Till Time's Last Sand

by David Kynaston

  The credit crunch began on 9 August 2007, as risk-aversion gripped the international money market and fears about counter-party exposure to subprime assets led banks to stop lending to one another.14 Immediately at the European Central Bank (ECB), and very soon at the Fed, the reaction was to provide emergency liquidity; but the Bank declined to follow suit, refusing either to ease collateral requirements or to waive the traditional penalty rate of 1 percentage point above Bank rate (the term had come back into general use in 2006, very much on King’s initiative), but instead relying on its recently introduced system of liquidity facilities, by which commercial banks were able to determine the size of their own reserves with the Bank – in effect, a mechanism by which the Bank could routinely provide more liquidity to the banks as and when they needed it. On 14 August the FSA informed the Treasury and the Bank that it had serious concerns about Northern Rock, the Newcastle-based mortgage lender that had expanded rapidly on the back of heavy borrowing in the now seized-up inter-bank market and was now not only inadequately capitalised, but faced by a fundamentally broken business model. King at the outset informed Northern Rock’s chairman that the Bank would be prepared to act as lender of last resort, but emphasised that if Northern Rock was to have a long-term future it would have to find new sources of funding. By early September the possibility had emerged of Lloyds acquiring Northern Rock – though only if it (Lloyds) was guaranteed a hefty stand-by facility, something that neither the new chancellor, Alistair Darling, nor King thought was an acceptable use of public money, given that the motives of Lloyds were essentially commercial and that the offer would not be made available to other banks. On Sunday, 9 September a four-way telephone conversation – Darling and King plus McCarthy and Sants of the FSA – saw the Lloyds initiative removed from the table, while at the same time the governor confirmed that the Bank was prepared, if necessary, to give emergency support to Northern Rock in its capacity as lender of last resort.

  Over the next couple of days, as Northern Rock’s share price plummeted and funds flowed out, King finalised a lengthy memorandum for the Treasury Committee, ahead of his scheduled appearance on 20 September with other members of the MPC. Entitled ‘Turmoil in Financial Markets: What Can Central Banks Do?’, it argued that ‘the source of the problems lies not in the state of the world economy, but in a mis-pricing of risk in the financial system’; it emphasised the importance of preserving the concept of moral hazard, noting tartly that ‘the provision of large liquidity facilities penalises those financial institutions that sat out the dance, encourages herd behaviour and increases the intensity of future crises’; and it concluded that although ‘the current turmoil’ had ‘disturbed the unusual serenity of recent years’, nevertheless, ‘managed properly, it should not threaten our long-run economic stability’.

  First thing on Wednesday, 12 September, shortly before King’s public statement was released at 10 am, the Court’s NedCo had the opportunity to discuss it with him and his executive colleagues. Although ‘several Directors congratulated the Governor for setting out a rigorous intellectual underpinning of his position’, the tone of the meeting was not entirely easy. One questioner from the non-execs ‘wondered if there was any thought about, or pressure to, accept lower-quality collateral’; another observed that ‘when the current market turmoil had subsided it would be important to assess whether the tripartite institutions were sufficiently alert to the development of non-banks through some conduits, SIVs and hedge funds that were not regulated but which were essentially providing banking-type functions’; and a third asked ‘if the risks associated with moral hazard vs the potential damage to the financial system were thought to be asymmetrical’. The minutes do not divulge the names of speakers, but the sentiments of the reply to that last question were undoubtedly the governor’s: ‘The Executive felt that was difficult to judge but suggested that in the careful assessment that needed to be done it was important that someone should ensure that there is a voice for the moral hazard concerns. There needed to be accountability by policy makers for decisions and the outcome not only in relation to the current crisis, but also for the longer-term consequences.’

