Eesti Pank - Bank of Estonia

David G Mayes (University of Auckland) and Geoffrey Wood (Cass Business School, University of Buckingham)

Up to September of 2007, the authorities in the UK, and most private sector observers there, thought that the idea of a bank run on a solvent bank, with pictures of distressed depositors queuing in the street, was something that occurred in other parts of the world, such as South America, and not something that could happen at home. After all it had been nearly 150 years since the last significant bank run (on Overend, Gurney, and Co. in 1866) and the London market, particularly through Bagehot, had developed the ideas ,which most other financial centres have followed, of an effective Lender of Last Resort to help banks which are illiquid but can offer adequate collateral. The UK was much slower to adopt deposit insurance, a device intended among other purposes to prevent bank runs, but such arrangements were in place and were more generous than in much of the rest of the European Union, as prescribed under EU law. Thus, according to the ideas of Diamond and Dybvig (1983), depositors should not have felt any need to rush for their money when a bank seemed to be in difficulty they were protected, and by more than one means.

This article deals with the experience from the run on Northern Rock, a substantial and venerable depository institution that in theory should never have occurred.

Northern Rock had been growing rapidly and pursuing an aggressive funding strategy, relying heavily on wholesale markets. Far from the being a secret it was an announced strategy by the management and hence as a public and supervised institution such risks should have been priced and prudential limits applied if needed. Although its loan book had been growing rapidly, it was generally believed that its loans had been granted prudently; it was generally judged that Northern Rock was solvent. Indeed the Chancellor of the Exchequer made this solvency explicit in justifying the loans and facilities granted to the institution.

While temporary special funding may have been inevitable given the unusual distortion to wholesale markets, this is something the safety net and the lender of last resort facility in particular are designed to handle and their mere existence, let alone use, should have provided the confidence depositors and investors required. But they did not.

We ask whether it is Bagehotian theory and/or its practice that was at fault, and how both of these should be adjusted to prevent such unnecessary lapses in financial stability occurring again. There has been a substantial enquiry into the events. That is still continuing. Both authors have contributed to it. There has also been considerable recrimination as the various parties involved try to blame each other. The UK Treasury, the Bank of England and the Financial Services Authority issued a Discussion Paper to invite submissions on how the system, particularly with regard to deposit insurance, should be reformed. Following that they made joint proposals that the Chancellor of the Exchequer presented to Parliament at the end of January on how the framework might be strengthened (Bank of England et al., 2008). Just prior to that, on Saturday 26th January, the House of Commons Treasury Committee produced its report and recommendations on the issue. We draw not simply on our own evidence but on the contributions of others.

Our findings are that the theory seems to stand up well but that the practice has revealed several useful lessons about the operation of Lender of Last Resort, coordination in crises, and the importance of avoiding liquidity losses to depositors, all of which have important implications for the conduct of policy in the future and the design of deposit insurance schemes in the UK and more widely in Europe. In particular it has become clear that the idea that depositors will be satisfied as long as they get access to their deposits within a few weeks or months as required under present legislation is highly erroneous. It also demonstrated again that the Lender of Last Resort has to act promptly and supply such funds as are needed against a wide range of collateral in a manner which exudes confidence. In this case a central bank has to act as a bank. It has to take a rapid decision whether to lend to or to close an institution and having decided it needs to act firmly to support that decision and minimise the losses to society. This involves taking a risk. It is also clear that the response to deal with public unease has to be swift, unified and credible.

One area where the theory does have to be revisited is transparency. Accessing emergency lending facilities needs to be viewed as a reassuring sign. As a result of many of the modern reforms of monetary policy, there is a wide gulf between normal liquidity operations and actions when that market mechanism does not supply what one or more institutions may need. The summer of 2007 has also shown up wider problems when normal sources of liquidity dry up. In the last 20 years the focus of prudential regulation and financial market structure has been on capital adequacy. This year has emphasised the need for attention to adequate liquidity. The lesson needs to be learned so the problem is not repeated but we do not see present circumstances as justifying a major increase in supervisory regulation. Indeed the substantial changes entailed by the adoption of Basel 2 may have taken some of the attention away from the fundamental principles of which the events of this summer have reminded us.

However, the Northern Rock experience has been a fortunate opportunity to focus attention on an area that governments in particular have not thought in need of serious attention, for it has done so without causing important losses. While shareholders have lost a lot of value and may well lose more before the incident is closed, it is unlikely that the losses will spread elsewhere in the system. The incident could have been far worse. Northern Rock is a domestic institution focused strongly on the retail housing sector. It could have been a major multifunction bank and it could have been an institution with strong crossborder activities. Here the current arrangements are far less satisfactory - if coordination between the ministry of finance, the central bank and a single unified supervisor did not work as intended, what would the chances be where several such institutions were involved and none had the real power to act and give confidence to depositors?

LESSONS FROM THE NORTHERN ROCK EPISODE