Britain: Rocking capitalism

The Northern Rock banking crisis

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Rocking capitalism

Early in September, the impending insolvency of Northern Rock provoked a classic bank run, with thousands of depositors queuing to withdraw their money. The scenes recalled events in Argentina in 2001, or the last bank run in Britain which occurred in 1886. The problems of this relatively minor bank threatened to detonate a major financial crisis, as well as a political crisis for the Brown government. Moreover, the event highlights the current fragility of globalised financial markets.

The Northern Rock directors informed the authorities in mid-August that they were facing serious problems. Unable to find a big bank willing to buy them out, Northern Rock went to the Bank of England for emergency assistance. The governor, Mervyn King, ruled out any assistance, though he was later overruled by the Chancellor of the Exchequer who authorised emergency funds for the bank. When news of this broke on 14 September, however, thousands of savers began to queue at local branches to withdraw their money. Far from reassuring them, news of emergency funding sounded serious alarm bells.

Directors of Northern Rock, as well as the Financial Services Authority, the regulatory body, reassured savers that the bank was solvent and that they could continue to deposit and withdraw funds. In practice, however, this was problematic. The internet site for online banking was jammed, while personal withdrawals required hours of queuing. In one branch, in Cheltenham, two account holders barricaded the bank manager into her office after she refused to let them withdraw £1 million from their account.

King appeared inflexible, rejecting an effective rescue package, while Alistair Darling, Chancellor of the Exchequer, offered only vague assurances that savers’ deposits would be safe. The run on Northern Rock was denounced as an irrational panic, unjustified hysteria.

Yet the facts emerging about Northern Rock’s ‘business model’ more than justified savers’ anxieties. The board and their apologists claimed that they had been hit by the unexpected and unpredictable sub-prime mortgage crisis in the US, which had led to a seizing up of short-term credit markets. But it was Northern Rock’s own business methods that made it vulnerable to the sub-prime crisis, a crisis that had been developing over the previous months.

Compared to other mortgage lenders, Northern Rock has only a handful of branches. Instead of investing in high street branches and building a wide base of savers, the board preferred to raise money on the wholesale money market, relying on this for 75% of their funding. They had increased their mortgage lending over 50% during the last year.

This was a high-risk strategy, short-term borrowing to finance long-term lending. When the banks reacted to the sub-prime mortgage crisis by withholding short-term credit during the summer, Northern Rock faced not merely a short-term liquidity crisis, but the prospect of insolvency. The directors tried to negotiate a takeover by bigger banks, but potential buyers were not prepared to shoulder the likely losses.

Northern Rock’s share price plummeted, forcing the directors to go to the Bank of England. This unsuccessful move led savers to withdraw around £2 billion in three days, directly threatening the viability of Northern Rock.

Bank of England humiliating u-turn

The government and the Bank of England were forced to make a humiliating u-turn. The possible collapse of Northern Rock potentially threatened the whole financial system. It has become clear, moreover, that other banks deliberately withheld funding in an effort to force action by the Bank of England and the government. At the same time, continuing queues outside Northern Rock’s branches intensified the political pressure on Brown and Darling, who had so far failed to take decisive action.

Then, on 17 September, Darling announced that the government and the Bank of England would guarantee all Northern Rock deposits. Only this announcement brought the run to an end, though confidence in Northern Rock is far from being restored. It seems unlikely that Northern Rock will survive as an independent bank, and its mortgage business may well be taken over by other banks.

Darling’s guarantee for Northern Rock depositors, however, has wider implications. How can the government guarantee one bank, without implicitly offering the same guarantee to all savers? Previously, Mervyn King opposed rescuing Northern Rock (or any other bank) on the grounds that it created ‘moral hazard’. In other words, the security of an ultimate government guarantee could encourage banks to undertake risky if not reckless speculative activities, secure in the knowledge that they would not face bankruptcy. But the prospect of an implosion of the whole banking system forced King, as well as Darling and Brown, to change their tune. Forget moral hazard, the system is under threat.

Writing in the Financial Times (19 September), Martin Wolf comments: “The decision to guarantee deposits raises large questions. Deposit liabilities are nationalised, while the financial system’s assets, albeit regulated, remain in private hands. If you do not understand the implications of that, you have not paid attention to what has been happening in the financial sector”.

Up until 21 September, Northern Rock had borrowed £3 billion from the Bank of England, in reality public funds to repair the damage created by its reckless ‘business model’. But there is widespread anger that the board still intends to make interim dividend payments to shareholders, including a number of directors. Adam Applegarth, chief executive, is due to receive £13,952 while others will receive between £6-8,000. There is pressure on them to waive these payments, but they have made no announcement about this so far.

Darling is now proposing to introduce a new deposit guarantee scheme, insuring deposits of up to £100,000. This would undoubtedly be an improvement over the current scheme, which only insures deposits up to £31,000 (100% up to £2,000, 90% for the rest). However, it would still be a question of the state picking up the tab for bank losses, while allowing their owners to carry on as usual.

The real answer would be to nationalise Northern Rock, together with all other major banks and building societies, to be run on a planned basis. That would secure savers’ deposits, and at the same time provide affordable mortgages for house buyers. Compensation would be on the basis of need, not to the big financial institutions or wealthy speculators, but to small investors who rely on the income to live on. Such a policy, of course, implies a break from the anarchy of the capitalist market, especially the current feverish financial speculation, and a decisive switch to a planned economy on a socialist basis.

Speculative policies

The government, the Bank of England, and the Financial Services Authority are now trying to offload the blame for the Northern Rock crisis on to one another. The truth is they all turned a blind eye to the speculative policies of the Northern Rock directors. History shows, however, that it is futile for capitalist governments to attempt to regulate the finance system, especially in periods of intense speculative activity and instability. For instance, in the 1990s in the US the government was forced to step in to bail out (effectively nationalising) the savings and loans institutions (the equivalent of building societies). They were forced to pay out between $150-200 billion to clear up the mess that resulted from speculation and fraudulent activity.

Earlier, in Britain in 1974-76, the Labour government of that time was forced to bail out around 60 so-called secondary banks, speculative outfits that sought to profit from the property and commodities boom of that time.

“Is this the end of the story of crisis and contagion?” asks Martin Wolf. “Far from it, is my guess. If we can have such trouble with the financial system when the real economy is healthy, I tremble at what may happen when conditions start to become worse. The financial system looks more insecure than I feared. The unwinding of past excesses may well bring more unpleasant surprises”.

Undoubtedly, there will be further, even more serious crises within the British and global financial system. Globalisation ensures that almost any serious problem has worldwide ramifications. But can ‘the real economy’ be described as ‘healthy’ when it is so tied up with debt and speculative activity?

This article also appears in the October issue of Socialism Today, monthly magazine of the Socialist Party (CWI in England and Wales)

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September 2007