Monday 17 September 2007

Northern Rock: Moral and Capital Inadequacy

iews on how to handle the Northern Rock fiasco seem to fall into the following categories:

Moral Hazard (Mervyn King on Wednesday): if the company runs with a stupid business plan, and/or behaves recklessly, the public purse should not be used to indemnify them.

Moral Relativism (Mervyn King on Thursday): “Sources close to the Bank of England said it would only lend to a bank it considered to be solvent and suffering a short-term problem rather than heading for full-scale bankruptcy”.

Moral ?-don’t-make-me-laugh (Gordon Brown): public money to cover up one of my fuck-ups is money well spent

Moral ?- how do you spell that? (City bonus-jockeys): we have run with a stupid business plan and/or behaved recklessly (again), so hand over the public purse (again)

Clearly the last two have nothing serious to contribute: they are morally bankrupt and i utterly diskard them. What of the others ?

The Moral Hazard standpoint is initially very attractive, and widely presumed to be what Mervyn King really thinks, prior to having his arm twisted sharply by Downing Street. This is Darwinian capitalism . To flout it is to do worse than just remit to the bonus-jockeys the winnings of their one-way bet, their premium-free insurance pay-out: it is to give a lease of life to large-scale economic inefficiency, which will cost us all a great deal more in the long run.

However, banks are banks: and we are in widows’n’orphans territory here. The reasons for hedging financial institutions around with complex rules, policed (*huh !*) by the FSA, is that it is socially unacceptable for innocent depositors to lose their all, when they are in no position to form a view on the creditworthiness of a bank or its bloody business plan. Caveat emptor cannot be applied to domestic depositors.

But banking is an enormous social good, the bedrock of capitalism and the free society. This being the case, a two-tier protective system is erected around those companies wishing to enjoy the privileges of being a financial institution. The second of these – the safety-net, which is not really meant to be used, is the Lender of Last Resort. It is this which is in the spotlight at present. Nobody (except, erm, us) seems to be commenting on the first and primary line of defence, which is Capital Adequacy. Banks must make complex calculations, daily, to quantify the risks they are running, and put aside cash (or other wholly liquid, risk-free assets) to cover the downside. The FSA must ensure they are doing this correctly. Since maintaining Capital Adequacy is a cost on the bank, it ‘penalises’ bank shareholders who allow risky strategies to be pursued, as is right and proper.

Now Northern Rock’s business model is relatively simple, if relatively unusual, and not a difficult one to assess for its inherent risks. I will not bore readers with the details. The fact that it was indeed a relatively unusual business model for a bank should have had the FSA all over them.

But the first line of defence seems to have failed. Why ? There are only three possible reasons:

Northern Rock was not following the rules for Capital Adequacy

AND the FSA / BoE were not supervising them sufficiently

OR - the evolution of market risk was such that no-one could reasonably have made the appropriate Capital Adequacy calculation

I would strenuously dispute the third (but not here & now, you will be pleased to learn).

SO – who takes the rap at Northern Rock AND the FSA, for failing to ensure Capital Adequacy ? There can be criminal penalties for flouting FSA regulations. We need to see some very public examples made here.

Finally, and back to the beginning, should NR be bailed out ? On one thing I am sure: ordinary depositors must be given well-founded confidence in the banking system. If the safety-net must be used in this case, so be it - whether or not the bank is solvent (pace the Thursday Mervyn King). But let the authorities re-visit the first line of defence and the integrity of its foundations (and policing), to ensure the second line is not required again.



Anonymous said...

I'm not sure I agree with you here. At first sight NRs business model seems sound enough. It really ought to be able to sell on its debt on the open market and is not able to do so through no fault of its own. The default rate here in the UK is pretty low at the moment and it is holding the deeds to 20% of the houses of Britain so really it should look like it is solid as a (northern) rock.

