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From The Times
September 27, 2007

Three-way system failed the big test

Richard Lambert: Viewpoint

People in the North East must feel badly let down. Northern Rock is a model corporate citizen, handing out large sums every year to support good causes in the region. It is a very important part of the North East’s economic, social and cultural life.

It is a highly efficient operator, with a good-quality loan book. In a country where financial power is concentrated in the City of London, it stands out as an institution with its heart and ambitions driven from a different perspective. It is proud to be a major employer in the region, and one of its few big plcs. But it has been seriously damaged by the events of recent weeks.

Let me say right up front that the board of Northern Rock must take full responsibility for the bank’s business model – which has left it more dependent on the capital markets for its finance than other similar institutions. That is what made it vulnerable to the perfect storm that has blown through the global financial system.

Other financial institutions around the world have been buffeted. Few of them have been holed. Could the outcome have been less damaging for the Rock?

We don’t yet know the detail of who said what to whom as the drama unfolded over the summer. But we do, I think, know enough to say that the crisis has not been well handled by those responsible: the Government and the City authorities.

The pundits are now saying that Northern Rock was an accident waiting to happen. But these are often the same people who, earlier this year, were recommending Northern Rock shares at more than £12 a time. And if the business model was so obviously vulnerable, where were the regulators as the bank stepped up its expansion in the early months of 2007?

We now know that, by August 14, the City authorities were well aware that the bank faced difficult times. But then more than four weeks passed before the announcement that Northern Rock had been forced to seek help from the Bank of England as lender of last resort – news that triggered the long queues outside the bank’s branches as depositors began to withdraw their money.

Their confidence was restored only when, after several days of uncertainty, the Chancellor made the unprecedented announcement that their deposits would be fully guaranteed by the taxpayer.

According to the Financial Services Authority (FSA), Northern Rock is solvent, exceeds its regulatory capital requirements and has a good-quality loan book. And yet the summer weeks passed, and despite frantic activity behind the scenes in the City, the problems were not fixed.

From my point of view, there’s no sense in looking for individual scapegoats. Mervyn King, the Governor of the Bank of England; Sir Callum McCarthy, chairman of the FSA; Alistair Darling, the Chancellor: so far as I am concerned, they are all intelligent, hard-working people doing their best to serve the public interest.

The problem, I believe, lies more in the system itself. This was the first big test of the so-called tripartite arrangement, created when the Bank of England was given its independence ten years ago. The deal then was that the FSA would supervise individual banks, the Bank would deal with systemic crises and sign the cheques, and the Treasury would – when necessary – provide public funding to keep sound institutions in business.

For whatever reason, this tripartite system has failed to deliver the goods. Perhaps there are just too many conflicts inherent in a system where three different institutions, with three different policy priorities, have to come together to tackle a fast-moving crisis.

And communications were not good enough. For example, the news that the Bank was coming in as lender of last resort may have given some reassurance to the banking industry, but it scared the life out of savers, and you can understand why. It is not enough to say, as the Governor did last week, that the main difficulties had been created by the complexity of today’s company law, and by our system of deposit guarantees. You do not wait for the cinema to catch fire before you check out whether the fire precautions are going to work.

Whatever the explanation, the events of the summer have cast a shadow over the future of Northern Rock. The reputation and standing of the UK as a world financial leader has also been tarnished. Outside the movies, a run on a bank is something that happens in a banana republic. That one should have happened under our noses, in a mature and prosperous country such as the UK, is almost unimaginable.

Of course, what has happened here has to be put into a much broader context. What we have seen around the world in recent months has been a crisis of confidence, and of trust, in the financial system. After years of more and more ingenious financial engineering, the markets arrived at a point where nobody knew the scale of potential liabilities in the event of trouble, or where those liabilities lay.

A downturn in the US housing market was all it took to show that the emperor had no clothes. Banks everywhere started to hoard their cash and were unwilling to lend to each other for anything other than the very short term. In a sentence, the markets gummed up.

This won’t last for ever: indeed, there may already be early signs of life returning to the US money markets. But here in the UK, it will take more than a few months to erase the memory of those depositors patiently queueing to withdraw their funds. Those images will have weakened the public’s trust in our financial system.

There is also a big question mark hanging over how our banks are going to return to normality. The Chancellor has effectively socialised the banking system by guaranteeing the deposits in Northern Rock and, by implication, any other big bank. That was the price he had to pay to restore the confidence of depositors.

But this is not a sustainable solution. As I see it, there are two very different paths ahead.

