Rock Sand and Confidence

5^th October 2007
The Malta Independent - Friday Wisdom

The Northern Rock is melting. Confidence had turned sand into a rock. Lack of confidence in the UK financial system is causing the rock to crumble back into sand. Soft confidence can do or undo what hard sledgehammer tactics fail to scratch.

This might be of little relevance to us in Malta given that we have a very solid and overly liquid banking system and there is not even a remote possibility of the inter-bank money markets seizing up as they did in UK. But given that we adopt a similar regulatory regime as that adopted in UK, it should interest us to watch and analyse how effectively this regulatory regime has performed when put to real test of financial stress.

In Malta, as in UK, there is separation between the monetary policy and financial stability oversight duties adopted by the Central Bank from the banking regulation duties adopted by the financial regulator (MFSA in Malta and FSA in UK) that actually licenses and regulates banks at the institution level.

The purpose of this separation was meant to ensure that the Central Bank is and is perceived to be totally autonomous in the conduct of monetary policy without being influenced by the stability of individual institutions.

How has it worked out in practice in the case of the Northern Rock crisis? Not very well I must say. With this first hand experience of how the system works when put to the stress test, it might just as well be that we need to review the whole structure of regulation, financial stability and monetary policy execution.

Northern Rock was a mutual building society that converted to commercial bank status being fully licensed and regulated by the FSA. Its business model involved operating as an important niche player in the UK mortgage market with very limited branch network for raising retail deposits and instead funding its mortgage loan book by short-term funding on the inter-bank markets and the wholesale commercial paper market.

No one has in any way accused Northern Rock that it has adopted irresponsible lending practices or that it is suffering any material deterioration of delinquency ratios of its loan book. On the contrary, regulators went on record stating that they are completely satisfied of the robustness of Northern Rock loan book and that the illiquidity problems have been caused by extraneous sources of systemic disturbance. Mortgage problems in the US and direct and indirect – as yet unquantified – exposure of some of the UK bank players to such problems and the general and sudden investors’ attitude shift from one of strong risk appetite to one of substantial risk aversion, forced the wholesale and inter-bank money markets to suddenly seize up.

Without the working of an efficient and liquid inter-bank market, the business model of Northern Rock went through the shredder. While the Bank of England was adopting a hands-off approach interpreting the problem as being specific to Northern Rock, depositors started lining up demanding instant return of their deposits.

The confidence foundation built over decades and decades of central banking tradition in acting as a lender of the last resort for preserving the integrity of the banking system was thrown out of the window in a couple of days by what appears to be lack of co-ordination between the FSA and the Bank of England. This lead to some under-estimation that Northern Rock was melting down due to a systemic freezing for reasons beyond its control and unconnected with their integrity of doing business.

Then when it was too late for confidence to escape unscathed there was a vault-face by the Bank of England. Not only did they suddenly give all the necessary credit lines and liquidity for Northern Rock to fund all the deposit drain in process but when this was not enough to reinstall confidence, they forced the Chancellor of the Exchequer to take the unprecedented step to guarantee all deposits of Northern Rock, and by implication of all banking institutions that might find themselves in its same position.

I dare suggest that this would not have happened if the Bank of England was directly responsible for licensing and regulation of individual institutions as the Bank of England would have had first hand ongoing experience of the problems of Northern Rock. It would have either not approved Northern Rock’s business model in the first place or would have provided liquidity more promptly without causing systemic seizing and without tarnishing the confidence foundation on which all of our financial systems are built.

Now with this first hand experience of how well or otherwise the new separation of duties between regulation and monetary policy has worked in practice, we can pass some judgement. Which is the more damaging? The risk of monetary policy execution being contaminated by the moral obligation to save a regulated institution or the risk of lack of coordination between the various regulatory players leading to a systemic failure causing the near collapse of licensed institution for reasons that are totally extraneous to their operations, causing hardship to individual depositors, leading to anxious queues outside branches right in the City which floats on financial confidence, and forcing the government to take on the obligation of the insurer of the last resort.

How are MFSA peer institutions in the euro area countries going to increase their coordination with the ECB to ensure that the Northern Rock experience in UK is not repeated unnecessarily in the euro area we are just about to join?