I wouldn't see what is happening as a bail out. The BoE is charging NR interest and is securing its loans using NRs assetts (in effect the deeds of peoples houses). NR will probably go under since it will be unable to buy back its collateral now that £2bn has left its accounts with perhaps another £10bn to follow this week. I can't see anyone wanting to buy NR right now, as its repuation is trashed and that is all a bank has to sell. So everyone at NR will lose their jobs. Personally I feel they don't really deserve that. They are the victims of the poorly regulated market in the US and the UK banks that were only too happy to play in those markets. Is NR guilty, or is it Barclays and HSBC who are just to big to feel the pain they have caused?

Mark Wadsworth said...

I see no problem with bailing out depositors, whether 100% or a slightly smaller figure is neither here nor there, 98%, say? That's only wiping out interest earned in last 6 months.The alternative is too gruesome to contemplate.

That money will just end up at another bank (presumably HSBC which seems the 'safest' right now).

NR management and shareholders can lose everything AFAIAC and the FSA should get a good kicking.

Bond holder are a different topic, I'd just deal with them under normal insolvency rules, they get what's left.

Anonymous said...

I have all the money I have in the world in my wallet right now...

Nick Drew said...

Mark - funnily enough, with such a low depositor-to-mortgage ratio, depositors are probably OK in an actual bankruptcy: the mortgage book is worth a lot more than nothing. As you say, the equity can fend for itself, it's more a question of the bondholders.

Which brings us to the Rating Agencies ...

Nick Drew said...

Mutt - Cash is King, eh?

Mutley the Dog, king for a day.

Nick Drew said...

Anon - like you, I think the NR business model could have been conducted soundly.

The key factor should have been a correct assessment of its risk (and costing thereof). If it sold tracker-mortgages, indexed to LIBOR, in principle it could have been fully hedged, subject only to default-risk (rather low for a while now, as you say). Again, if it sold fixed-rate mortgages it could have hedged them perfectly also.

Trouble comes with non-LIBOR, indexed mortgages, when the basis-risk becomes acute at times like these. But this can be assessed and costed - and was the obvious risk all along. So in my view it's down to the FSA: they should have been clambering all over NR when it became clear (months and months ago) just what an 'extreme' business model they were following.

Anonymous said...

Hmmm, I didn't know the fine details of the NR model so I wasn't aware that they were running a particularly extreme business model. I also note that NR has been offering high rates on longer term deposits - but they are not the only ones. A look over at Moneynet will give a long list of those offering 6.5% on 1 year deposits - Bradford and Bingley, Alliance and Leicester. Anglo-Irish is offering almost 7%. So I'm not convinced that NR are being caned for doing something that these other banks were not - it looks like many are short of cash. If you borrow short and lend long then this can be a problem if the market for debt dries up. It wasn't always like this. When I were a lad you had to deposit your salary with a Building Society for several years before they would give you a mortgage - thus they sourced a lot of their finance via the front door.

tory boys never grow up said...

I am afraid what we seeing now is herd mentality - it is now in the general public but it started first in the financial community.

The risks or otherwise of Northern Rock's lending have been known about for a very long time - and if the market had been efficient it would have stopped dangerous lending (if that was what it was) a long time ago. But the herd mentality has now changed - and as in any previous crisis which institutions are the most vulnerable to the whims of the market. Surprise surprise none other than those who are most reliant on the markets for their funding - step forward the Northern Rock.

All the bright boys and girls in the City (and other financial markets) failed to properly assess the risks attached to sub prime mortgage lending and/or the Northern Rock before it was too late. I wonder how many of those concerned will now be asked to pay back their bonuses for failing to do their jobs properly - especially those who earned their money on securitisation vehicles (funny that they seem to have gone very quiet for the moment - perhaps they are packaging up distressed debt for their next bonus!)

