Transcript Wynne comments - Cass Business School

LESSONS FROM THE
NORTHERN ROCK EPISODE
David G Mayes and Geoffrey Wood
Auckland University
Cass Business
School
University of Buckingham
MOTIVATION
• First bank run in UK since 1866 Overend Gurney
• How could it happen?
– Strategy and risk well-known
– Northern Rock thought solvent
– UK had Lender of Last Resort/Emergency Liquidity
Arrangements (home of Bagehot)
– UK had extensive deposit insurance
– Experienced central bank, unified supervisor, tripartite
arrangements
• Was theory or practice at fault?
• Crises usually caused by something new
– In this case drying up of wholesale markets with US sub-prime
problems
ISSUES
• Problems with LOLR/ELA
• Why did deposit insurance not stop a run
– Diamond-Dybvig
• Why was there not more action earlier?
• Keeping a failed institution open
– Temporary nationalisation a solution not a problem
• Problems of co-ordination
• ‘Certainty’
CERTAINTY
• People will rush for safety if they do not know
what may happen.
• Future is uncertain – cannot prescribe specific
solutions
• 4 general sources of certainty
– Unlimited ELA against acceptable collateral
– No taxpayer bailouts – closure or takeover by the
authorities to keep critical functions
operating/minimise the loss
– Insured depositors have no material break in access
to funds
– Regulatory authority forced to act early accelerating
scale of severity
CERTAINTY
4 general sources of certainty
– Unlimited ELA against acceptable collateral
– No taxpayer bailouts – closure or takeover by the
authorities to keep critical functions
operating/minimise the loss
– Insured depositors have no material break in access
to funds
– Regulatory authority forced to act early accelerating
scale of severity
• None of these applied: ELA late cautious, viewed as
penalty; government stepped in; major break in access
to deposits and share of loss, lack of action (no PCA)
EMERGENCY LIQUIDITY
ASSISTANCE
• ELA has worked in the sense that there has been
adequate collateral for the Bank of England to provide
all the necessary liquidity to meet the withdrawal of
retail deposits
• The government should not lose money from
nationalisation unless there is a problem with
compensating shareholders – not a problem with ELA
• However it did not prevent the run
• Two main drawbacks highlighted
– Transparency – could not put problem right quietly
– Stigma – use of ELA interpreted as disaster not
salvation
TRANSPARENCY
• Ideally problem and solution are revealed
simultaneously.
• Is it possible to hold the discussions in secret?
• Is it permissible? Duty to inform shareholders?
• Are other switches in funding disclosed?
• Is effect on share price different from takeovers?
– Price of NR fell by 50% between Feb07 and Sept; fell
by further third after news broke
TRANSPARENCY
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Ideally problem and solution are revealed simultaneously.
Is it possible to hold the discussions in secret?
Is it permissible? Duty to inform shareholders?
Are other switches in funding disclosed?
Is effect on share price different from takeovers?
– Price of NR fell by 50% between Feb07 and Sept; fell by further third after
news broke
• Creditors normally protect themselves if a company looks in
trouble – banks different because funds are an essential input –
cannot reschedule – safety net especially deposit insurance should
reassure
• Opacity only justifiable if it is in interests of creditors and
depositors and all know there will be disclosure afterwards
• Key is ability to close bank early before there are losses to
creditors if recapitalisation fails
STIGMA
• A dilemma
– Should access to ELA be sufficiently frequent that it is not
regarded as a signal of disaster?
– If ELA is common then it may increase risk taking – moral
hazard
• Needs to be at an above market rate to enable the
market to work first – should this be described as a
‘penalty rate’ – risk premia are common
• No progressive structure – either using ELA or not
• Difficult to match by general lending to the market
• Is the problem unusual due to banks offloading the risk from
normal borrower-lender relationship? Safety net not so well
designed for market risk as idiosyncratic risk?
DEPOSIT INSURANCE
• Issues
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Does coinsurance help improve incentives?
Must all deposits be insured?
How long can access to funds be interrupted?
Does prefunding matter?
DEPOSIT INSURANCE
• Issues
– Does coinsurance help improve incentives?
• UK unusual in having coinsurance after first £2000 10% of
next £33000 others zero or 100% to limit
• NZ experience suggests people do not check
• NR shows exposure leads to a run
• Theory OK but does not work if there is threat of loss
• NR has killed coinsurance
– Must all deposits be insured?
– How long can access to funds be interrupted?
– Does prefunding matter?
DEPOSIT INSURANCE
• Issues
– Does coinsurance help improve incentives?
– Must all deposits be insured?
• Current UK limit gives 100% coverage to over 90% of
depositors. Are remainder well informed? Do they exit early
before run? US experience suggests no. Can they afford the
loss (not widows and orphans)
• Raise to US levels? Already high by European standards –
regime competition within single market?
• NR shows that having no insurance is likely to result in a
blanket guarantee – also Nordic crises
– How long can access to funds be interrupted?
– Does prefunding matter?
DEPOSIT INSURANCE
• Issues
– Does coinsurance help improve incentives?
– Must all deposits be insured?
– How long can access to funds be interrupted?
• If there is any material break people will have problems – but Irish
Bank strike example
• Keep core functions operating – NZ approach
• US tries to get full access within a week – EU 3 months permitted
renewable twice
• In NR people shifted banks rather than into cash – access is crucial
• Implementation difficult – need considerable prior knowledge of banks’
computer systems. Bank systems must identify insured deposits on an
ongoing basis (problem of aggregation) Must avoid netting.
– Does prefunding matter?
