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Saving the banks

• Robert Peston
• 18 Sep 07, 08:00 AM

If the run on isn鈥檛 stemmed by the Government鈥檚 decision to guarantee that no depositor will lose money, well then nothing will stem it.

The decision is without precedent. Historically, all British governments, regulators and the have been persuaded that to 鈥渕ake whole鈥� all savers would be to create a serious moral hazard problem.

They have believed it really important that Mr and Mrs Bloggins should live in fear that they could lose some money by having their savings in Northern Rock or any bank, in the rather na茂ve believe that the Blogginses and other depositors would put pressure on said bank to conduct its affairs in a prudent way.

The theory is, of course, utter nonsense in complex modern capital markets 鈥� where even the specialist watchdog, the , has difficulty understanding the precise risks being run by individual banks (as we have seen in recent weeks).

And in practice the puritanical theory that everyone has to lose something has led to the near-collapse of Northern Rock.

Why?

Because when Northern Rock was singled out as a vulnerable bank after it was given emergency support by the Bank of England, the one thing the Blogginses remembered was that the official deposit protection scheme only guaranteed that a portion of their savings would be safe 鈥� and they may also have recalled that it would be months before they received even this limited compensation, in the event that Northern Rock collapsed.

So even though Northern Rock was not bust, it was not rational for the Blogginses 鈥� and all those other savers 鈥� to keep their money in Northern Rock, once even the faintest question was raised about its viability.

What the Northern Rock panic demonstrated is the huge potential for there to be runs on banks, when savers have so many banks to choose from. And, if Northern Rock鈥檚 website had been a little less prone to falling over, it would also have shown how technology has increased the risk of capital flight in these circumstances.

However, there is no point in providing this protection for simply Northern Rock or any other bank that faces a funding shortage in the current market turmoil (the chairman of the FSA, confirmed to me last night - you can watch the interview here - that such protection was being extended to all other British banks).

The Government must swiftly legislate to formalise this new approach to the public insurance of savers鈥� money.

The good news is that senior officials tell me such legislation in on the cards.

However, some important details are yet to be worked out.

The Bank of England would like elements of the US model to be imported, such as a provision for all small depositors to receive their money within days of a bank going bust.

But perhaps the most important question is where the ceiling on insured deposits should be set.

In the current crisis, the Treasury is saying that no depositor will lose his or her money, no matter how big the deposit.

That is not sustainable as a general approach, because it would create a serious moral hazard issue. It would effectively be extending protection to sophisticated professional money-market players 鈥� which would have the effect of reducing the pressure on banks not to take excessive risks, because they could take comfort that the Government would pick up the tab if it all went wrong.

The pressure on banks not to take excessive risks must come from the substantial providers of capital, those who buy their shares, purchase their bonds or finance them in other ways through the wholesale money markets.

Make no mistake, Alistair Darling has bailed some or all of them out in the Northern Rock case. And that is a very unfortunate precedent.

If it became the general rule that all deposits were protected, well the financial system would soon go to hell in handcart. As one bank after another took stupid risks to inflate profits, they would all end up in public ownership.

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The watchdog growls

• Robert Peston
• 18 Sep 07, 07:45 AM

Last night I interviewed Sir Callum McCarthy, chairman of the City watchdog, the Financial Services Authority, about the run on Northern Rock and the wider crisis in the financial markets. McCarthy said the era of cheap money based on banks 鈥渕ispricing risk鈥� was probably over. That may push up the cost of borrowing for all of us. But in the long term, it should put the economy on a more sustainable footing.

You can watch the interview in full by clicking here.

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