Things may well have been happening in the real economy but they didn't happen this quickly and if the markets had been efficient they would have been dealt with this quickly. This is the best argument I have seen for more market regulation in a long time. We perhaps ought to rememember who was originally responsible for market deregulation - do the Tories still want some more? Time for Gordon to remember that social democrats believe that markets need managing - not that recent house guests would have been much help.

There need to be some very hard questions about the new Basel capital adequacy regime which will to allow banks to set capital requirements based upon their own internal risk models and/or credit ratings (might be worth looking at the back testing results for those models in the light of the current crisis or the last one with Russian debt etc. before we put the lunatics in charge of their won asylum)

Anyway - what will happen now - some bank will buy up the Northern Rock on the cheap, with some interim funding from the Bank, and some bright boys will then get nice big bonuses from the subsequent profits. My guess is that the only people who will suffer in the end will be the poor employees of Northern Rock.

tory boys never grow up said...

A further point re capital adequacy - as far as I am aware neither the new/old Basel regime place any extra capital requiremeents on banks which draw a higher proportion of funding from interbank markets. Perhaps they should given Northern Rock and what happened to Continental Illinois (which was not an entirely dissimilar situation for those old enough to remember)

Anonymous said...

Talk of capital adequacy is good in theory (and I agree that others should be pointing it out), but Basel 2 and the FSAs rules don't properly take into account the liquidity risk. (I sense that the BOE is a bit miffed with the FSA for that). You can have all the valuable assets you like, but if no-one will lend you against them, or buy them for fair value, it's not much use.

So the answer to your question is probably poor regulation but not due to poor supervision, but rather poor rules...

Sackerson said...

Other than banks (e.g. Barclays 1690, Lloyds 1765), brewers (e.g. Stella Artois 1366) and the oldest profession (shortly after 4004 BC), are there any other businesses that never make a loss?

Anonymous said...

The Nurdgaia seems to suggest that LloydsTSB had an agreed takeover lined up early last week and that the FSA torpedoed it. So do we have an arm of government to thank for this run? If so, it's rather like our government-supplied Foot and Mouth outbreak.

Anonymous said...

@Tory boys never grow up:

Oh right, so Labour have been in power 10 years and saw at first hand the previous house price boom and bust. So no excuses for Gordon "No more boom and bust" Brown to hide behind. It isn't regulation of mortgage companies that is required. It is de-regulation of planning rules to allow more building for all our citizens at affordable rates. When people like you wake up to the truth that NuLabour is just a conspiracy by the very rich to stitch-up working people we will be able to move on. Perhaps I should give myself the handle "Labour supporters never learn".

Mark Wadsworth said...

Toryboys All the bright boys and girls in the City (and other financial markets) failed to properly assess the risks attached to sub prime mortgage lending

I thought they knew perfectly well and fobbed off the risk to hedge fund managers who fobbed off the risk to stupid rich people after pocketing their 2%?

Mark Wadsworth said...

Toryboys Anyway - what will happen now - some bank will buy up the Northern Rock on the cheap

Well, as NR market cap has fallen from £8bn to £2bn and probably about £500m by the end of the week, they're going to have to give it away.

Nick Drew said...

Anon @ 11:42 - the 'extreme' was in inverted commas: the model is relatively unusual but still potentially sound, as I think we both agree. Needs to be executed properly, of course.

dearime - seems to suggest that LloydsTSB had an agreed takeover lined up ... - interesting, perhaps more will leak out on this in due course. I can't see who'd want to spare NuLab's blushes.

Nick Drew said...

Anon @ 3:37 - no excuses for Gordon - exactly right, and the perfect riposte to Toryboys.

On CapAd for liquidity risk (market liquidity, that is), I would argue to both Toryboys and Anon @ 1.29 that the FSA rules do indeed cater for this if interpreted with real risk management intentions in mind. There was always a multiplier for adverse market conditions, liquidity most particularly included: and the principle behind the old Large Exposures Requirement is not dissimilar in its purpose.