If the taxpayer is going to back bank deposits for anything more than the short term, then banks are going to need massive regulation to prevent them taking risks. But that would kill competition and punish innovation. It would severely limit consumer choice and clog up the arteries of our economy. Unless we are careful, there is a risk that what has happened in recent weeks may push us in this unwelcome direction.

The other route, vastly to be preferred, is to return to a world where market forces operate. In that world, depositors are protected by adequate guarantees, but shareholders lose their money and managers lose their jobs if things start to go wrong.

Getting from here to there will require careful analysis followed by decisive policymaking. First, we need to understand the strengths and weaknesses of the tripartite arrangement, now that it has been tested and found wanting. How can the responsibilities of a monetary authority like the Bank of England best be aligned with those of a financial regulator like the FSA? Who should have overriding authority in the event of a crisis?

The next step will be to consider whether the regulator needs more authority to examine a lender’s business model, and how the legal complications identified last week by the Governor can be fixed. The lender-of-last-resort process will certainly have to be reassessed. And the deposit protection scheme needs to be reviewed carefully.

It is hard to see how Northern Rock can return to its former glories any time soon. But we must learn the right lessons from what has happened, so that we never see such shocking sights on our streets again.

Richard Lambert is Director-General of the CBI. This is an edited version of his speech to the CBI’s North East annual dinner last night.

to L. Gee,

I have no concern with the religion of the author of a criminal act, just the consequences of that act. The idea that a criminal cannot be denounced because he is Jewish, seems a strange point of view to me. And extremely rich individuals of many different religions are among the top 100 families currently ruling the planet financially, and doing a very bad job of it, as they have led us to the possible destruction of the entire human race, through environmental catastrophe, war, famine and intolerance. I suggest you see the film, all 3.5 hours of it, and look up the old financial times articles on the history of the Rothchild family, and even to the Jewish on-line dictionary, concerning this particular family. Their financial conduct has been reprehensible in a large number of cases. It is all there if you look for it. It's called HISTORY.

victor compton, Cherbourg, France, France

Northern rock fiasco brought to light the little known fact to little known people that your money on deposit is not guaranteed ,but bank to bank loans are, by being first on the list in liquidation.come on banks look after,themselves first.
Lets not start thinking ,that they are thinking of the public good.

mike j w, london, uk

"People in the North East must feel badly let down...." Then why did they precipitate this crisis by precipitately withdrawing their funds to the extent which they did? Do they not feel ashamed, rather than 'let down? The only constructive thing the BofE could do now , in light of the "very healthy state of the N.R. bank's loan book", would be to temorarily guarantee ALL future deposits, to encourage those who withdrew the life-blood funding of the bank to re-deposit it! Yes, and the N.R. bank could offer interest nearer to the rate they are being forced to pay the BofE, which is hampering, if not crippling, their hopes of recovery. Two things the N.R. bank need right now are 1. The aforementioned re-influx of the funds which have been so impulsively removed, in order to restore confidence in the future of the institution; and 2. Immediate removal and re-placement of the rest of the supine board of directors, with people who actually seem bothered!
[A small investor] S.Barraclough.

S. Barraclough, Huddersfield, W. Yorkshire

The problem is the big money bonus culture. This resulted in the adoption of a poor funding strategy with no fall back in place - that would have cost money and reduced profits- so was apparently simply ignored by Management, the Treasury and the FSA.

Doug, Glasgow,

"an accident waiting to happen" is exactly what northern rock was. Dont blame the city, dont blame market forces - blame a previously discredited business plan. If you havent heard of, and understood the implications of Continental Illinois. you dont deserve to be managing a bank or commenting on the situation.

This was no perfect storm and other hyperbole, it was just a change in liquidity preference. Those exposed to excessive liquiidty risk deserve to fail. LTCM didnt understand it either and they failed as well. Its not a difficult concept.

Steven Bowles, London, UK

In answer to Victor Compton of Cherbourg, and this piece of vindictiveness has been on the blog site for about a week at least,which as a probable anti-Jewish hate attack should not have gone by unnoticed and passed by the so called 'moderators', one must point out that all banks in general and certainly including Nathan Rothschild, can only possibly lend out money up to the amount that it has already received from investors. The 'Reserves' that he mentions does not exist as a normal financial definition term except for the Central Banks ie 'gold and currency reserves'. All the remaining high street banks, and this applied also to Rotschilds, lend out as just stated but hold about 8-10% in cash as its effective 'reserves' , and known as the 'liquidity ratio' to pay out investors and other banks' offset payments, as required.

L. Gee, London, UK

The deposit insurance system created by the UK deposit insurance system was always fatally flawed. In contrast to the model in most other countries the individual depositors take a hit when a bank collapses. In the US, for example, depositors are protected up to $100000 for one hundred percent. There is therefore no incentive for a run on a bank. The British system favours the large High Street Banks against their competitors because they are, correctly, seen as too big to be allowed to fail.

