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24 May 2014

Inside the Banking Crisis

Tag(s): People, Politics & Economics, Business
This week Bloomsbury published Hugh Pym's new book, Inside the Banking Crisis: The Untold Story. They say it’s the definitive insider's guide to the UK banking crisis, the drama and characters involved in the collapse of some of the major pillars of British banking and the commitment of £66 billion of taxpayers' money. ‘This as-yet-untold story, informed by conversations with highly placed policymakers, explains what really happened behind closed doors in Downing Street and the City.’ While several excellent books have been written about the banking crisis in the US, notably Too Big To Fail by Andrew Ross Sirkin[i], so far not many have covered the British end of the crisis. Iain Martin and Ray Perman have published books about RBS[ii] and HBOS[iii] respectively but noone has covered the crisis as a whole except, of course, those politicians such as Gordon Brown who wanted to put their version of events.[iv][v] [vi]

Hugh Pym is one of the few leading broadcasting correspondents to have covered the financial crisis since 2007 when the credit crunch struck and Northern Rock was crippled. He reported on developments in the summer of 2008 when the UK plunged into recession followed by the global meltdown triggered by the collapse of Lehmann Brothers. He covered the dramatic government banking bailouts and was part of the BBC news team which won a Royal Television Society Award for coverage of the banking crisis.  He has worked as a BBC correspondent since 2001 becoming Chief Economics Correspondent for BBC News in 2009, covering major economic and banking developments.

I was invited last month to a preview of the book at the Oxford and Cambridge Club where I received a complimentary copy of the book. Hugh describes the crisis as Britain’s biggest peacetime crisis. His main thesis is that though ill-prepared for the crisis Britain’s policy makers won the first battle to contain the crisis but have lost the ensuing peace.  The crisis emerged after excess liquidity had developed but with interest rates set too low investors sought desperately for higher and so riskier yields and hence the sub-prime crisis in the US with contagion in Europe as European banks purchased packages of irrecoverable debt.

In the UK a similar situation had developed with poor mortgage lending, some of which was sliced and diced into toxic parcels of debt much of which went bad. There was political consensus in favour of light touch regulation which even Vince Cable supported while voices in the media raised serious concerns. There were exceptions such as Gillian Tett at the Financial Times but even there such reporting was usually buried near the back of the newspaper.

The first signs of trouble were in April 2007 when New Century Financial, one of the largest sub-prime lenders in the US, filed for Chapter 11 bankruptcy protection. In May Federal Reserve Chairman Ben Bernanke said the effect of troubles in the sub-prime market would be limited with no significant spill over to the rest of the economy or to the financial system. But in July Wall St investment bank Bear Sterns said that its two troubled hedge funds were virtually worthless following the busting of the real estate bubble and two days later, just two months after his previous statement, Bernanke warned that the crisis could cost up to $100bn. Of course it would be much more than that in its impact on the total economy. In August French investment bank BNP Paribas froze three funds because of the knock on effects of the subprime troubles. This swift action meant that BNP Paribas emerged largely unscathed from the long-term crisis and today is the fourth largest bank in the world as measured by total assets. German banks IKB and WestLB were also affected and the European Central Bank pumped €95bn into the credit markets to improve liquidity.

Around this time it subsequently emerged that the Financial Services Authority (FSA) disclosed concerns about Northern Rock to the Treasury and the Bank of England but it was another month before Northern Rock issued a statement on market conditions and trading and depositors queued to withdraw their savings from branches around the country, the first bank run in the UK since the nineteenth century. The money markets had dried up as banks, concerned about each other’s credit worthiness, were reluctant to lend to each other. Northern Rock had long played a foolish game of borrowing short on the money markets and lending long to mortgage holders, sometimes as much as 125% of the value of the property. Such a policy should have been obvious to the regulator but no restraint was shown.

The banking crisis in the UK was quite different from that in the US though there was some fallout from the Lehman Brothers collapse. While investment banks like Bear Sterns and Lehman Brothers became insolvent through their excessive exposure to poor performing and complex derivatives, in the UK large retail banks simply got involved in poor banking practice with bad lending policies and strategies. While depositors in the US have 100% protection up to a certain level in the UK only 90% over £32,500 was protected. Alistair Darling and Mervyn King were at a meeting in Europe when the pictures of the Northern Rock queues were shown on television sets. Mervyn King told Darling “They’re behaving perfectly rationally, you know.” But if the depositors were behaving rationally the Northern Rock management weren’t as they had made no plans for such an event. Their website crashed and outside the North East their network was small thus exacerbating the situation at each branch. Staff had not been trained and so the queues became longer than necessary. It was a humiliation for the UK as these pictures were beamed all over the world, still a year before the Lehman Brothers shock.

