How Northern Rock set a dangerous precedent

News that Northern Rock (NRK) is to cancel the payment of its interim dividend is one more blow for its shareholders, who must by now be feeling that they have suffered enough.

Shareholders were looking forward to receiving, on October 26th, 14.2p for each share held. This would have been some small consolation for the huge loss that they have sustained on the capital value of their holding.

However the Financial Services Authority, having stood by and done nothing as the crisis arose before its very eyes, has now decided that it had better look lively.

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So it has leaned upon Northern Rock to cancel the dividend payment, thus saving £59m. This is a drop in the ocean for a company that has outstanding loans of over £100bn, and yet I guess this is a time when Northern Rock should be counting every penny.

But it is one more blow for Northern Rock's shareholders, and one more reason why private investors should think twice before ever again investing in a financial institution.

Financing a can of worms that should never have been opened

There seems to be a general view that depositors in Northern Rock should be protected.

The small man', with his life savings tucked away in his local building society should not suffer. Perhaps he has £10,000 in a Northern Rock account. But there must be many private investors who have or did have - a few thousand pounds worth of their hard earned cash tucked away in Northern Rock shares.

The general attitude towards the latter is: They knew the risks. They had it coming to them. They should never have financed this can of worms in the first place. Let them suffer.'

Well I don't agree.

For a start, Northern Rock was a member of the FTSE 100 and so far as most investors are concerned at least those who have forgotten Marconi, Railtrack et al that made the shares a blue chip. And blue chip means safe. It means it's OK for widows and orphans. It means that you can buy the shares, forget about them, and sit back and allow the juicy dividend cheques to supplement your retirement income. It also meant that the shares were held in hundreds of pension funds, unit trusts and other repositories of our long-term savings.

Depositors in Northern Rock might have been saved, but many of them will, unwittingly, be shareholders in Northern Rock and they have suffered from the £5bn hit to its market capitalisation.

Taking it out on the shareholders?

Anyway, the principle that has been established is this: The depositors must be saved. The shareholders don't matter.

This is foolish and something that the government may live to regret.

For a start, why shouldn't the depositors suffer? Why did they put their money into the Northern Rock? Why, for that matter do they favour building society over bank deposits?

Answer: because they pay a better rate. Why? Because building societies only lend money for residential mortgages. They do not diversify their lending risk in the way that banks do. I wonder how many depositors who bagged the good savings rates of the Northern also took a bearish view of the housing market - but never made the connection?

Secondly, unless we go down the road of having financial institutions that are either owned by the government, or else raise all their capital by borrowing off each other, this country will need to have equity shareholders in banks and building societies.

The proposition now facing these shareholders is this: The government will at all time protect depositors. Banks and building societies will not be allowed to go bust. Therefore they can go out and lend as recklessly as they want, knowing that when the proverbial hits the fan, depositors will not get hurt. But shareholders will.

This is what has happened, and since the memory of loss lingers for years, equity investors will now be very wary about owning the shares of any financial institution. This will ultimately make it more difficult for banks and building societies to raise equity capital to the detriment of the wider economy.

Shareholders, who put their cash to work in businesses, contribute more to the economy than depositors who put their cash under a huge mattress labelled banks and building societies.'

So in the forthcoming discussions about this country's financial regulation, the powers that be need to think very carefully about who should be protected, and who should not.

This article is taken from Tom Bulford's free daily email Penny Sleuth'. For more information please click here