From Northern Rock to Lehman: who should share the blame?

Martin Jacomb assesses the extent of the damage to the banking system so far — and the effectiveness of responses by central banks, regulators and lawmakers Will it be short and sharp, or drawn out and deep, with lasting damage? A recession is upon us, but no one knows its path. Its course and its force are, like Hurricane Gustav’s, unpredictable.

It is already more than a year since it all started. Banks everywhere have made enormous losses; some, even important ones such as Lehman Brothers in New York, have collapsed, and more may do so. They are being blamed for the catastrophe. But it is not as simple as that.

A decade of the miraculous combination of low interest rates and low inflation inevitably led to banks lending ever higher volumes to riskier borrowers. Conditions in credit markets awash with easy money were made to seem even more benign with the growth of securitisation. This is the process whereby banks bundle up a package of loans, such as residential mortgages, and then slice these up into tranches of differing quality, so that these tranches can then be sold to investors outside the banking system. Banks were thus enabled to expand the volume of their lending which made up for the lower returns they were able to earn in an era of low interest rates. It also supposedly diversified risk. Everyone thought that this made the banking system safer; even Alan Greenspan made pronouncements to this effect.

However, when the underlying lending started to go bad (in the US mortgage market) many of these securitised loans turned out not to have been effectively disposed of but to have remained the responsibility of the banks which originated them. Many senior managers, paid big salaries and bonuses based on the volume of business and ‘apparent’ profitability, had not grasped the reality.

The resulting problem is now huge and serious. The whole point (and justification) of the banking system is to collect money from savers and those with temporary surpluses, and then to lend to productive enterprise. In normal times it works well. An efficient banking system is essential to all economies, and is the only way to ensure healthy economic growth. The bank sector is fully rewarded for this, as it should be, because lending is a risky business and requires skill and expe rience. Otherwise when losses exceed profits, they eat into the banks’ capital, capital which is needed to reassure depositors that their money is safe. But with massive losses incurred on all this recent bad lending, the machinery has solidified.

This is the result when many banks make big losses simultaneously. For they know that other banks have made losses also, and so they stop lending to each other and hang on to their liquid assets. The credit market ceases to function. This is what caused Northern Rock to collapse.

When this happens the problem can rapidly become self-fulfilling. For when banks have less to lend, they curtail loan facilities. Some customers get into trouble, so the loans to them go bad and the bank makes even more losses. Banks thus become even less willing to fulfil the role of financing enterprise.

This is why central banks have to step in to provide liquidity. And this they have been doing in enormous quantities. The ECB was the first to act; the US Fed followed, and so did the Bank of England which apparently now has well over £100 billion out under its emergency lending scheme. This is money the Bank of England lends to banks against securities pledged by the borrowing banks. There is a theoretical risk of the value of the securities declining so much that the loan is not covered; but the Bank of England knows the ropes, and requires a good margin of safety.

The nationalisation of Fannie Mae and Freddie Mac in the US is another part of this process. Now the refusal by the US authorities to help Lehman Brothers starts a new chapter.

The ECB, on the other hand, is having to tighten the terms on which it provides liquidity. It is faced with being asked to lend against securities which banks have created especially to get access to euros from the ECB. New rules will curtail the ability of banks (which include UK banks) to exploit this loophole.

The help of the ECB, and other central banks, is still needed. For the liquidity so far pumped in, though massive, has not been enough to restart the machinery. Credit markets everywhere are still gummed up.

There is the added complication that the big banks have deposit liabilities in currencies other than their own. ‘Lender of last resort’ facilities are needed in those other currencies. This requires the relevant central banks to collaborate. So far this has worked, but there are limits.

So the problem is acute all round. And the mistakes banks have made have put them near the centre of the circle of responsibility. But governments, central banks and regulators are in there too. So are bank shareholders, who sanctioned remuneration structures which incentivised management in the wrong direction. And, bizarrely, UK bank shareholders apparently believe that the managements which were in charge then are the best ones to lead recovery from the mess now.

Governments have presided over and encouraged massive over-borrowing both by themselves and by individuals, offering the promise of a standard of life which it now transpires cannot be afforded. The need for saving has been neglected, and consumption encouraged.

Monetary policy in the US and elsewhere, with very low interest rates over a long period, has for long fed the demand for borrowing, not only for consumption but also for acquiring assets, including houses. Asset prices have increased with this easy money, and the inevitable result is the asset-price bubble which is now bursting. Central banks saw this risk, but with no inflation worries they presumably were reluctant to increase interest rates for fear of slowing economic activity.

Regulators also have to take an important part of the blame. Everyone knows about Northern Rock and the FSA. But, more significantly, take the example of the Basle regulations which govern the amount of capital a bank needs for a given amount of lending.

Capital is expensive; so given that the rules required very little capital for the ‘super senior tranche’ of securitised assetbacked loans, many banks tended to keep large quantities of these on their own trading books. The fact that many did this is an example of how regulations tend to force firms into the same business model, thereby losing the benefit of diversification. And so in this case, when credit got scarce, all banks needed to sell these ‘super senior tranche’ assets. The market was at once swamped with sellers, with no buyers in sight.

Massive losses resulted, exacerbating the banking crisis greatly. An unintended consequence of regulation no doubt, but with the call now to tighten capital requirements, you can be sure that the same sort of mistake will happen again.

Governments and supervisors have fos tered the ‘too big to fail’ principle; and have extended this to banks which are ‘too deeply interlocked with other market participants’ and also those with ‘too many voting retail depositors’. This brings with it a nasty taste of moral hazard. This is the concept whereby the private sector owners get the profits when things go well, but the public steps in with taxpayers’ money when there is a failure. When the authorities give full rein to the ‘too big to fail’ concept, the responsibility of bank managements obviously tends to be undermined. Only now, with the collapse of Lehman, has a halt been called to this malignancy.

Rather than tinkering, the introduction of a system in which a bank in trouble can be taken into temporary public ownership quickly, on terms whereby the shareholders lose their money and the management lose their jobs, but the depositors are kept safe, would be an important step back towards the days when bank managements felt themselves at risk from the consequences of their own misjudgments. And with such a system there need be no dithering as there was with Northern Rock.

The legislation now being proposed, however, is too complex. It will have significant adverse consequences. What is needed must be simple and limited, but effective. The government’s plan should be torn up and the job of framing the legislation given to a lawyer with banking and market experi ence. The Scandinavian banking crisis in the 1990s provides a model.

There is no easy way out of this. An essential element is confidence. This will only return when sufficient buyers appear for bad loans at an appropriate discount; which they eventually will. The UK government’s errors have stifled its ability to engender hope of early recovery.

In the UK, more tax relief to limit the rate of housing price decline (further decline is inevitable) would be desirable, if only to limit further trouble for the banks with large mortgage lending books. It might take the form of much wider stamp-duty relief, or of a three-year window of capital gains tax relief for losses incurred in house sales. But this administration has handled public finances with such incompetent profligacy that there is unfortunately no room for such giveaways. Moreover, the idea of encouraging first-time buyers to buy in a falling market is mystifying.

So governments which cannot afford this kind of help would do better to stay away. Although bankers have done badly, no one should think the other parties have done any better.