Ian, Frederick , USA MD

I really think that at the heart of this crisis is the lack of confidence in both politicians and the administration. People are that used to spin and deceit that the do not have faith. This was clearly seen during this crisis as both the politicians and the Bank of England (treasury) were seen to almost pause while the problem was announced and 'look over their shoulders' to see what the readings were of public opinion and other political entities and the press, before actually doing something positive and useful. Even that seems to be a cack handed decision as existing depositors only are protected - how can this help the bank to recover - who is going to be a new depositor in these circumstances? No, the bank is once again reliant on money market funds - so with the increasing interest rates for these funds how is the bank to survive? The existing depositors are the only clear winners:- how can these Treasury guarantees ever be withdrawn now - even if the bank is sold off?

Diddly Do, Liverool,

With Britain's mountain of debt, I am sure we are a banana republic. Only people have not yet woken up to that fact.

Chris, woodbridge, suffolk

Apparently, according to the Bank of England governor who sits on the board of the FSA, the Northern Rock's business model was no concern of the FSA. I was questioned by the FSA several times, as the chairman of a regulated company, and very frequently they asked, "What is the biggest threat to your business?" The right answer was, " irrelevent regulation " but they received the answer they wanted to hear - as do all regulators. However, in the Northern Rock case and based on such authoritative confirmation, we must conclude that borrowing short and lending long is not the business or the concern of the FSA.
So what are they for, exactly?

Graham McKean, Sevenoaks, UK

Northern Rock is an excellent business with a short term funding problem. Running the liability side of their balance sheet is easy if you don't try and be too smart. I believe their long serving finance director retired in March so I guess the problem is in their Treasury dept. It sounds like the need a new FD and MD and a new bunch of non-execs who know the business. Non-exec D Wanless was formerly in charge of Nat West pre RBS takeover and after that the GP large salary increase recommendation for less work. Nuff said.

Eric Edmond, Somerset, UK

Having seen money stolen from their pensions you cannot blame people for having no faith in the system when their cash may be in danger of disappearing also.

Steve Byrne, Christchurch, UK

It's be great if we could grow bananas here - surely cheaper than importing them!

cww, Ipswich,

Still giving away 6 times salary or 117% of value last week.
Some monitoring,some quality,some result,some stupidity.
Maybe the main players aren't so intelligent or your assessment
so right.

dave, Northwood, england

I recently visited the UK and unhappily had to use the Dartford Tunnel and the M25 and got nowhere fast. I thought all these people sitting in their stupid mostly 4x4s for hours on end must be bananas and when saw the prices for sub standard meals and hotels I realised I was in a "Banana Republic".

Frederick, London, UK

Now we know why the British government refused point blank to join the EURO zone. The ECB has far more power to stepin and stop dubious practices and disallow above average money supply expansion not supported by GDP growth. British building socities in general are flooding the mortgage market causing 20% increases in London house prices in the last year. Greenwich London up from £300,000 to £500,000 for some tiny 2 bed apartment with a LEASE. No wonder the building socities own the estate agents/realtors....to hide the losses when they come in 2008.

Richard Bond, London, England

Ian do your homework.. BOCI too.... and do you really think sub debt holders if fact even senior debt holders of NR will get 100% back - if a stategic buyout/ hedge fund buys it - such as proposed -- their business is to sell assets off to their other companies cheap --- not to pay out creditors.... do you think pettle wants to run a U.K. mortgage lender ~!%$!

slarty, se, kent

I believe Northern Rock will indeed be insolvent by Christmas. It has lent the most money at the top of the market measured both by loan-to-value and earnings multiple, as well as concentrating on the worst sectors: "self-certified" (= fictional borrower data) and buy-to-let. If the government is forcing taxpayers to guarantee savings, we taxpayers should at least have the assurances (a) that Northern Rock makes no new loans at all, (b) that all borrower data and loan-to-value data is refreshed, and (c) that the entire loan portfolio be re-indexed according to the risk-weighting system of HSBC. Then we will see if Northern Rock meets its capital ratios (which are worked out from its own internal risk weightings, and allow Management a lot of leeway for optimism). At Lloyds Bank International we were taught that "illiquidity is the harbinger of insolvency". Never a truer word...

Bob, Thames Ditton, UK

Ian,
"In reply to some of the comments by foreigners.

The UK is the biggest financial centre in the world. And no-one has lost a penny who invested in any British based bank."

I suspect the shareholders and subordinated debt holders of Barings may disagree with you sir...

