How Bank of England was compelled to rescue Northern Rock

Did the Bank of England
Cave In to Political Pressure?

By Iain Dey
The Telegraph, London
Sunday, September 23, 2007

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/09/23/ccbank...

It was late on Tuesday afternoon when Mervyn King summoned the chief executives of Britain's top five banks to a meeting that night at the Bank of England.

The Governor's problem was obvious. While the queues outside Northern Rock branches had begun to die down, Britain's financial system was still creaking. HSBC, Royal Bank of Scotland, Barclays, Lloyds TSB and HBOS were still refusing to lend to each other to any great extent, clinging on to their piles of cash instead. Only the previous day, a hedge fund whispering campaign had wiped 30 per cent off Alliance & Leicester's shares. Fear of contagion was real.

King shepherded John Varley, Sir Fred Goodwin, Eric Daniels, Andy Hornby and Michael Geoghegan round the table. The mood was already tense. He then revealed his astonishing U-turn: the following day he would announce plans to pump some liquidity into the markets through a £10bn money market auction.

The reaction was fierce. The banks had been demanding such action for more than a month. King had been resisting on the grounds of principle. Only six days earlier he had sent a letter to the House of Commons Treasury Select Committee explaining the dangers of "moral hazard".

Goodwin and Varley in particular wanted to know why King had suddenly changed his mind. If he'd done this when they'd asked him the Northern Rock crisis could have been avoided, they argued.

This was no longer about principles, but pragmatism. For weeks King had been behaving like King Canute, trying to hold back a flood of liquidity that the market believed could bring the banking system back to life. But the tide had overcome him.

He may have been right on principle. But his successive U turns prove that King made some bad judgment calls.

"There have always been a lot of people who disagree with King," says one banker. "But they still respected him. Is that still the case? We'll have to wait and see."

Of all the major figures at the heart of the British financial system, no one has been more critical of the excesses of recent years than King. The Bank of England's quarterly publications have warned time and again of excessive leverage, the poor pricing of risk in the system and the dangers that could be posed by a freeze of liquidity. These warnings were spelled out in long explanatory documents rather than bold red letters. And no one paid much heed.

King made his point more explicitly in his speech to the Lord Mayor of London's banquet at the Mansion House on June 20. It was the first half of his speech that caught the imagination -- an appeal to the banks to help him round up the nation's tatty old fivers, so he could replace them with the shiny new ones in the vaults at Threadneedle Street. But the real meat came later:

"Excessive leverage is the common theme of many financial crises of the past," he said, after detailing again the dangers inherent in complex financial instruments. "Are we really so much cleverer than the financiers of the past?"

Just one week later Northern Rock issued a profits warning. It was already apparent that the financiers of today were cursed with the same hubris as their forebears.

Paul Tucker, the deputy governor of the Bank responsible for the money markets, was increasingly worried. In early July he sent a memo to the Treasury and the Financial Services Authority warning of the potential dangers of a liquidity freeze. In the Bank's eyes, it had just passed the baton to the FSA, which should now start hunting out the individual banks with potential problems.

On July 25 Northern Rock flashed on to the radar screen again, with another profits warning and an admission that some of its hedging strategies were a bit off the mark. Two weeks later, on August 9, the market for commercial paper -- short-term money market loans -- ground to a halt. Northern Rock's reliance on wholesale funding had turned from an inconvenience into an impending disaster.

It took five more days for the FSA to raise the prospect of Northern Rock's imminent collapse with the Treasury and the Bank of England. All the investment banks that had ever had a relationship with Northern Rock began pitching bailout ideas. JP Morgan, for one, offered a rescue financing deal. But Adam Applegarth, Northern Rock's chief executive, and his board balked at some of the terms.

King wanted to do a covert deal, providing Northern Rock with emergency funding behind closed doors. He argued that this was the easiest way to save the Rock without spreading panic. But lawyers kept telling him that he could not do this -- it would breach the EU's market abuse directive.

King spent the next nine days arguing his legal case, picking over the wording of the relevant legislation. But it seems that lawyers from the Bank, the FSA and the Treasury were all telling him that it couldn't be done. Bizarrely, the European Commission disputes this interpretation of its law. But obviously no one asked its opinion before forcing King into submission. There was to be no secret bailout of Northern Rock.

