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Northern Rock – Nationalisation

January 22, 2008

Northern Rock - Nationalisation

For sure there have been more spectacular banking crises than that which has affected Northern Rock in recent months. The phenomenon of a ‘run on the bank’ was almost commonplace in Victorian times. More recently the collapse of BCCI (1991) and Barings (1995) show that even a highly regulated banking sector is never immune to mismanagement and fraudulent activity.

The fiasco of Northern Rock is a modern day sorry catalogue of poor judgement and woeful indecision. Understandably the Conservatives have been keen to point the finger of blame entirely at the actions of the Treasury and especially the inaction of the erstwhile Chancellor of the Exchequer. In truth, responsibility for what has happened at Northern Rock should be more widely spread.

First, and foremost, the senior management of the Bank – in particular its former chief executive, Adam Applegarth, and the array of non-executive directors. Collectively they should have realised that the aggressive growth in turnover strategy being adopted by Northern Rock depended upon continued economic blue skies and liquidity in the money markets. Northern Rock’s strategy was so diametrically opposed from any of its competitors that alarm bells should have been ringing amongst the well-remunerated non-execs (a roster which included some well known City names) about its sustainability.

Second, once the credit crunch hit in early August the Bank of England should have been far more fleet of foot. In particular its Governor, Mervyn King, ought to have been more amenable to the proposal by Lloyds TSB to take over Northern Rock before the crisis became public. No doubt this would have required substantial Treasury guarantees, but almost certainly UK taxpayers would have been in a considerably more favourable position than they now find themselves. Mr King’s reappointment should not be regarded as automatic.

Once queues began to develop outside branches of Northern Rock across the nation during mid September, the crisis had become public. It was at this stage that the possibility of an autumn General Election and the fact that the bank was a large, almost iconic employer in Labour’s North Eastern England heartland, resulted in a catalogue of ill-advised Treasury decisions. Simply allowing Northern Rock to collapse was never an option. Banks are different to other companies – they have depositors as well as shareholders. Whilst the value of a shareholder’s investment, in principle, can be allowed to diminish to zero, the entire confidence of the banking system depends on a bank’s depositors being assured that they will be fully compensated in the event of a collapse.

Four months on Northern Rock is less a financial and more a political headache for the current government. But make no mistake – the proposal on the table to turn the current loan from the Bank of England into bonds guaranteed by the Treasury is nationalisation in all but name.

This proposal allows the government to claim that it has avoided taking Northern Rock into public ownership, but rather like the public finance initiative (which is designed to keep public debt off the balance sheet) it is likely to prove very poor value for money for the taxpayer in the years ahead.

It is also strangely reminiscent of the convoluted creation of Network Rail after the collapse of Railtrack in 2001. In short, the bond mechanism allows for political closure of a controversial issue, but it will most likely continue to cost the British taxpayer vast sums for some time to come.

The trouble with this sort of innovative hybrid financial structuring is that even the financial whizzkids at Goldman Sachs probably do not fully understand how it works (although in fairness to that bank it foresaw the credit crunch and divested to other banks its entire sub-prime mortgage liabilities during the second quarter of last year.)

The Northern Rock rescue plan, involving more than £50 billion in state-backed loans and guarantees, is designed above all to get the government out of a political hole. If the words ‘Northern Rock’ are kept out of the front page headlines, then the government’s plans will in their own terms have succeeded. However, the endgame for Northern Rock, not to mention the accumulated costs to the hapless UK taxpayer, will only be apparent half a decade or more in the future. It may be politically expedient, but it makes little economic sense.