  Yet, for all that, King in his memo did leave the door slightly ajar, noting that central banks, in their traditional lender-of-last-resort role, could lend ‘against good collateral at a penalty rate to an individual bank facing temporary liquidity problems, but that is otherwise regarded as solvent’. By Thursday, 13 September, with Northern Rock’s situation deteriorating by the hour, a rescue plan was in place, agreed with the Treasury and the FSA, and to be announced before the markets opened on Friday the 14th. That evening, shortly after the BBC’s Robert Peston had revealed to the world that Northern Rock had successfully applied to the Bank for emergency aid, the Court met in emergency session formally to authorise the Bank to proceed, on the basis of a penalty rate of 1.5 percentage points over Bank rate as well as collateral ‘at an appropriate margin’. Members of the Court were ‘told that both the Bank and the FSA were in total agreement that if Northern Rock was allowed to fail it would create serious economic damage’; they were also informed that in the tripartite press statement first thing the following morning, the wording would say, ‘In its role as lender of last resort, the Bank of England stands ready to make available facilities in comparable circumstances, where institutions face short-term liquidity difficulties’; as to the ‘potential for some commentators to suggest that the Governor was doing a U turn’, there was ‘a clear distinction to be drawn between the moral hazard of a general bail-out to banks, e.g. by relaxing interest rates to try to influence inter-bank lending rates, and the type of collateralised assistance considered here’. Altogether, this would be, the executive told the Court before the latter gave its go-ahead, ‘the most significant lender of last resort facility since the lifeboat episode in the 70s – when times were very different’.

  The memorable Friday the 14th saw powerful TV images of the run on the Rock, as alarmed depositors queued to get out their money. A difficult weekend ensued, with King pushing strongly the necessity of government giving a full guarantee to all Northern Rock deposits; and Darling duly announced that in the late afternoon of Monday the 17th, thereby ending the run. Two days later, in what the Economist immediately described as ‘a breathtaking volte-face’, the Bank announced not only that it would through an auction process be injecting £10 billion into the money market, but that it would be doing so ‘against a wider range of collateral, including mortgage collateral, than in the Bank’s weekly open market operations’.15 As for Northern Rock, it eventually passed in February 2008 – after several months of major liquidity assistance, with the Bank managing the Liquid Support Facility on the Treasury’s behalf – into reluctant public ownership.

  In September 2007, the most wounding instant verdict came from the Economist. The front cover of its issue dated the 22nd featured a carefully chosen photograph of a rather anxious, slightly puzzled-looking King, alongside the words ‘The Bank that failed: How Mervyn King and the government lost their grip’. Inside, the editorial verdict was damning. The paper did not necessarily agree with the governor’s critics who claimed that if he had ‘acted more promptly to restart seized-up lending markets’, then ‘Northern Rock might have muddled through’, observing that ‘no one will ever know whether that is true’; but it did argue that ‘the lurches in the central bank’s policy leave Mr King looking either as if he made a mistake, or as if he cannot stand up for his views’, with ‘neither characteristic’ being ‘much sought after in a central banker’. And it concluded: ‘Nobody trusts politicians. Regulators are always disliked. But central bankers are held to a higher standard; which is why Mr King is the past week’s main victim. He has lost credibility; and a central banker without credibility is not much use.’ Four months later the Treasury Committee’s report, ‘The run on the Rock’, did not go so far as to argue that Northern Rock would not have needed specific emergency support in September if the B
ank the previous month had undertaken the kind of open-market liquidity operation being asked for by at least several banks. Nevertheless: ‘We are unconvinced that the Bank of England’s focus on moral hazard was appropriate for the circumstances in August. In our view, the lack of confidence in the money markets was a practical problem and the Bank of England should have adopted a more proactive response.’ Later in 2008, Alex Brummer’s account of The Crunch did not spare the governor – ‘King’s early approach was quickly exposed as wrong-headed. It increased jittery nerves rather than calming them … Ultimately, King’s refusal to pump money into the markets after 9 August made a bad situation worse … Whatever excuses are made for King, the fact is that the hero of the fight against inflation had not proved adept at battling turmoil in the markets and the most dramatic run on a British bank seen in modern times …’ – while towards the end of his governorship, in 2012–13, retrospective verdicts on this episode remained generally critical. ‘Sir Mervyn’s [he had been knighted in 2011] response to the unfolding run on Northern Rock was tardy and unsure’ (Times). ‘His initial reaction was ill-judged … Talking about abstract economic concepts in the teeth of the crisis made him look out of touch’ (Economist). ‘The effect was rather like a fireman worrying about the moral implications of dousing an arsonist’s blaze: fine, until the entire street is engulfed in flames’ (Guardian).16