The authorities were no better prepared. Attempts were made to seek a buyer for Northern Rock but none appeared. The Bank of England could not afford to take the liabilities onto its balance sheet so eventually the government realised the taxpayer would have to do it. All of this took time and in February 2008 Northern Rock moved into a period of ‘temporary public ownership.’ The bad news now came thick and fast. House prices in the UK fell by 10% in a year thus putting in negative equity all those who had borrowed 100% of the price. In August Bradford & Bingley posted losses of £26.7m for the first half of 2008 blaming surging mortgage arrears. The same day Alistair Darling warned that the economy was facing its worst crisis for 60 years. The pound and the FTSE both fell. In October the Bank of England provided covert liquidity to Halifax/Bank of Scotland (HBOS) and to Royal Bank of Scotland (RBS). Fred Goodwin, CEO of RBS, insisted that the problem was only one of liquidity not capital but the Government could see it was both. By now the BoE was monitoring liquidity at all the top banks but was particularly concerned with RBS. Alistair Darling was called out of a European finance ministers’ meeting in Luxembourg by his special adviser Geoffrey Spence, who had been monitoring the rapidly falling share price of RBS on a screen in a side room. Spence told him it was curtains for RBS and the bank’s chairman Sir Tom McKillop wanted to talk urgently. They called McKillop who gave him the chilling message: ‘Chancellor, my bank is going to run out of money by 5pm today, what are you going to do about it?’

The Government decided the taxpayer had to recapitalise the bank at a cost of £45bn. Noone knew if it would work. It did. Investors bought the idea. They could have decided it wasn’t enough and sold the pound or gilts. So in Hugh Pym’s view the battle was won, but the peace was lost. There was no precedent for this recapitalisation later repeated with Lloyds after it had taken over HBOS. The US tried a complicated programme of Troubled Asset Relief Program (TARP) after allowing Lehman Brothers to fail. But banks like RBS and Lloyds play a much more important part in the economy. In seeking to recover and rebuild its capital base RBS has slashed lending to SMEs by two thirds. This is the principal reason why the recovery from the recession has been so slow. The normal pattern of cyclical movements in the economy means that recessions rarely last more than a year or two. This has gone on for over five because a banking crisis makes it much harder to recover.

Hugh Pym in his book goes into great detail about how the protagonists played out their hand. He is hugely impressed with the fortitude of these men and women some of whom worked round the clock for days on end in analysis, debate and negotiation. He gives credit to a few politicians and several civil servants who kept their heads. He records the admiration of other leading figures in other economies who took a different path and saw how the British solution appeared to work in the short term. But he finally concludes that while this is the case this solution has made it more difficult for the rescued banks and the economy as a whole to recover.

I wanted to ask him more about the role of the regulator. But an elegantly dressed woman had sat next to me with her husband on her other side. At the beginning of his talk Hugh recognised Sir Hector Sants, the CEO of the FSA at the time of the failure of Northern Rock. Lady Sants asked me if she could look at the book and she looked up her husband’s entries in the index. I quote “The FSA later owned up to failings over the policing of Northern Rock before the crisis. In March 2008, it published details of an internal performance audit. The chief executive, Hector Sants, said at the time: ‘Our supervision of Northern Rock in the period leading up to the market instability of last summer was not carried out to a standard that is acceptable.’ ” To be fair to Sir Hector he had only taken over as CEO in July 2007, a month before Northern Rock discussed its problems with the FSA. Prior to that he had been in charge of the Wholesale and Institutional Markets. It seemed churlish to raise the question.

Copyright David C Pearson 2014 All rights reserved

[i] Too Big to Fail Andrew Ross Sorkin. London, New York: Penguin, 2009
[iv] Beyond the Crash: Overcoming the First Crisis of Globalization Gordon Brown London: Simon & Schuster, 2010
[v] Back From the Brink: 1000 Days at Number 11 Alistair Darling. London: Atlantic Books, 2011
[vi] The Storm: The World Economic Crisis and What it Means. Vince Cable. London: Atlantic Books, 2009

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