Bank of England has acted like a 'paper tiger' on Northern Rock
First, it is by no means obvious that Northern Rock (total assets £113bn as of 30 June 2007) suffered just from illiquidity rather than from the threat of insolvency.
The organisation has followed an extremely aggressive and high-risk strategy of expansion and increasing market share, funding itself in the expensive wholesale markets for 75pc of its total funding needs, and making mortgage loans at low and ultra-competitive effective rates of interest.
No matter how efficient you are, or how safe your assets are, if the effective interest rate on your borrowing exceeds that on your investments, you are unlikely to be a long-term viable proposition, no matter how impressive the growth of your turnover.
Northern Rock's share price had been in steep decline since February of this year, well before the financial market turmoil hit.
Second, it is hard to argue that the survival of Northern Rock is necessary to avoid a genuine threat to the stability of the UK financial system, or to avoid a serious disturbance to the economy. The bank is not "too large to fail".
As the fifth largest mortgage lender in the UK, it is not systemically significant. When all else fails, the "threat of contagion" argument can be invoked to justify bailing out even intrinsically rather small fish, but irrational contagion, that is, contagion not justified by objective balance sheet and off-balance sheet realities, is extremely rare in practice, and could have been addressed directly had it, against the odds, occurred, following the insolvency of some bank.
No doubt its depositors (of which there are rather too few) are covered by the Financial Services Compensation Scheme to the tune of £31,700 per person (100pc of the first £2,000 and 90pc of the next £33,000). If most of its mortgage assets are good (albeit unprofitable, given Northern Rock's funding costs), they will find willing buyers among the remaining viable mortgage lenders.
Northern Rock's shareholders would, of course, lose everything and the remaining creditors (including depositors with balances in excess of the deposit insurance limit) would have to wait to see how much the realisation of the assets generates.
Top management would lose its jobs. All this is as it should be. What would happen to staff below the strategic decision-making levels would depend on which parts of the business remain viable after the financial restructuring following the insolvency.
Following the bail out of Northern Rock, I can only conclude that the Bank of England is a paper tiger. It talks the "no bail out" talk, but it does not walk the talk. It does not matter whether the decision to bail out Northern Rock was initiated and/or actively supported by the Bank, or whether the Bank was bullied into it by the Treasury and the Financial Services Authority.
Moral hazard has received a boost in the UK banking sector and in the UK financial system as a whole. We will all pay the price in the years to come, when the next wave of reckless lending washes over us. Let's hope that the collateral requirements and penalty rate charged on the credit line will be tough enough to limit the damage.
Source: telegraph.co.uk
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