Northern Rock and Banking Reform

Part of Supplementary Estimates, 2007-08 – in the House of Commons at 7:04 pm on 10th March 2008.

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Photo of Philip Dunne Philip Dunne Conservative, Ludlow 7:04 pm, 10th March 2008

I am pleased to be able to contribute to the tail end of this debate.

The Treasury Committee report is a fine example of a Select Committee having undertaken relevant, topical and timely work, and it is the only independent investigation into affairs surrounding the run on the Rock that has been published so far. I congratulate the Chairman and other members of the Committee, on which I sit, on conducting the hearings that we did and producing a unanimous report. As has been said by Members on both sides of the House, it has captured the imagination of policy makers and commentators as being of value. It is a shame that the Government have not yet grasped some of our recommendations, and I hope that the Financial Secretary will pick up on some of them.

I should like to touch on some of the lessons from the past for Northern Rock before looking forward. Mr. Mudie referred to the tulip bubble and to the American sovereign debt crisis, and my hon. Friend Mr. Hands mentioned problems closer to home—at least, closer to his constituency. Financial institutions do go bust. Periodically, there is a herd mentality in financial markets. That is within human nature, and it is not possible to regulate against it. As a consequence, one arrives at extremes, on the way up and on the way down, in any financial market. We would be ill advised to think that one set of banking reforms can call a halt to that process.

The last mortgage bank in this country to fail was National Mortgage Bank in 1992. Although it was much smaller than Northern Rock, there are many parallels. Not least, it was owned by a quoted company, National Home Loans; it relied on wholesale funding, mostly foreign banks; and its business model was not robust when working capital became scarce. In that case, the then deputy governor was able to deploy his famous eyebrows to nominate Barclays to put together a syndicate of 26 banks to provide the required funding, which was covertly guaranteed by the Bank of England. Eddie George, for it was he, did so to protect the reputation of British banking among foreign banks, which were the entities due to lose out from the crisis. Unfortunately, the parallels in the conduct of the Northern Rock case have not enhanced the reputation of regulators or of the Government. Last week, the Chairman of the Select Committee and I attended a debate in the City about whether the case has affected the City's reputation. The commentators present were more or less united in the view that the City survives these periodic crises, but the reputation of the regulators and, by extension, that of the Government, suffer. I think that that is regrettably the case.

The role of the banking regulators should not be to protect individual banks from the folly of their conduct, but to limit damage in the event of a failure leading to a systemic problem infecting other financial institutions. When the tripartite arrangements were set up 10 years ago, the focus was very much on giving the Bank of England, through the Monetary Policy Committee, the power to set interest rates and to remove that from the political process. Much less attention was given to the regulatory regime for supervision that was put in place at the same time. There was talk of having a new paradigm, with no prospect of a major bank getting into difficulty. As a consequence, as we discovered through the Select Committee inquiries, no stress test was undertaken, when the system was set up or since, on a major bank—that is, one of the top dozen—getting into financial difficulty. That is a fundamental failing of the regime that was set up 10 years ago, from which we need to learn a lesson.

There are some specific lessons to take from the Northern Rock experience. Although we say in our report that there was systemic risk, there were conflicting views at the time when the crisis was unfolding. Who knows how history will look at this with the benefit of hindsight, but people may take a different view from those of us on the front line.

At that time, during August, the Governor of the Bank of England initially appeared to think that there was not a systemic risk, as he was resting on the moral hazard argument that we touched on earlier. The Chancellor, perhaps concerned about the political ramifications, thought that there was moral hazard, but it took him a long time to recognise that, and he stepped in only when the queues were snaking round from the Northern Rock branch front doors. The Financial Services Authority seemed to think that there was a problem, but was not in a position to force the sort of quick decision making needed to get a grip on the crisis.

There were four distinct phases to the crisis that I should like briefly to mention. It is instructive to identify what went wrong in order to decide what needs to be put right. First, in the year leading up to 9 August, various signals were issued by market commentators, and by the Bank of England in January and the FSA in April, that reliance for funding on credit markets internationally was of concern, particularly given the emerging developments in the US sub-prime mortgage sector. Those warnings were not acted upon by the board of Northern Rock, which failed to put in place stand-by lines of credit in the event that its securitisation programmes could not be rolled over.

