the next sale was due in September The Bank told Northern Rock it was prepared to act as lender of last resort but this did not emerge until 13 September, when the BBC reported that Threadneedle Street was operating behind the scenes to keep it afloat.
But savers took to the internet to try to withdraw their cash and queued round street corners to get their hands on their savings. Northern Rock had fewer than 80 branches, but the hour news coverage meant the queues were broadcast on television scenes in living rooms around the UK and across the world. The next day, a Friday, King and Darling attended a meeting of EU finance ministers and central bank governors just outside Lisbon. It had the opposite effect. On the Monday, the government responded to a third day of queuing with an announcement that no Northern Rock saver would lose money.
Darling, whose relations with the governor became increasingly strained, said he was reluctant to guarantee all deposits for fear that it would in effect be underwriting the entire banking system. There was also no formal mechanism for doing so. After a long period without a financial crisis, putting in place a regime to tackle bank failures had not been a priority. Powers were shared by the Treasury, the Bank and the new Financial Services Authority after the changes in when the central bank was given control of monetary policy but stripped of oversight of the big lenders.