  Unsurprisingly, that was not King’s perspective. On 20 September 2007 – only three days after Darling’s guarantee to Northern Rock depositors – he made a robust appearance before the Treasury Committee. In the face of some hostile questioning, he argued that for the Bank to have undertaken in August a large-scale liquidity operation ‘would undoubtedly have been a signal that the authorities were deeply concerned about the entire UK banking system’ – a signal that would have been ‘wholly unfounded’, given that ‘the UK banking system as a whole is well-capitalised’ and ‘there is no threat to the stability of the banking system’; in relation to Northern Rock specifically, he pointed out that the European Union’s Market Abuse Directive of 2005 meant that ‘we were unable to carry out a covert lender of last resort operation in the way that we would have done in the 1990s’; he denied that, during the past week, he had been leaned on by government (‘I can assure you that the operation we announced was designed in the Bank’); he also denied that moral hazard was ‘just some dry academic concept’, insisting that ‘it is moral hazard that has actually led us to where we are’; he linked his refusal to ‘provide ex post insurance’ to the banking system to how ‘the whole regime of monetary policy that we have put in place has been to demonstrate that taking the easy option and giving in in the short run without looking to the long-run consequences of those actions is damaging’; and he described the previous day’s announcement of a £10 billion liquidity facility as the result of ‘a balance of judgement’ – on the one hand, ‘designed and structured in a way that minimised the moral hazard’, on the other hand, providing ‘some liquidity to the markets’ in the context of ‘strains’ in those markets seeming ‘somewhat greater’.

  Over the next year, until the crisis moved decisively to its climax, the governor continued to make his case. ‘Nothing would have been easier than for the Bank of England to lend freely without a penalty rate,’ he told the Northern Ireland Chamber of Commerce in October 2007. ‘Almost every actor in this drama saw advantage in cheap money and plenty of it. The role of the central bank is to ensure that the appropriate incentives are in place to discourage excessive risk-taking and the underpricing of risk, and in so doing to avoid sowing the seeds of an even greater crisis in the future.’ As for the analogy that commentators were drawing between the Bank and a fire service, he did not quarrel with fire departments who ‘put out fires started by people who smoke in bed’; but at the same time he observed that ‘fire services do not offer free insurance for people who smoke in bed or set fire to their own house, thereby encouraging them to take risks that endanger others’. In November, interviewed by Peston for a BBC radio File on Four special, the governor reiterated that ‘the role of the Bank of England is not to do what banks ask us to do, it’s to do what’s in the interest of the country as a whole’; appearing again in December before the Treasury Committee, he denied that there was ever a firm Lloyds bid for Northern Rock on the table and described the latter’s pre-crisis business model as ‘fatally flawed’ on the borrowing side, for all its excellence on the lending side; in April 2008 his reappointment session with the Treasury Committee included two explicit admissions – that ‘during August when the events in the financial markets started to unfold, I think I made a mistaken judgement that I did not want to add to the cacophony of voices which seemed to me not to be shedding light but raising concern’, and that he also regretted ‘the failure to press early enough for a guarantee to be announced when the lender of last resort operation for Northern Rock was implemented’ – but was otherwise unapologetic, with as usual an emphasis on how the Bank ‘had no responsibility for individual institutions’; while that July, appearing once more with feeling before the Treasury Committee, he stressed ‘the absence of any Special Resolution Regime’, which if it had been in place the previous year would have allowed Northern Rock ‘to have been dealt with immediately’. Almost eight years later, in March 2016, King was still fighting his corner. ‘A very odd myth persists about the ECB,’ he told the New Statesman’s Ed Smith. ‘They announced that they would lend over €100 billion, and the next day they would lend €95 billion. Everyone thought, “Gosh, they’re lending vast amounts.” After one month, the amount of lending to the banking sector was precisely zero. They lent a hundred billion for one day, 95 billion for one day. After one month they had extended no net liquidity. The Bank of England had.’17