The bank's business model, in terms of growing its market share, was clearly reckless, as has been touched on by Dr. Cable. At a time when house prices in the UK were hitting record highs, this bank was extending its market share dramatically; in the first half of 2007, it captured 19 per cent. of new mortgage advances, compared with its overall market share of 8 per cent.—the former is some 2.3 times higher. At the same time, other major mortgage lenders, such as Nationwide, were reducing their new business exposure. If the regulators did pick that up, they failed to persuade the board to do anything to moderate Northern Rock's rate of expansion.

The second phase covered the period from 9 August, when the credit crisis struck and closed down the securitisation markets, until 10 September, the date on which the Chancellor finally declined the offer of a lender of last resort facility to Lloyds TSB. Lloyds TSB had indicated that it would be prepared to make an offer should such a facility be available, but only in those circumstances. During that month-long period, the lack of experience of handling a stricken bank in a crisis was exposed at the Bank of England, where, famously, no one was specifically in charge; at the FSA, which consistently advised the Chancellor that Northern Rock was solvent; and at the Treasury, where a new ministerial team had only just been appointed with no one aside from the Chancellor having any prior experience in the Department, and with no senior officials with experience of a previous banking crisis. Advice to the Chancellor on whether a covert operation could be undertaken was confused, with the Bank of England convinced that the market abuse directive prevented covert activities, despite subsequent denials by the European Central Bank and the European Union commissioner, and the evidence of facilities provided to continental banks in a similar situation.

The third phase was a short one, lasting from Monday 10 September to Monday 17 September. That was the period in which critical decisions, or a lack of timely decision making, actively contributed to the run on the bank. Once the Lloyds TSB offer was finally terminated, the Chancellor and his advisers should have acted far more rapidly to get a grip on the developing crisis. Specifically, they should have confirmed the deposit guarantee at the same time as announcing the lender of last resort facility. It was that lack of action on deposits that led to the queues around Northern Rock branches.

The final phase lasted from the announcement of Government support on 17 September, which was extended on 9 October, until final nationalisation on 22 February, more than five months later. That delay speaks volumes about the lack of experience in the Treasury in handling such crises. Every previous banking crisis has been handled as rapidly as possible, from Johnson Matthey to Barings, or the National Home Loans crisis to which I referred earlier. Those were all handled within a week—sometimes over a weekend. The failure to find a credible private sector buyer should have been apparent when the remaining bidders in December were clearly insubstantial and not credible.

Now the bank has been nationalised, one or two issues need to be addressed. The business plan referred to by my hon. Friend Mr. Hands is clearly critical, and the Government have agreed, somewhat reluctantly, that it will be published once it has been finalised by Mr. Sandler. The plan is critical to Northern Rock's relationship with its funding entity Granite, and to the quality of loans—the asset base that the FSA has consistently said is of high quality. The hon. Member for Twickenham has said that it may not be so sound.

Granite has not been nationalised, but its securitisation issues are backed by Northern Rock mortgages. Northern Rock is obliged to top up that security package if mortgage repayments or redemptions exceed the rate of maturity of the securitisation issues. We learned that, from the September period until nationalisation, no additional mortgages have been provided to Granite by Northern Rock. That can last for a while, but at some stage—I would argue that it will be when the two-year interest rate fixed terms expire at around January of next year—unless very attractive rates are offered, mortgages will be redeemed at what may be a more rapid rate than hitherto.

If Granite's security package declines and Northern Rock cannot refresh the mortgages that it provides for that underlying security, an accelerated amortisation will be triggered and Granite will be compelled to liquidate at whatever price it can get for its remaining assets. At that point, Granite's structure will implode, Northern Rock will suffer losses on its 16 per cent. share of the mortgages in Granite, and the taxpayer will lose substantial sums—substantially more than we have been led to believe by the Chancellor. He says that, with business as usual, there will be no loss. The expression "business as usual" is critical, and I shall return to that point.

I have four points to make on banking reform, some of which have been touched on by others. First, we need to fix the bust tripartite regime. The Chancellor's proposals for banking reform seem to reward the FSA and give it the primary role. But supervisors are not bankers; there is a fundamental flaw to that idea. The supervisors who monitor a bank have a vested interest, once it goes wrong, in validating the quality of its assets. The situation would be the same for individuals who put loans on to the balance sheet in the first place. As soon as a bank goes wrong, they must be taken off the case because they have a vested interest in arguing that the loans are good.

