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Unstable Governor

• Robert Peston
• 19 Sep 07, 05:15 PM

One of the main functions of a central bank like the is to provide liquidity - or funds - to banks to ensure the smooth running of the financial system and the economy.

It’s a bit like a water company - no one really notices its existence until there is difficulty getting stuff out of the taps.

Well, on August 9, the equivalent of the mains system in the banking market seized up.

Banks became reluctant to lend to each other and would only do so at relatively high interest rates.

Think of it as turning on a tap at home and only finding a trickle.

However, the Bank of England consistently said that its system for providing liquidity didn't need overhauling.

It claimed that to do so would be to bail out banks which had lent or invested in an injudicious way - and it had no intention of doing that.

It has now changed its mind.

The Bank has agreed to accept mortgages from banks as collateral against three month loans.

Baffled?

It's the equivalent of opening up a whole new reservoir in the water system.

But here's the humiliation for the Bank.

If it had done this three weeks ago when banks were clamouring, might never have feared that it was running out of money.

So it would not have had to approach the Bank of England for emergency support.

And there would never have been that on Northern Rock - the first run on a British bank for 140 years.

The possibility that the flight of capital from Northern Rock could have been avoided is seriously embarassing for the Governor of the Bank of England, Mervyn King, one of whose functions is to maintain financial stability.

Right now, stability may not be the correct word to describe his employment prospects.

IMPORTANT UPDATE: 19:59 The Bank of England has now told me that individual banks can only apply for £1.5bn each under the £10bn facility. It says that Northern Rock would have needed far greater funds - and that if this finance had been provided three weeks ago or so, the liquidity would not have eliminated the Rock's funding difficulties.

It is slightly odd that the Bank should divulge this to me now, because it failed to provide this detail (or any answer at all) when I asked this afternoon whether what it announced today could have provided succour to Northern Rock. So although the Bank of England has changed course in respect of the way it is prepared to tackle the crisis in the money markets, it is sticking to the position that it has no regrets about the way that it provided its initial support to Northern Rock.

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Mervyn - still on Rocks

• Robert Peston
• 19 Sep 07, 08:03 AM

What happened at Northern Rock, the first run on a British bank in living memory, has caused deep shame and embarrassment in the banking industry.

It is not the sort of thing that is supposed to happen here.

Senior bankers are livid and looking for someone to blame.

First in their sights is Mervyn King, Governor of the Bank of England.

His refusal to flood the banking system with cash over the past few weeks is the cause of the humiliation of their industry, or so they claim.

Just over a fortnight ago, the biggest UK banks – HSBC, Barclays, HBOS, Lloyds TSB and Royal Bank of Scotland – met with Hector Sants, chief executive of the Financial Services Authority.

Sants asked if there was anything the FSA could do to ease the conditions in the money markets.

They replied that there was little the FSA could do, but it would be helpful if the Bank of England would widen the collateral it was prepared to accept from banks in return for providing short-term funds.

The FSA communicated this demand to the Bank through the tripartite group of Treasury, Bank and FSA whose job is to steer the UK through financial crises.

Sants and the FSA’s chairman, Sir Callum McCarthy, were broadly sympathetic to the demands of the banks.

In a way, that is predictable. They are both former investment bankers, with a visceral understanding of markets.

However King – a world-class economist with an intellectual grasp of markets rather than an emotional one – said no.

He feared that he would in effect be bailing out some banks and financial institutions which – for the future safety of the financial system – ought to feel the pain of their imprudent lending and investments.

Minimising moral hazard is, for King, paramount.

What’s more King received representations from one or two banks which had taken the brave decision not to follow the pack into some of this dodgier lending and were therefore outraged at the idea that their injudicious rivals would be bailed out.

So the Bank stuck to its own rulebook of how much it would lend into the banking market and how it would do so.

There was no recovery in banks willingness to lend to each other and - with a grim inevitability - Northern Rock started to fear it would run out of cash.

An attempt to sell itself to Lloyds TSB foundered on the Bank of England’s refusal to effectively subsidise the deal by providing guaranteed credit to finance Northern Rock’s loan book.

So Northern Rock had no option but to request an emergency loan from the Bank of England – which it was duly given last Thursday night.

What followed has been a shocking new chapter in the annals of banking history, as images of queues of anxious customers flashed across the world.

The Government too has been humiliated. All its reassurances to Northern Rock depositors were ignored, until - with all the appearance of panic - it ditched its existing limited insurance scheme for depositors by promising that no Northern Rock depositor would lose a penny.

The Chancellor, Alistair Darling, was bounced by the crisis into pledging that in a worst case of Northern Rock running out of funds, it would be nationalised.

So for many banks, King's purist refusal to provide succour to all of them eventually forced the new prime minister, Gordon Brown, to agree that £113bn of mortgages made by Northern Rock could go on the public sector balance sheet.

Again, that is just not the sort of thing that is supposed to happen in a well-functioning economy.

Is King at fault?

It is too early to say.

As of this moment, no depositor has actually lost any money.

And it is unclear precisely how much the seizing up of the money markets will slow down the wider economy.

More germanely, few would dispute that the Bank must take enormous care not to reward foolish lending or investing – because that would only encourage foolhardy institutions to behave even more stupidly next time, to the detriment of all our future wealth.

That said, top British bankers – who met the FSA again yesterday – are sickened that their industry, the very heart of the economy, should have been tarnished by those pictures of anxious depositors scrambling to withdraw funds.

Their anger at the Bank of England shows no sign of easing – and it is shared by one or two members of the Government.

For the sake of his reputation and that of the Bank, King has a lot of explaining to do.

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