09-23-2007, 08:29 PM
STRESS TESTING BoE and FSA SYSTEM 10 YEARS POST 1997 AS CREDIT CRISIS WINDS 140 YEARS BACK
ATCA
Upon closer examination, complete trust in the decisions of the independent Old Lady of Threadneedle Street -- The Bank of England -- would appear to be the biggest casualty of the Northern Rock financial turmoil in the UK. The hourly television bulletins reinforced the image of a bank run via the queues which formed outside Northern Rock, up and down the country's fifth-biggest mortgage lend er. This represented the first bank run in Britain since the 1860s, which was nearly one and a half centuries ago !
Most citizens in Western democracies have limited trust in politicians at the best of times. Regulators can sometimes be feared in open and despised behind-closed-doors. Central banks are held in high esteem; which is why the Bank of England (BoE), would appear to be the past week's main victim. There is a palpable sense of loss of credibility in regard to the role of the BoE -- and the FSA to some extent -- amongst many at the Palace of Westminster and across the country. Central banking without the perception of serious credibility can itself be a moral hazard to a fiat currency. Notice the falling value of Sterling against many major currencies including the Euro and Swiss Franc since the Northern Rock tremors.
Going back just one week, the panic was prompted by the announcement initially designed to achieve the exact opposite. Only when the B oE said that it would stand by the stricken Northern Rock last Thursday night did depositors start to run for the exit on Friday. Attempts by Alistair Darling, the Chancellor of the Exchequer -- the UK Finance Minister -- to reassure savers served only to lengthen the queues of people outside branches demanding their money. The run did not stop until Mr Darling gave a taxpayer-backed guarantee on Monday, 17th September, that for the moment all the existing deposits at Northern Rock were safe.
No sooner had the queues disappeared than the House of Commons ', the UK Lower Chamber of Parliament's, inquest began. This was the first big test of Britain's new monetary and regulatory system introduced in 1997, when New Labour came to power and Gordon Brown, then Chancellor of the Exchequer, fundamentally altered the financial chess board by giving The Bank of England operational independence to set interest rates and handing banking supervision to the newly created Financial Services Authority (FSA). HM Treasury, the central bank and the FSA reached a new understanding about how they should run the system together. However, the new system was not really stress tested by the markets in the last ten years until September 2007.
Until the high LIBOR rates' differential of 100+ basis points with the base rate began to rear its uncertain head in August, as pointed out on ATCA, Mr Brown's much vaunted reforms of the UK financial system seemed to be working rather elegantly.
The Bank of England enjoyed huge credibility for keeping inflation close to the government's target -- notwithstanding Governor King's one letter to the Chancellor earlier this year in regard to an inflation overshoot -- whilst ensuring steady growth of the UK economy. The FSA won global praise for its capabilities, especially in regulating complex financial businesses, which have helped strengthen London's image as an international centre of excellence, overtaking New York in many key areas. In just a few days a financial hurricane of "category five" has blown a hole in the hard-won reputations of the regulator and the central bank, as the new system of split responsibility between the BoE and the FSA has failed its first big stress test since its inception 10 years ago.
Moral Hazard
Whilst left with no choice, the Chancellor of the Exchequer -- UK Finance Minister -- Mr Darling's guarantee sets a dangerous precedent: it threatens to encourage savers to put their money in high-rate accounts in shaky banks and shareholders to invest in "extreme" non-bank banks, comfortable in the knowledge that the government will be there for them when the going gets tough.
On the one hand, it would be fair to note that by the time the Chancellor acted, he had little choice but to save Northern Rock or risk a disastrous run on other British banks whose share price was coming under excessive pressure. On the other hand, Northern Rock deserves condemnation for its dangerous non-bank banking business model. The Newcastle-based mortgage lender had grown too fast on the back of short term money markets rather than branch deposits. Clearly, this left it utterly defenceless against a shortfall in funding when easy credit dried up in August and September. Fault for that does lie first-and-foremost with Northern Rock's management , but it also looks as if the FSA was caught off guard. Sir Callum McCarthy, Chairman of the FSA, said this week that Northern Rock's business model was "extreme." Referring to Andrew Hunt's ATCA submission, "The UK's Non-Bank Banks and High LIBOR," we would humbly suggest that the problems in the UK banking system have arisen because many banks in the UK -- not just Northern Rock -- have, in effect, been behaving in the same "extreme" way as though they were non-banks. So, Northern Rock is not unique and therefore "extreme" could be defined as mainstream within certain boundary conditions .
Central bankers across the world had been warning about the likelihood of credit tightening for a while . The FSA ought to have paid close attention and discouraged Northern Rock and other UK non-bank banks from pursuing their risky business models . The FSA's vigilance is essential , because it is the guardian of the public scheme of deposit insurance. Last year, it said this scheme was working just fine. But when stress- tested in September 2007, in the extreme case of the Northern Rock bank run, the scheme failed: depositors neither understood nor trusted it at all. And w hy should they have done so ?