As the hon. Member for Leeds, East mentioned, we learned only today, as a result of a freedom of information request, that five out of the seven individuals in the FSA with some responsibility for supervising Northern Rock have now left their posts. All of them should have left their posts within a few days of the situation going wrong. They should have been replaced by experts who are accustomed to dealing with bank work-outs.

Secondly, on the Bank of England, the Treasury Committee made a recommendation in its report with which I wholeheartedly agree. We should establish an individual in the Bank with the credibility that stems from the title of deputy governor who has responsibility, as the head of financial stability, for maintaining relationships and running a stricken bank in crisis. It was interesting to me that Mr. Clarke came into the Chamber specifically to support that recommendation, and I hope that the Financial Secretary will give us her initial view of it. There is clearly widespread support for it throughout the House.

On the subject of deposit protection, it is agreed that small depositors need to be protected. Had 100 per cent. protection existed up to the £35,000 level, which is now in place, the run on the bank would not have occurred. I have some questions—I raised them in Committee, but I went along with the report—about the feasibility of a pre-funding scheme for depositor protection. It is a good idea but it needs to happen over a prolonged period. Banks currently lack trust in each other and are therefore not lending money. To some extent, that gives them a bit of liquidity on their balance sheets, but as we experience weekly, a new sector of the financial community is calling in facilities. The banks therefore need their facilities to fund their obligations, and if we imposed a significant additional obligation to provide funding for a deposit protection scheme, we would be doing so at precisely the wrong time. It would aggravate the current liquidity crisis.

I suggest that the Financial Secretary examine the existing deposits that commercial banks have with the Bank of England. Some £2.7 billion is currently sitting on deposit. Interest on that money funds the operations of the Bank of England, but also generates a profit for the Treasury. That profit could be used as an insurance policy to provide significantly greater insurance protection, or the capital sum could be used as a first call on a deposit protection scheme. Money is sitting there and I urge Treasury Ministers to consider those suggestions. The alternative is to build up such a fund gradually, over a period of years. However, that would inevitably run the risk of the good banks bailing out the poor banks, and I do not support that.

Thirdly, other hon. Members have mentioned capital adequacy. The Basel II regulations, which were introduced last year, need to be reconsidered by international bodies. As has been said, Northern Rock used Basel II to justify increasing its dividends as recently as last July. Banks are actively incentivised by Basel II to encourage debt of more than 365 days to be placed in off-balance-sheet vehicles. One reason that banks welcomed Basel II is that it allowed them to take more of their existing commitments off balance sheet and have less capital on balance sheet. That seems a perverse incentive to me. A solution can be achieved only through international co-operation, and I hope that the Treasury and the Bank of England are actively engaged internationally with financial authorities to consider what adjustments need to be made, especially to capital adequacy but also to banking reforms.

Fourthly, other speakers have mentioned credit rating agencies. We discovered in the Committee an inherent and multiple conflict of interest at work. I found it extraordinary that, according to Standard and Poor's figures, the credit rating agencies currently give 570 corporates, financial institutions, insurance companies and sovereign issuers a triple A rating while, as at the end of last year, they gave 9,418 special investment vehicles a triple A rating. That large disparity has mushroomed in recent years and clearly drives the credit rating agencies' business model. We need more competition and that needs to be achieved on an international basis. This country cannot start imposing a regime on only credit rating agencies that operate here, because that would drive the securitisation business offshore, and we clearly do not need to do that.

What will we do when the next crisis arrives? The impact of global credit contraction is not yet over. The initial impact has been on the banks, from bailing out their off-balance-sheet vehicles. It recently struck the monoline insurers and is now affecting the hedge fund community. Where will it strike next? There is little clear understanding of where leveraged securities are held in the financial system. We should not be surprised if insurance companies emerge with lower bonuses and significant holdings, especially in countries such as Japan, where they have been desperate for yield, with such low interest rates. We should not surprised if pension funds are affected.

Northern Rock was fundamentally a domestic business, although my hon. Friend the Member for Hammersmith and Fulham said that it is now conducting activities in three other jurisdictions, which was news to the House. No nation's central bank is large enough to cope with the failure of a major bank. What will the Chancellor do if a similar sized—or, heaven help us, larger—bank needs help? The latest legislation gives the Treasury the power to step in during the next year until the banking reform Bill is in place. A much wider framework of solutions is needed. Rather than hoping and praying that something else will not happen to this country, we need to work with international organisations and devise an international framework of supervision, which will be effective as and when the larger crisis occurs.

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