How Gordon Brown failed the banking test

What's the problem?

The turmoil in the credit markets recently engulfed one of Britain's best-known banks and fifth-largest mortgage lender, Northern Rock. The bank's business model relied heavily on funding from the inter-bank lending market. When this froze, fears that the bank might be insolvent were quickly raised. The ensuing panic wiped 70% off Northern Rock's share price in just two days and triggered almost unprecedented scenes at many of its 72 branches as frantic savers withdrew an estimated £2bn of deposits. A degree of calm was restored only after what Capital Economics describes as the Treasury's "huge gamble" when Chancellor Alistair Darling promised to guarantee "all the existing deposits in Northern Rock", the first time that the UK government has bailed out a high street bank since 1973.

Shouldn't the UK regulator have prevented this?

The Northern Rock fiasco, which has "torpedoed confidence in the savings system at a time when the savings rate is at an all-time low", says The Times, also exposes a lack of accountability at the heart of UK retail banking supervision, with several key players caught "asleep at the wheel". Under Gordon Brown's early stewardship of the Treasury, back in 1997, responsibility for banking regulation was taken from the Bank of England its brief was reduced to setting interest rates and "maintaining financial stability" and handed to the financial regulator, the Financial Services Authority. The result was a three-way power split, making it hard to know who has overall responsibility for UK banking. When Tory MP Michael Fallon asked who was in charge during the crisis, Bank of England governor Mervyn King replied lamely: "What do you mean by in charge'?" Callum McCarthy, the head of the FSA, which did nothing to prevent Northern Rock rapidly building its high-risk mortgage business, did eventually pop up on the BBC after the Treasury had intervened, only to dismiss anxious consumers as "irrational". Overall, as The Observer concluded, the crisis made "the City's top policemen look like the Keystone Cops".

So the main issue was a lack of clear leadership?

Yes, but the crisis also threw up another serious problem. Unlike countries such as France and the US, the UK lacks a decent deposit guarantee scheme. Under antiquated rules inherited by the FSA, there is a Financial Services Compen­sation Scheme, designed to compensate savers in the event of a bank going bust. But only the first £2,000 is completely underwritten and the maximum payout is capped at £31,700, a cut-off described by The Independent as "a bit of a joke". What's more, since the scheme has never been tested, no one is quite sure how long it would take to settle a claim nor how secure this guarantee actually is. Hardly surprising then that many baffled Northern Rock customers opted to take out their hard-earned cash as soon as rumours of a funding problem emerged.

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So what's the solution?

Anatole Kaletsky in The Times blames the debacle directly on the unsatisfactory way in which responsibilities were parcelled out in 1997 between the Treasury, the FSA and the Bank of England, resulting in "buck-passing, confusion and dissent". The solution is greater accountability with one regulator in charge both of banking supervision and financial stability which is exactly what the Bank of England did before Gordon Brown hived off regulation to the FSA. The trouble is, the Prime Minister doesn't agree that his changes caused the problem, telling the BBC this week that "the banking regulations system worked well in handling the bank rescue".

Can anything be done?

Given that Gordon Brown is unlikely to dismantle the system he created, Julian Knight in The Independent suggests urgent improvements instead. Firstly, the existing compensation scheme must be overhauled. Alistair Darling has suggested the minimum deposit protected by the scheme may rise to £100,000. Secondly, while Mervyn King did as much as his post-1997 role allowed earlier this year, when he warned both lenders and borrowers about the risks of excessive credit, the same couldn't be said of the FSA. To retain credibility with consumers, who were clearly not reassured by Callum McCarthy's arguments that Northern Rock was "solvent", the FSA must "make it crystal clear that a Rock-style business model relying on the single crutch of money markets for funds is no longer on". Lastly, consumer group Which? has questioned whether the FSA can ever effectively manage its dual, and arguably conflicting, jobs of protecting the interests of both the City and consumers. More than ever it seems a single consumer champion is needed, whose public utterances are not a "master class in financial jargon and double-speak".

Will the proposals prevent further trouble?

Not by a long shot. It is unclear how Alistair Darling's proposed deposit guarantee threshold of £100,000, nearly double the limit of $100,000 in the US and described by The Independent's Jeremy Warner as "astonishingly high", will be funded according to Reuters, the existing compensation scheme only has £4.4m at its immediate disposal, so the required injection, presumably provided by the financial services industry, could be huge. But there is also the wider issue of what economists term "moral hazard". By radically extending the compensation scheme, writing a blank cheque to the likes of Northern Rock and endorsing the tarnished system of banking regulation, the government is in danger of indirectly sponsoring the kind of reckless behaviour that resulted in the current crisis.