  Although much criticised by the press, King also had his defenders in the public prints. ‘For the top management of Northern Rock to seek to pin responsibility for the disaster that befell the institution for which they were responsible on others, such as the Bank of England, is an example of financial illiteracy,’ declared Central Banking at the outset, adding that ‘there was no justification for them to expect the Bank either to lower its lending rate or weaken its collateral just to help the stricken lender’; in the same magazine’s next issue, Charles Proctor (a partner in Bird & Bird, specialists in financial regulation) broadly backed King’s claim that various existing legislative or quasi-legislative aspects – including corporate insolvency laws, deposit-protection provision and the Takeover Code as well as the Market Abuse Directive – had collectively placed significant obstacles in the way of a properly structured solution to Northern Rock. In later years, writing the first drafts of history, the Telegraph stable offered the most sympathetic assessments. ‘In the end,’ asserted Jeremy Warner in 2011, ‘the debacle of bailing out Northern Rock had little to do with either a failure in judgement or the tripartite regime of split responsibility between the Bank, FSA and Treasury. Rather it was the absence of an effective resolution regime, compounded by inadequate deposit insurance.’ So too Liam Halligan. ‘I believe he was correct, when the credit crunch first hit, to make the banks sweat, questioning unconditional root-and-branch bail-outs,’ he argued the following year as he appraised King’s record. ‘“Moral hazard” isn’t an academic parlour game. It’s the reason why the Western banking system collapsed and why, unless drastic reforms happen, it will ultimately collapse again.’

  The debate will no doubt continue to run, especially once full Bank records become available in the late 2020s. Yet, as many remarked – both at the time and subsequently, and often not unsympathetically – a sharp, unexpected crisis was probably not the ideal milieu for King. A deeply methodical man, and an intellectual thoroughbred, all his instincts were to think things through carefully and make sure he got them right, as opposed to taking any hasty, impromptu action. Hypothetical thoughts inevitably turned to his predecessor, Eddie George; and over the years it would become the conventional w
isdom that if he had still been governor in 2007 he would have ignored tripartite constraints and forcibly banged heads together in order to get the Northern Rock situation sorted out quickly. It is a tempting scenario, but almost certainly exaggerates the freedom of manoeuvre available for finding a buyer for Northern Rock. Perhaps more tenable is the other aspect of the conventional wisdom: namely, that George as governor in 2007 would have had a more acute ‘nose’ for the banking system’s true condition, in comparison to King’s assertion that September to the Treasury Committee that it was ‘very well capitalised’ and ‘very strong’.18 Yet, as ever with counter-factual history, there is simply no way of knowing for certain.

  ‘Things have improved significantly since August,’ King told Peston in early November 2007. ‘We’re not back to normal in terms of a number of important financial markets, but things are improving. And I think that most people expect that we have several more months to get through before the banks have revealed all the losses that have occurred, have taken measures to finance their obligations that result from that. But we’re going in the right direction.’ For the bankers themselves, in some but not all cases struggling with lack of liquidity, this was not a mellow autumn, and often they directly blamed King – with one, half jokingly, claiming that it was the governor’s revenge for their failure to read his speeches. King himself denied that the Bank was not doing enough, assuring the Treasury Committee a week before Christmas that through its money market operations it was now supplying £6 billion more to the banking system each month than at the start of August, an increase of 37 per cent. Even so, the perception remained that lack of liquidity was a key issue; and indeed, earlier in December, five major central banks, including the Bank, came together in concerted action to try to unblock the world’s credit markets through an emergency injection of £50 billion (£10 billion from the Bank). Significantly, concerns by this point were not just about liquidity. ‘The action was being taken,’ the Bank’s executive informed NedCo on the day of the joint announcement, ‘to address the credible scenario that saw a serious downturn in the world economy inevitably leading to losses in the banking system. This, coming on top of the losses that may result from the current repricing of complex financial instruments, would pose a challenge to the capital base of the banks.’ Preceding weeks had already seen significant bank losses and write-downs (including Citi, Merrill Lynch and UBS), and King in his pre-Christmas evidence to the Treasury Committee twice mentioned the importance of the banks rebuilding their balance sheets; over Christmas, mulling things over, he came increasingly to the conclusion that what the West’s banking system faced was not just a liquidity problem, but in essence a solvency problem.