Mark, Luxembourg,

the non ecec directors should be publically and quickly , examined

DAVID, EDINBURGH,

John,
Total consumer debt in the UK is "only" 160% of the country GDP, versus the circa 110% in the US. London is the world financial capital (yes, of debt!). I think there are bananas on both sides of the pond.

Michele, Richmond, Surrey

Perhaps Mr. Lambert would care to describe these mysterious "market forces" in more detail? With the kind of equations, and diagrams that real engineers have to put out, before they're allowed to do anything that is potentially massively destructive to complex real time systems?

When this is possible, and at the current state of economic system level understanding possessed by Mr. Lambert and his colleagues, it unfortunately isn't, then it may be possible to have an informed debate about how to govern the system. In the meantime, we're all just along for the ride, when as Kipling so eloquently put it, "The Gods of the Copybook Headings with terror and slaughter return."

Jacky Mallett, Los Angeles, USA

The UK needs to return to being a democracy -
(i) one where the government is properly elected by the people i,e. with rather more than 25% support,
(ii) holds a referendum whenever it proposes to transfer power away from the sovereign Parliament
(iii) protects its population from unwanted and potentially overwhelming immigration or invasion

So long as the English government is run by socialist Scots, trust will continue to ebb away along with many of its skilled middle classes and confidence in its institutions.

MarkS, Leeds,

About time the blame was placed fairly and squarely with the managers of Northern Rock - they designed the business model! Shareholders invested in Northern Rock becuase this model gave higher returns - surely they know that higher returns only come with higher risk. This time they got it wrong and will loose money - this is capitalism. Long live capitalism because it has made the worls a better place. The chancellor must not throw the baby out with the bath water!

Gwilym Ashworth, Pulborough, West Sussex

Bit rich coming from Lambert as he was on the MPC that made interest rate decisions which has resulted in today's mess in the UK economy with its booms, bubbles, imbalances etc

cww, Ipswich,

All this financial agitation is deliberate. The root cause is fractional reserve banking practices which allow every bank to loan out 10 times its actual reserves. Nathan Rothchild incorporated this criminal practice used by goldsmiths in the 1600's, into his family banking practices, and then into private banking corporations in every major western system. Having private banks responsible for creating, printing, and distributing currency gives a few of the worlds richest families, complete control financially of the world. The English economy has been under their power for 200 years. Go see the film, "The Money Masters" at this address. http://www.informationliberation.com/?id=8702 It will tell you much more than you are supposed to know.

Victor Compton, Cherbourg, France

Bob Brown of California - if the UK is a banana republic, what does that make the US which has public debt, unemployment and those below the poverty line significantly greater per capita than the UK.

Think before you spout such drivel.

John Cutler, London, UK

UK the biggest financial center in the wordl? You might want to read The Economist's recent special article on world financial centres. London was number one in only one of ten metrics they used. New York was top in nine of ten, eclipsing London in most of those by several hundred percent.

nigel roberts, warrington, england

A Crisis of confidence in a financial institution invariably leads to withdrawals by depositors.

This is either resolved by take-over - in the case of NatWest (by RBS) whose Treasury made unsound investments or

in case of BCCI whose CEO stuck 2 fingers in the air to the US Federal Reserve in the face of Money Laundering charges and refused to place 9 employees on suspension until after court hearings.

In the latter case, the institution went into pre-death coma in 1989 - 3 yrs before it died......

Northern Rock will be a take-over case - hopefully.

Richard Prior, Bucharest, Romania

Well, what is so wrong about bananas? It is full of potassioum, fibers, vitamins, easy to find, easy and clean to eat.Besides, the republics that are familiar with the banana trees are usually friendly, warm, peacefull and rarely arrogant.
Enjoy banana, sir!

Murilo, Porto Alegre, rs-Brasil

In reply to some of the comments by foreigners.

The UK is the biggest financial centre in the world. And no-one has lost a penny who invested in any British based bank.

Ian, UK,

Why for BCCI depositors were allowed to lose?

AAA, MAURITIUS,

Well, the voters seem to be regarding Mr Brown's performance on Northern Rock as a big triumph. Shows you what spin can do.

Doug, Glasgow,

"Outside the movies, a run on a bank is something that happens in a banana republic."

So the USA in 1907, when several Bank runs took place, including the Mercantile Bank and the Knickerbocker Bank, was a "banana republic" was it?

And the US was a "banana republic" in 1929, 1930, 1931, 1932 and 1933, when even more Bank runs took place?

Or did those Bank runs just take place in the movies?

jon livesey, Sunnyvale, CA/US

Correct - the UK has been a banana republic for some years now. Who and what is going to change that at this stage?

Bob Brown, Tustin, California

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