DEPOSIT INSURANCE
• Issues
– Does coinsurance help improve incentives?
– Must all deposits be insured?
– How long can access to funds be interrupted?
• Implementation difficult – need considerable prior
knowledge of banks’ computer systems. Bank systems must
identify insured deposits on an ongoing basis (problem of
aggregation) Must avoid netting.
• Can transfer all deposits to another bank, can take over
bank and keep deposits in ‘good’ bank, bridge bank in US
– Does prefunding matter?
DEPOSIT INSURANCE
• Issues
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Does coinsurance help improve incentives?
Must all deposits be insured?
How long can access to funds be interrupted?
Does prefunding matter?
• Without prefunding cannot payout in a hurry or offer other
quick solutions
• Funding increases credibility of the fund
• If problems occur in a downturn rest of banking system not
in good shape to provide funds in a hurry.
• Cost of prefunding small particularly if pay interest after
cost recovery
GETTING EARLIER ACTION
• Prompt Corrective Action
– In US a required series of increasingly harsh
interventions within a timetable as capital falls ending
in closure before capital is exhausted.
– However NR shows that intervention must occur
before capital falls – risk taking and liquidity
problems. Need Pillar 2 and Pillar 3 to require action
– NR share price falling; FSA clear that reliance on
wholesale market a risk.
– How is this turned into clear rules? PCA limits
discretion
– NR shows that authorities hold off in the hope of
achieving a less difficult solution
GETTING EARLIER ACTION
• Prompt Corrective Action
– Prompt action requires intervention by the private
sector well before regulatory limits are breached
– Midland and National Westminster are UK examples
– Can only be encouraged not compelled – main
encouragement is that failure to act will be
unattractive
– Action on risk needs to be based on quantitative
assessment – NR shows standard approaches can be
underestimates
GETTING EARLIER ACTION
• Prompt Corrective Action
– The authorities must have the power to step into a
troubled institution should it get too close to failure
– They have to be capable of forming a rapid
judgement about the extent of the losses and the
sensible action
– They have to be capable of acting fast enough to be
able to assign the losses and keep the bank operating
without a material break
– Furthermore if the bank does close the authorities
have to be able to act fast enough to ensure that
insured depositors have access to their funds without
any significant break.
All these must be believed to apply in advance
KEEPING CORE FUNCTIONS
OPERATING
• In general banks that cannot perform to the rules should be
closed and closed early before there are losses
• However, some banks are too important to be allowed to close
because of the disruption it will cause to financial markets and the
wider economy
– Not simply too big to fail but too important in certain functions – market
maker for example
– NR shows this applies to smaller institutions than previously thought
• US have good way of achieving this through ending legal
personality and reopening in whole or essential parts as a bridge
bank under temporary government control without a break –
time limit laid down
• UK does not have legal power but recommended by
BoE/FSA/HMT paper – avoids costly litigation and taxpayer
being exposed to full extent of losses
COORDINATION FAILURE
• Government by committee
• Cross-border arrangements
COORDINATION FAILURE
• Government by committee
– 3 players in the UK – BoE, FSA, HMT
– In US FDIC has clear lead role – UK deposit insurer FSCS has
none – others only involved if Systemic Risk Exemption
invoked – never used
– NR showed some problems with each being reluctant to act
– Treasury Committee recommends Office of Deputy Governor
in BoE to lead
• Cross-border arrangements
– Much worse when more countries involved
– Who should lead? ECB? Has possibility under the Treaty.
European Deposit Insurance Corporation only for banks with
systemic implications - 30-50
– How shall different interests be balanced?
– Whose jurisdiction applies
COORDINATION FAILURE
• Government by committee
• Cross-border arrangements
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Much worse when more countries involved
Who should lead?
How shall different interests be balanced?
Whose jurisdiction applies?
Need agreement about how joint arrangements shall run in
normal times to avoid recrimination if things go wrong
Lead of consolidating supervisor of college of supervisors, with
single database, able to exercise similar powers (single rule
book)
Agreed PCA – respecting all countries’ financial stability
Closure at positive capital before any losses to argue over
Currently do not have power to take account of other
countries’ interests
LESSONS
1. deposit insurance needs to be designed so that
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the large majority of all individuals’ balances are fully
covered
depositors can all have access to their deposits without a
material break
2. the activation of emergency liquidity assistance
arrangements needs to give confidence that those being
assisted will survive, and should be seen as the system
working as it should, rather than signalling some
breakdown
3. there needs to be a regime of prompt corrective action
for supervisors whereby prescribed actions of
increasing severity are required within short time
periods according to a set of triggers based on capital
adequacy and risks of failure
LESSONS (2)
4. there needs to be a legal framework such that the
functions of systemic importance in banks that fail can
be kept operating without a material break
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such ‘failure’ should occur before the bank becomes
insolvent so that there is little chance of losses to the taxpayer
this will normally involve a special insolvency regimes for
banks
5. some designated institution needs to be in charge of
intervention in failing banks to ensure rapid and
concerted action
6. At a European level far greater coherence among the
legislation and authorities of member states is required
if these provisions for the handling of problems in
domestic banks are to be equally successfully handled
in the case of large cross-border banks
REMARKS
• If 1 to 5 had been in place there would have been
no run on Northern Rock
• But if NR had been a more complex cross-border
bank the problems could have been much worse
• This unfortunate and unnecessary incident will
help authorities not just in the UK but round the
world avoid much greater threats to financial
stability
• If distinguished and well thought out authorities
have a problem so will others
• No safety net can be completely successful