The credit crunch hit the UK just over seven months ago now. The ramifications have been huge and they continue. The collapse of Northern Rock and customers queuing for hours outside branches will always symbolise the crisis in the UK.
Even though the origins of our current problems are in the US subprime mortgage market, there are lessons to be learnt from the affair. The government has made it clear that they want to legislate by the summer – to strengthen the financial sector, reduce the likelihood of bank failures in the future and to increase confidence among investors and consumers.
Some reforms – around supervision of banks will clearly be useful (the FSA has publicly stated that supervision of Northern Rock in the months and years preceding its downfall were found wanting). Strengthening deposit insurance would also reduce the risk of future bank runs – if depositors know that they can get their money back (quickly) in the event of a bank failure then Northern Rock-style queues should not form again.
But beware, also, the law of unintended consequences. The rush to legislate in the US on the back of the Enron and Worldcom corporate governance scandals, in the form of the Sarbanes-Oxley legislation resulted in companies delisting from the New York Stock Exchange and a lot of extra work for lawyers and accountants – to meet the letter, if not the principles, of the new laws.
Let’s take a couple of examples of proposals for UK legislation.
First, who should pay for greater deposit insurance? After a visit to the US, the Treasury select committee is arguing that banks should pay a levy to build up a fund that can be drawn down in the event of a failure. In the US, banks have been paying in to such a scheme since 1929. But, the total value amassed is only $49bn (£25bn) – less than the guarantee that the Bank of England has given to Northern Rock customers. Although suitable in the US, where there are a large number of small banks operating at a state level, such a system is unlikely to work in the UK with much larger (and generally better capitalised) banks. Moreover, there would be big decisions to be made about whether the levy should depend on the probability of a bank needing to draw on the fund – and who would make such judgements. Such a levy could also reduce the liquidity of the banks – when in current circumstances most analysts think the goal should be to increase liquidity.
Another idea that the FSA has floated concerns when a bank can be nationalised. The FSA appears to want to make it easier to bring banks into public ownership if they do not recapitalise or increase liquidity in lines with FSA advice. This, they argue, should reduce the chance of bank failure and enable the authorities to take preemptive action to help secure the future of vulnerable financial institutions when they can’t or won’t sort out their balance sheets. But who is best placed to make these decisions – a regulator, shareholders, or the management of a bank? All three have been found wanting in the past few months. Such moves could have destabilising effects – the law of unintended consequences.
It is clear that there are lessons to be learnt. Greater clarity on responsibilities between the FSA, the Treasury and the Bank of England will be useful. Clarity on what the Bank of England can do to confidentially ‘rescue’ a bank in trouble would help reduce the chance of failure in the first place.
But, there is a lot more debate and consultation needed on the detail – and it will be the detail that determines whether we get good or bad law.
I understand the desire to legislate before the summer – it would look neglectful to have made no legislative changes a year on, especially when it is far from clear that there are not more problems to come. Legislation to protect deposits and give the Bank of England powers to provide intensive care support for banks who go to it as the lender of last resort will be useful and should increase confidence in the markets. Don’t though do everything at once, and don’t unintentionally increase fragility in financial markets when what is needed most is calm.