Trust in Financial System 's Regulation
The FSA, BoE and HM Treasury are all likely to come out poorly from the Northern Rock episode. At the outset, the BoE, talked tough and wanted to teach financiers a lesson that they should not expect the central bank to bail them out if they took on too much business risk. Unlike the European and American central banks, which injected copious liquidity repeatedly into the money markets, the BoE held back from pumping cash with a clear justification for its stated policy. When it did intervene, it did so rather modestly, insisting on high quality collateral. The BoE argued that central-bank money could do little to save the three-month LIBOR money market, which had reached a fever of a 100+ basis points differential with the base rate.
In the end, t he BoE's tough line turned out to be unworkable, and events forced the BoE to change its declared policy. On September 19th, the day after the run on Northern Rock ended, the BoE performed a U-turn. It announced that over the next few weeks it would be providing extra liquidity to try to sort out the three-month LIBOR market's high differential. Furthermore, it said that it would lend against riskier collateral, including mortgages, which is precisely what other reputable c entral banks have been doing since the credit crunch emerged in early August.
The charge against the BoE appears to be that its pretence turned the credit crisis into a farce. If the BoE had acted more promptly to provide a redressal for the high LIBOR rate, Northern Rock might have survived. Who knows and what good is speculation at this stage ? The 180 degrees turn in the BoE's policy looks either as if the Old Lady of Threadneedle Street made a mistake, or as if the Lady cannot stand up for her strongly held principles and values . Neither characteristic is endearing in central banking.
As the Governor of the BoE, Mr King pointed out, defending his performance in front of a House of Commons committee on Thursday, 20th September, English law prevents the BoE either from staging a covert rescue operation or from engineering a swift takeover; and clear flaws in the protection of depositors mean that, once an overt rescue operation is under way, depositors are likely to flee -- as became the case with Northern Rock. The Governon defended the separation of powers between the Treasury, the BoE and the FSA, but this may not be a solid line of defence . The split power has exacerbated the system's flaws: nobody was in charge of the operation when there was a desperate need for one leader to run the show . Northern Rock fell in the wide cracks that appeared.
This debacle not only holds key lessons for the system which regulates UK financial institutions but also for the way in which the Euro-zone national financial institutions are regulated: with the European Central Bank (ECB) at one end of the spectrum and old national central banks and finance ministries at the other end . What of the chasm of poor de facto regulation in no-man's land which has opened up, post the ECB's creation and the Euro's inception in 1999? When has the Euro-zone financial institutions' regulatory environment been stress tested by the markets in the last decade? How sound is it under extreme pressure? Is the Euro-zone regulatory system 's stress testing going to begin soon as the global credit crunch continues? What are the recent sub-prime linked banking insolvencies in Germany and elsewhere in the Euro-zone suggesting ? Watch the Euro-zone carefully for unfolding answers to these key questions over the coming weeks and months.
ATCA
Upon closer examination, complete trust in the decisions of the independent Old Lady of Threadneedle Street -- The Bank of England -- would appear to be the biggest casualty of the Northern Rock financial turmoil in the UK. The hourly television bulletins reinforced the image of a bank run via the queues which formed outside Northern Rock, up and down the country's fifth-biggest mortgage lend er. This represented the first bank run in Britain since the 1860s, which was nearly one and a half centuries ago !
Most citizens in Western democracies have limited trust in politicians at the best of times. Regulators can sometimes be feared in open and despised behind-closed-doors. Central banks are held in high esteem; which is why the Bank of England (BoE), would appear to be the past week's main victim. There is a palpable sense of loss of credibility in regard to the role of the BoE -- and the FSA to some extent -- amongst many at the Palace of Westminster and across the country. Central banking without the perception of serious credibility can itself be a moral hazard to a fiat currency. Notice the falling value of Sterling against many major currencies including the Euro and Swiss Franc since the Northern Rock tremors.
Going back just one week, the panic was prompted by the announcement initially designed to achieve the exact opposite. Only when the B oE said that it would stand by the stricken Northern Rock last Thursday night did depositors start to run for the exit on Friday. Attempts by Alistair Darling, the Chancellor of the Exchequer -- the UK Finance Minister -- to reassure savers served only to lengthen the queues of people outside branches demanding their money. The run did not stop until Mr Darling gave a taxpayer-backed guarantee on Monday, 17th September, that for the moment all the existing deposits at Northern Rock were safe.
No sooner had the queues disappeared than the House of Commons ', the UK Lower Chamber of Parliament's, inquest began. This was the first big test of Britain's new monetary and regulatory system introduced in 1997, when New Labour came to power and Gordon Brown, then Chancellor of the Exchequer, fundamentally altered the financial chess board by giving The Bank of England operational independence to set interest rates and handing banking supervision to the newly created Financial Services Authority (FSA). HM Treasury, the central bank and the FSA reached a new understanding about how they should run the system together. However, the new system was not really stress tested by the markets in the last ten years until September 2007.
Until the high LIBOR rates' differential of 100+ basis points with the base rate began to rear its uncertain head in August, as pointed out on ATCA, Mr Brown's much vaunted reforms of the UK financial system seemed to be working rather elegantly.
