Tuesday, 29 January 2008

Treasury select committee report on Northern Rock

This is seriously worth a read. If you want to cut through a lot of the guff that has been talked about Northern Rock this is a really good way to do it. Downlaod the report here. It pulls together written and oral evidence from all the key players (the management, Bank of England, FSA, market participants) and does a good job of describing what happened, when and (to some extent) why. There are loads of interesting insights from a variety of sources, many of which are enlightening (to me anyway).

The FSA gets an absolute pounding, and is accused of systematic failures. The BoE gets off more lightly, though it is clear that the committee is sceptical of the Governor's initial stance of making the avoidance of moral hazard a top priority. There is also a very interesting bit where the Governor challenges the idea that he should have been quicker to provide liquidity, especially given the action of other central banks.

"One of the points most people fail to understand … is that the European Central Bank has not increased the amount of liquidity at all since the beginning of August. It has redirected some of the liquidity that it would have done at one-week term to three-month term, but the total amount of liquidity that it extends to the banking system is absolutely the same now as it was in June and July before the turmoil began in August. That is not readily understood by many people. The amount of liquidity that we are extending to the banking system is almost 30% higher. I do not put enormous weight on that. I think what we have is a system, which I prefer, in which the banks can choose their own reserves targets. If they say they would like to hold more reserves with the Bank of England we readily supply it on demand. That is why we are supplying 30% more now than we were. Equally, the Federal Reserve has not raised the total amount of liquidity very much. There is a certain myth in all this that goes around and we take our share of the responsibility for not explaining it properly, but it is not easy to get across these points."

Equally the appears to committee accept that a further injection of liquidity by the BoE was unlikely to have been able to save Northern Rock, nor would it have necessarily been good for the market:

"We cannot know whether an open market liquidity operation of the kind asked for by a number of banks in August would have prevented Northern Rock’s need for emergency support from the Bank of England in September. It is most unlikely that any such lending operation in September, following the stigmatisation of Barclays which we deal with later, could have been of a sufficient scale to ensure that Northern Rock could have received the liquidity it then required. Such an operation would also have raised severe ‘moral hazard’ concerns, signalling to the banking sector as a whole that public sector support would be made available in the event of any bank facing distress."

Finally and most importantly the report is clear that the primary responsibility for the crisis that hit Northern Rock lies with the company's management. That this needs restating says a great deal about how these issues are presented by both the financial sector and repeated by some business journos.

Why the board got it wrong is probably worthy of a report by itself. Although the business strategy was clearly risky, they could have covered themselves by, for instance, taking out more insurance which would have given them access to long-term loans (something actual sub-prime lenders like Countrywide did). As I have posted before, they also believed that credits markets freezing simultaneously was 'unforseeable', but that's perhaps why they ought to have planned for such a Black Swan. At the end of the day it was their responsibility.

Here's what the report says:

"The high-risk, reckless business strategy of Northern Rock, with its reliance on short- and medium-term wholesale funding and an absence of sufficient insurance and a failure to arrange standby facility or cover that risk, meant that it was unable to cope with the liquidity pressures placed upon it by the freezing of international capital markets in August 2007. Given that the formulation of that strategy was a fundamental role of the Board of Northern Rock, overseen by some directors who had been there since its demutualisation, the failure of that strategy must also be attributed to the Board."

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