Of course, if the Risk Committee (prop: D Wanless according to Guido - is looking for excuses to 'take a view' on this, they will find some. But as I said, surely when NR was taking an unusual position (and this was well known) it was for the FSA to get in there, pre-emptively, with its Size 10 boots and some appropriately conservative rulings on interpretation.

Nick Drew said...

Mark - I thought they knew perfectly well ... - in my experience the risk managers always know what the score is: it is their lack of independence and authority within the company that is the problem: nothing is allowed to get in the way of those bonuses.

And this, I continue to maintain, is primarily an issue of enforcement, not shortcomings in the rules (even though there may indeed be some issues on that score, too).

Nick Drew said...

Sackers - ... any other businesses that never make a loss?

Arms manufacturers ? (Mrs D suggests chocolate makers ...)

Wolfie said...

Being a risk analyst myself I'll tell you this, when the analysis looks unfavourable I'm told "the figures are wrong".

But they never have been.

There is a very poor attitude towards regulation throughout the sector and that needs to be addressed. It may however be too late for that now. CU your faith in the system seems a little jaded today, and its the culture of big bonus which has encouraged this.

Nick Drew said...

Wolfie - I think we are saying something similar about risk analysis: you guys are quite up to the task of asessing what's what, and what could go wrong. (Do you agree with me that in NR's case it's basis risk as much as market liquidity?)

Jaded with the system ? Actually, as I've tried to say, I think the design of the system is good - it's the lack of rigorous enforcement that bothers me.

CityUnslicker said...

Nice set of posts to come too home too.

Saw Darling with his gaurantee speech today; the right thing to do to stop a wider panic.

If Alliance and Leicester and B&B get into difficulties then we are in shit street so to speak.

Hvaing said that, the Government is in a right pickle. The BoE has tried to do the right thing, but with the wolrd set against it is has now ended up looking foolish!

The BoE needs a wider remit from the Government if it is to be truly independent. In addition the FSA has a lot to answer for as well; which does not surprise me as it is full of banking insiders.

Everyone will be fine in NR except the shareholders. The business will have a new brand on the shops etc in a few weeks time.

However, the wider confidence issue is the main problem; that could cause a recession in short order.

tory boys never grow up said...

Nick what you appear to be arguing for is a return to old Bank/Building Societies Commission approach to capital adequacy ehen the regulator could change capital ratios on an institution by institution basis to refelct individual risk factors and their perception of management. As a social democrat who believes that markets need smart regulation in order to operate efficiently I have absolutely no problem with that providing that we have enough regulators who are up to understanding the risks and who can get off their bottoms to see the institutions in action rather than stage managed reviews they undertake at present. And if I'm telling Gordon Brown to start/restart behaving as a social democrat so be it.

In practical terms it doesn't make much sense to make more than small
changes in capital adequacy ratios to handle short term market fluctuations - they can be a very blunt instrument - better to use specific instructions and/or liquidity.

However you need to realise that the financial institutions have been pushing for a capital adequacy regime which avoids allowing the UK regulator the discretion to allocate extra capital requirements (for risks which are not necessarily reflected in market prices) - largely on the argument that other countries do not do this to their banks and we cannot place UK at a commercial disadvantage (the same lowest common denominator approach which is used when arguing for reducing tax or any other regulatory burden). You should also not that has been a major part of Basel II - why do you need such complicated and detailed regulations and to allow the banks to use their own risk models, if the regulator is going to impose an additional requirement to reflect their judgement as to the true level of risk.

I don't know whether the FSA has done everything properly according to the current rules - there are always lots of rumours in any crisis (though I am not sure how often information has leaked to the BBC in past and/or whether the BBC would have used such information in the manner which it has), but you shouldn't be blinded to the market failures which have occurred here. Risks were taken on for many years which were known to be greater than was indicated by their pricing (and as other comments here have shown were hidden so as to earn bonuses etc.) - didn't Adam Smith say something about effcient markets depending on knowledge being freely available.