The Bank of England enjoyed huge credibility for keeping inflation close to the government's target -- notwithstanding Governor King's one letter to the Chancellor earlier this year in regard to an inflation overshoot -- whilst ensuring steady growth of the UK economy. The FSA won global praise for its capabilities, especially in regulating complex financial businesses, which have helped strengthen London's image as an international centre of excellence, overtaking New York in many key areas. In just a few days a financial hurricane of "category five" has blown a hole in the hard-won reputations of the regulator and the central bank, as the new system of split responsibility between the BoE and the FSA has failed its first big stress test since its inception 10 years ago.
Moral Hazard
Whilst left with no choice, the Chancellor of the Exchequer -- UK Finance Minister -- Mr Darling's guarantee sets a dangerous precedent: it threatens to encourage savers to put their money in high-rate accounts in shaky banks and shareholders to invest in "extreme" non-bank banks, comfortable in the knowledge that the government will be there for them when the going gets tough.
On the one hand, it would be fair to note that by the time the Chancellor acted, he had little choice but to save Northern Rock or risk a disastrous run on other British banks whose share price was coming under excessive pressure. On the other hand, Northern Rock deserves condemnation for its dangerous non-bank banking business model. The Newcastle-based mortgage lender had grown too fast on the back of short term money markets rather than branch deposits. Clearly, this left it utterly defenceless against a shortfall in funding when easy credit dried up in August and September. Fault for that does lie first-and-foremost with Northern Rock's management , but it also looks as if the FSA was caught off guard. Sir Callum McCarthy, Chairman of the FSA, said this week that Northern Rock's business model was "extreme." Referring to Andrew Hunt's ATCA submission, "The UK's Non-Bank Banks and High LIBOR," we would humbly suggest that the problems in the UK banking system have arisen because many banks in the UK -- not just Northern Rock -- have, in effect, been behaving in the same "extreme" way as though they were non-banks. So, Northern Rock is not unique and therefore "extreme" could be defined as mainstream within certain boundary conditions .
Central bankers across the world had been warning about the likelihood of credit tightening for a while . The FSA ought to have paid close attention and discouraged Northern Rock and other UK non-bank banks from pursuing their risky business models . The FSA's vigilance is essential , because it is the guardian of the public scheme of deposit insurance. Last year, it said this scheme was working just fine. But when stress- tested in September 2007, in the extreme case of the Northern Rock bank run, the scheme failed: depositors neither understood nor trusted it at all. And w hy should they have done so ?
Trust in Financial System 's Regulation
The FSA, BoE and HM Treasury are all likely to come out poorly from the Northern Rock episode. At the outset, the BoE, talked tough and wanted to teach financiers a lesson that they should not expect the central bank to bail them out if they took on too much business risk. Unlike the European and American central banks, which injected copious liquidity repeatedly into the money markets, the BoE held back from pumping cash with a clear justification for its stated policy. When it did intervene, it did so rather modestly, insisting on high quality collateral. The BoE argued that central-bank money could do little to save the three-month LIBOR money market, which had reached a fever of a 100+ basis points differential with the base rate.
In the end, t he BoE's tough line turned out to be unworkable, and events forced the BoE to change its declared policy. On September 19th, the day after the run on Northern Rock ended, the BoE performed a U-turn. It announced that over the next few weeks it would be providing extra liquidity to try to sort out the three-month LIBOR market's high differential. Furthermore, it said that it would lend against riskier collateral, including mortgages, which is precisely what other reputable c entral banks have been doing since the credit crunch emerged in early August.
The charge against the BoE appears to be that its pretence turned the credit crisis into a farce. If the BoE had acted more promptly to provide a redressal for the high LIBOR rate, Northern Rock might have survived. Who knows and what good is speculation at this stage ? The 180 degrees turn in the BoE's policy looks either as if the Old Lady of Threadneedle Street made a mistake, or as if the Lady cannot stand up for her strongly held principles and values . Neither characteristic is endearing in central banking.
As the Governor of the BoE, Mr King pointed out, defending his performance in front of a House of Commons committee on Thursday, 20th September, English law prevents the BoE either from staging a covert rescue operation or from engineering a swift takeover; and clear flaws in the protection of depositors mean that, once an overt rescue operation is under way, depositors are likely to flee -- as became the case with Northern Rock. The Governon defended the separation of powers between the Treasury, the BoE and the FSA, but this may not be a solid line of defence . The split power has exacerbated the system's flaws: nobody was in charge of the operation when there was a desperate need for one leader to run the show . Northern Rock fell in the wide cracks that appeared.
This debacle not only holds key lessons for the system which regulates UK financial institutions but also for the way in which the Euro-zone national financial institutions are regulated: with the European Central Bank (ECB) at one end of the spectrum and old national central banks and finance ministries at the other end . What of the chasm of poor de facto regulation in no-man's land which has opened up, post the ECB's creation and the Euro's inception in 1999? When has the Euro-zone financial institutions' regulatory environment been stress tested by the markets in the last decade? How sound is it under extreme pressure? Is the Euro-zone regulatory system 's stress testing going to begin soon as the global credit crunch continues? What are the recent sub-prime linked banking insolvencies in Germany and elsewhere in the Euro-zone suggesting ? Watch the Euro-zone carefully for unfolding answers to these key questions over the coming weeks and months.