I wrote last week that the outcome of the credit crunch lay largely in the hands of policymakers. Get it right and it could all blow over; get it wrong and we could be in serious trouble. I also wrote that, with the UK potentially most vulnerable to the turmoil, the UK authorities would be tested more than most. But I never imagined that, days later, they would be tested in such spectacular fashion and found desperately wanting. The run on Northern Rock the first run on a mainstream lender for 100 years should never have happened. And it raises troubling questions about the credibility of the UK regulatory system in general and the Bank of England in particular.
Mistakes were made every step of the way. The first was to have allowed Northern Rock to get into the position where it needed emergency funding. This crisis did not emerge as a bolt from the blue. Many in the City had been warning for years that the bank's business model left it vulnerable to a credit-markets squeeze. Funding long-term mortgage lending with short-term borrowing was asking for trouble. A robust regulator should have insisted Northern Rock maintain tougher capital reserves to reflect its high-risk strategy. Instead, the Financial Services Authority allowed it to continue its breakneck dash for growth, increasing its dependence on the capital markets.
But the biggest mistakes were made when the crisis broke. The overriding aim should have been a quick sale to a larger, more robust bank. When two German banks ran into trouble in the summer, the German authorities had bullied domestic banks into a co-ordinated bail-out before any depositors knew there was a problem. Yet somehow, the Bank of England contrived to allow an offer from LloydsTSB to take over Northern Rock to fall by the wayside and with it, any hope of a market-based solution.
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Worse still was the inept way the bail-out was communicated to the public. In a grown-up country, the details of the emergency funding would have been announced to the Stock Exchange first thing in the morning, at which point the key players would been set to reassure the public. But this being 21st century Britain, the news was leaked to the BBC's 10 o'clock news before the directors of the Bank of England had even agreed the terms. Not surprisingly, anxious viewers started withdrawing their deposits online that night. By the time the official announcement was made, the run had begun and the game was pretty much up.
To compound the error, the Bank governor and the FSA chairman refused to appear in public. The job of calming the public was left to politicians a breed whose word the public long since ceased to trust. Crucially, neither the Bank nor Northern Rock would disclose the terms of the emergency funding, adding to the sense of alarm. How big was the loan? How long would it last? What was the rate? No one was saying. So when the chancellor said there was no reason to panic, no one believed him.
Finally, the chancellor was forced explicitly to guarantee deposits at Northern Rock and, by extension, at every other British bank. Another error. It may have stopped the run on Northern Rock, and prevented it spreading to other banks, such as Alliance & Leicester but at the cost of writing the greatest blank cheque in history. Darling had better hope the credit crunch quickly passes with no further bank failures, or taxpayers may be footing the bill for generations. More importantly, he has thrown a lifeline to Northern Rock's investors and management, who escape punishment for their mistakes. A far better option would have been to nationalise Northern Rock as the price of the guarantee to depositors. That would have sent a powerful message.
How did UK financial regulation come to this? Look at the regulatory reforms introduced by Gordon Brown ten years ago, when he gave the Bank of England its independence. A key part of those reforms was Brown's decision to strip the Bank of its role in supervising the banking system and pass it to the newly created FSA. The then Bank governor, Eddie George, believed this such a mistake he considered resigning. Now it is clear why. The FSA has proved a weak regulator, while the Bank's standing has been diminished. Meanwhile, the so-called Tripartite rules, governing the division of responsibilities between the Bank, FSA and Treasury, have proved a recipe for buck-passing and bureaucratic muddle.
Most alarming, the fabled independence of the Bank of England, upon which Brown built his reputation, has been exposed as a sham. The Tripartite rules make clear that final responsibility for bailing out banks lies with the chancellor. That is as it should be, since public money is at stake. But, in the last week, the chancellor has humiliatingly forced the Bank to tear up its carefully articulated rules for dealing with a crisis and perform one U-turn after another. One of the few civic institutions capable of commanding respect and public attention is now the creature of politicians, robbing us of one of the few checks on their power to debauch our money. The events of last week may yet impoverish us in more ways than one.
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