Anon 3:37am

"It isn't regulation of mortgage companies that is required. It is de-regulation of planning rules to allow more building for all our citizens at affordable rates."

Totally agree about the need to improve housing supply - but I
doubt deregulation of planning rules is the answer - unless you want more houses on flood plains and want the building firms to manipulate the market with their land banks.

Nick Drew said...

Hey, CU, how's the new job looking? (They let you home to sleep at night on your first day!)

Toryboys, yep, I'm with Adam Smith on this one (!)

Wolfie said...

ND :

Do you agree with me that in NR's case it's basis risk as much as market liquidity?

Yes I do.

TB :

Basel II has contributed to this problem not alleviated it. IMHO

CU :

If Alliance and Leicester and B&B get into difficulties…

Some of the press seem to be "talking up" this possibility and I suspect a rat.

However I do agree with you on the Darling strategy.

Anonymous said...

How can the public be expected to believe the government's pledge that investor's money will be safe?

Nick Drew said...

Ellee ! - you cynic !

Anonymous said...

"Totally agree about the need to improve housing supply - but I
doubt deregulation of planning rules is the answer - unless you want more houses on flood plains and want the building firms to manipulate the market with their land banks."

Well we have been here before and I think the conclusion was that [1] only a small amount of land would be taken up by extra housing and [2] with farming contributing only 1% to GDP there was really no excuse for not allowing building on existing farmland. Therefore there really is no excuse for not getting on with allowing building wherever - the emphasis should be the other way around. The anti-s should have to come up with a good reason for NOT allowing building in a particular area BEFORE any such building is proposed.

The issue of land banks is an interesting one. In my opinion this should never have been permitted in the first place as it is clearly anti-competitive, as you would discover if you tried to build your own home. Therefore I for one would not protest if the government brought an end to this dubious practice. The obvious way to end it is to say that companies must sell at market rates on request. In other words, if I decide I want to build my own home on a plot of land and Persimmon have an option on that land - they have to sell it to me without question at the market rate. With an effectively unlimited supply of building land available on demand the price of land would quickly fall and with competition from self-builders and small builders rapidly expanding the big boys would be forced to build to take their share of the market. We would have a glut of housing within 10 years, no young couples would be without a home ever again and no more asset bubbles. Of course if you want to live in a Georgian mansion you will still have to pay top dollar...

Anonymous said...

Henny Penny Henny Penny! The skies falling in!

Old BE said...

Would not the Land Value Tax prevent land hoarding? An annual fee for not making the most profitable use of land might put the wind up the hoarders!

Anonymous said...

Enter the Thunderer:-
"The Bank’s refusal to allow Lloyds TSB to structure a deal with Northern Rock is, with hindsight, more perplexing still. Mr King apparently argued that the central bank could not provide blank cheques to healthy banks, just because they were buying tottering instutions. But his refusal to fashion a deal that worked both for Lloyds and Northern Rock meant that the Bank was forced to act as lender of last resort. The crossed lines of communication between the Bank, the Treasury and the Financial Services Authority have prompted questions about the wisdom of the tripartite system of financial regulation introduced in 1997 by the former Chancellor, Gordon Brown. And the way that the Bank’s emergency action was announced - a late night leak to the media on Thursday - added unnecessarily to the sense that events were spiralling out of control."

Anonymous said...

"Would not the Land Value Tax prevent land hoarding? An annual fee for not making the most profitable use of land might put the wind up the hoarders!"

The problem is that the land is actually owned by farmers but big building companies like Persimmon buy options in the land so that if it ever gets planning permission they get first choice on buying it. I'mm not sure a land tax would frighten the likes of Persimmon if the land were still owned by the farmer.

Nick Drew said...

dearime - thanks for the update, this one could run and run

speaking of which

Mutt - no, it's just Loosey Goosey passing overhead ...

In times like these, wear a hat, and keep your hand on your ha'penny