In the meantime, Northern Rock was touting itself round the City, with some help behind the scenes from King and Tucker.

All the major banks operating in Britain were approached. Lloyds TSB was the only one to show serious interest. But it wanted assurances that the Bank of England would provide emergency lending facilities to tide it through. In testimony to the Treasury Select Committee last week, King said he was asked about rolling over the emergency credit line to a new owner only a week ago, on Sunday August 16, when Callum McCarthy, the chairman of the FSA, called him. But according to sources close to the situation, King did hold talks with Lloyds TSB on whether emergency funding would be available if it were to press ahead with a bid.

Eric Daniels, the Lloyds TSB chief executive, was pushing for this facility to be made

available without a penalty rate of interest. He wanted emergency funds for the Rock priced at Libor, the interbank lending rate, as a favour for solving the problem. The deal that was made available to Northern Rock later that week was priced at 1.5 percentage points above base rate.

These talks were apparently taking place one week before that conversation with McCarthy. So while King may have been willing to offer a funding line to a new buyer, he wasn't prepared to do so at a price that was acceptable.

In any case, Northern Rock's board was still reluctant to accept that the Lloyds deal was the best offer on the table. A bailout would be the only option.

In an attempt to set the tone, King sent an open letter to John McFall, the chairman of the Treasury Select Committee, on September 12. He railed against the dangers of flooding the market with liquidity, warning that it "encourages excessive risk-taking and sows the seeds of a future financial crisis".

King was clear in his own mind. If Northern Rock needed a bailout, it would have to pay dearly. As for everyone else, it was not up to him to ensure that the money markets allowed them to make profits. Hector Sants, the chief executive of the FSA, still disagreed. In daily conference calls he pushed for more liquidity to the system as a whole.

The bailout of Northern Rock was announced. King had been clinging to the hope that this would reassure the public, not alarm them. The queues outside Northern Rock branches all over the country proved him wrong.

Alistair Darling, the Chancellor, attempted to reassure the public that their money was safe. But now that the run on the bank had begun, none of this was enough. Meetings continued over the weekend between King, Darling and McCarthy.

On Monday morning Darling pledged to guarantee the nation's bank deposits with taxpayers' money. That helped reassure the public, but did little to solve King's problems. The interest rates that banks charge each other were climbing again in view of the panic.

Sants was making desperate attempts to persuade the UK's big banks to make a co-ordinated move in the money markets to free up the system. They told him they simply couldn't do that. There were still too many potential demands on their balance sheets that had yet to be drawn down. It was not in their interests to do so.

Sants turned again to King. If the banks wouldn't help themselves, it was up to the Governor to pump money into the system. King was still protesting his stance on "moral hazard". The FSA chief said it had gone beyond that point. Darling and his Treasury officials agreed.

Even within the bank, there may have been an element of pressure on King's position. Some sources believe that Paul Tucker was also trying to persuade the Governor to change his stance. Tucker is known to have been more open to intervention than King.

All in all, King began to realise that things had gone too far. Bank officials began drawing up plans for the L10 billion emergency lending facility. By the time he called in the five bank chief executives to Threadneedle Street, he had already made the decision. He would have to go back on his word.

To the outside world it looked as if he had caved in to political pressure. Senior City sources thought he had been made to look like a fool. From King's perspective, it seems that he just realised he had been proved wrong. The way things had panned out, he had no option but to move. The chain of events had overcome him.

His brush with the Treasury Select Committee last Thursday proved King to be a man of principle. But those principles helped contribute to the first run on a British bank in 140 years.

Even now that he has ceded ground, it is unclear whether King has made the right decision. Britain's major banks are this weekend in talks to try to work out a way to use his L10 billion liquidity line. Whispers about who has had to take part in the Bank's auction could simply lead to more disturbing rumours about banks in trouble.

"People have been debating whether the governing structure of the Bank of England needs to be reformed," says one senior City source. "That's not the issue. The problem lies with decisions made by certain individuals involved."

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