THE Northern Rock situation has thrown up a number of questions. Is the tripartite system between the Bank of England, the Financial Services Authority (FSA) and the Treasury working? Should the Bank of England take back prudential supervision? Who was at fault for not foreseeing the problem?

Much has been written about the moral hazard created by protecting depositors from the consequences of a bank’s failure. But there is little debate on the fundamental question: why should banks be protected from failure? The answer is clear: banks should not be protected, but their customers should be protected from the consequences of a bank failure.

There are two reasons for doing so: the first is that the consequences of a bank failure and an unconstrained liquidity shock with the consequent credit squeeze can create serious damage in an economy.

The second is that it is simply impractical to make the man or woman in the street responsible for evaluating the credit worthiness of a bank. That is why there are deposit-protection schemes.

It is important to distinguish between protecting customers and protecting the bank itself. Banks should be allowed to fail in the sense that their shareholders should lose their investment and the (senior) management their jobs.

Shareholders must be responsible for their investment decision and should bear the pain of any failure.

In the 1970s secondary-bank crisis, the shareholders in failed banks lost the money they had invested, but the “lifeboat” launched by the Bank of England ensured that depositors did not lose their money. Shareholders were effectively wiped out, but damage to the economy and subsequent contagion were limited.

There are four reasons for protecting retail depositors – and indeed for protecting all (senior) creditors. The first is common sense.

To argue that depositors should bear responsibility for their decision in putting money into an authorised bank is like arguing that people should be responsible for checking that the food they buy is not adulterated. We all rely on health-and-safety standards being enforced. When such standards are breached, we expect the offender to be closed down. But we do not expect the NHS to refuse to treat us on the grounds that we had brought our illness on ourselves.

To suggest that the ordinary citizen should be on his/her own when placing money in a regulated institution is simply unrealistic. They have neither the skill nor the information to make such a judgment.

The second reason is economic reality. No government can afford a major banking failure. The knock-on, domino effect is simply too severe to risk. A small bank can be allowed to fail but the reality is that no government will allow the depositors in any bank of any size to lose money. Too many votes would be lost.

The third reason is that, without a comprehensive guarantee scheme, those banks that are “too big to fail” will enjoy a competitive advantage in the marketplace. This is undesirable.

The final advantage is that an explicit government guarantee for all (senior) depositors and creditors in authorised banks is the cheapest and economically most efficient way forward.

Subordinated debt holders and shareholders would, equally explicitly, be known to be at risk of loss for part or all of their funds. So innocent bystanders would be protected, the systemic risk would be avoided and the pain would fall on the equity risk takers.

The confidence of retail depositors is the bedrock on which everything else stands. A government guarantee ensures that retail depositors’ confidence was not shaken.

So let’s be open about it. The consequence of an explicit guarantee for retail depositors (and I would argue for all senior creditors) would be an equally explicit warning to shareholders and subordinated creditors that they were at risk.

The result, at least in theory, would be an immediate focusing of attention on the risks that they would be running. Shareholders may not react quickly, but the money markets certainly could punish any bank whose credit worthiness looked in doubt.

Had there been an explicit guarantee backed by the government, the Northern Rock crisis would not have developed the way it did. The Bank of England, reportedly, was not willing to provide the £30 billion funding line Lloyds TSB reportedly wanted to acquire Northern Rock. Few would bet against the Bank having to supply Northern Rock with £30 billion over the coming months.

Nor is transparency necessarily the answer. While it would ensure that everyone knew where the bodies were buried, transparency would also ensure that everyone knew which banks had a real problem, and the result would be an immediate run on them.

Transparency also assumes that the facts of a situation are clear. But as all bankers know, bad-debt provisions and write-offs are an art, not a science. What can be recovered is not usually clear at the time.

We must move to having 100% insurance for all depositors and senior creditors of all UK regulated banks. The cost of that insurance should be borne in the first instance by shareholders and subordinated creditors of any failed bank.

Any additional cost after a failure should be met by a levy on all banks inversely pro rata to the size of their balance sheets over their capital base. So the stronger banks will pay relatively less than banks that are less well capitalised.

Non-UK-regulated banks would not be subject to the levy, but nor would their depositors receive any protection. That lack of insurance would have to be a contractual condition made clear to all depositors.

The tripartite system works well in America with the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation.

The problem in Britain is that the lines and responsibilities have not been drawn clearly enough.

Sir Peter Burt was chief executive of Bank of Scotland from 1996 to 2001. When it merged with Halifax in 2001, he became deputy chairman of HBOS, stepping down in 2003.

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