Shattered on the Rock? British financial stability from 1866 to 2007

Original Article Shattered on the Rock? British financial stability from 1866 to 2007 Received (in revised form): 24th November 2008 Alistair Milne is Reader in Banking and Finance at the Cass Business School, City University London (UK) and holds a PhD in Economics from London School of Economics (UK). His previous posts include Economic Adviser to the Bank of England, a lecturer in the Department of Economics at University of Surrey, Research Fellow at London Business School, Senior Economist at HM Treasury and a statistical adviser to the government of Malawi. Geoffrey Wood is a Professor in Banking at the Cass Business School, City University London (UK) and a visiting Professorial Fellow in the Centre for Commercial Law Studies at Queen Mary and Westfield College, University of London, and has been a visiting professor at the University of Athens. In the academic year 2004–2005, he was Visiting Professor at the University of Oxford. He was a lecturer at the University of Warwick and then Visiting Scholar at the Bank of England, the Federal Reserve Bank of St Louis from 1977 to 1978, the New Zealand Treasury and the Federal Reserve Bank of New York, and served as Research Adviser at the Bank of Finland. He is on the editorial boards of the Greek Economic Review, The Journal of Financial Education and the European Journal of Political Economy, and is a general editor of the Journal of Financial Regulation. Correspondence: Alistair Milne, 106 Bunhill Row, London EC1Y 2TZ, UK ABSTRACT This paper provides an answer to the basic question of why in the United Kingdom the traditional techniques for the maintenance of banking stability appeared to fail in the Northern Rock episode. It also considers how the techniques may need to be changed or supplemented to prevent such problems in the future. We propose the following actions to make the banking system robust. First, there should be arrangements for prompt and orderly closure of a bank as it approaches problems, before it would otherwise be forced to close by either insolvency or illiquidity. Second, there should be reform of deposit insurance, such that whatever sum is guaranteed is completely guaranteed, and can be accessed without any significant delay. Third, arrangements need to be made such that customers retain access to all core banking services either through speedy transfer of all accounts or the continued operation in some guise of the troubled bank. Journal of Banking Regulation (2009) 10, 89–127. doi:10.1057/jbr.2008.28 Keywords: banking stability; crises INTRODUCTION In the autumn of 2007, Britain experienced its first bank run of any significance since the reign of Queen Victoria.1 The run was on a bank called Northern Rock. This was an extraordinary event, and the lapse of time since its immediate predecessor is the least extraordinary aspect of it, for Britain had been free of such episodes not by accident, but because by early in the third quarter of the nineteenth century the Bank of England had developed techniques to prevent them. These techniques had been used, in Britain and elsewhere, had worked, and appeared to be trusted. A second extraordinary aspect of the affair was that it was the decision to provide support for the troubled institution that triggered the run. That run was halted only when the Chancellor of the Exchequer (Alistair Darling2) announced that he would commit taxpayers’ funds to & 2009 Palgrave Macmillan 1745-6452 Journal of Banking Regulation www.palgrave-journals.com/jbr/ Vol. 10, 2, 89–127 Milne and Wood guarantee every deposit at Northern Rock. And third, unlike most runs in banking history, it was a run only on that institution; funds withdrawn from it went only to a trivial extent to cash, and were largely redeposited in other banks or in building societies. The main aim of this paper is to address the basic question of why the traditional techniques for the maintenance of banking stability failed – if they did fail – on this occasion. We then consider how these techniques may need to be changed or supplemented to prevent such problems in the future. The paper starts with a narrative of the events leading up to and immediately following the bank run. We then turn, insofar as these can be separated from that narrative, to banking policy before the event and to the policy responses after it.3 In the course of discussing these, we suggest both why the decision to provide support triggered the run, and, more tentatively, why the run was confined to one institution. This prepares the way for our consideration of why the traditional response appeared to fail, and of what should be done to help prevent the recurrence of such episodes. WHAT HAPPENED? DESCRIPTION AND CHRONOLOGY Background Northern Rock was founded as a ‘building society’. These societies were mutuals, owned by their depositors and their borrowers. Their deposits came primarily from retail customers, and their major (essentially sole) lending activity was to individuals to buy their residences. In the 1990s, these organisations were allowed to demutualise, and ‘convert’ (in the term of the time) to banks. Incentives to convert were strong. Management gained much greater freedom on both sides of the balance sheet, and the owners acquired shares in their institutions. These shares paid 90 r 2009 Palgrave Macmillan 1745-6452 dividends and could be traded on the stock exchange, both features being attractive to most society members. Most of the large societies converted. Northern Rock was among them. It demutualised on 1 October 1997. The development of Northern Rock to end 2006 All the demutualised societies grew, and many were taken over by or merged with previously existing banks. Northern Rock remained independent. Aside from this, two features of its post-demutualisation behaviour were distinctive. First, it grew very rapidly. At the end of 1997, its assets (on a consolidated basis) stood at £15.8 billion. By the end of 2006, its assets had reached £101.0 billion. According to Adam Applegarth, its then chief executive, Northern Rock had been growing its assets ‘by 20 per cent plus or minus 5 per cent for the last 17 years’. Despite this rapid growth, it never departed from its traditional focus on residential mortgage assets, which by end 2006 were £86.8 billion, that is, about 86 per cent of total assets. Even so, at the end of the second quarter of 2007, these mortgage loans were only 8 per cent (by value) of the stock of mortgage debt in the United Kingdom, and therefore only about 5 per cent of total bank lending, and Northern Rock deposits were only about 2 per cent of sterling bank deposits. It was most certainly not an enormous institution. The second feature relates to its activity. Although on the asset side of the balance sheet it remained close to the traditional building society model, in that it stayed concentrated on lending on mortgage to individuals wishing to buy their own home, ther (...truncated)