Failure After Failure

For some years now, financial services have been the U.K.'s biggest industry. And, in many ways, London has become the world's leading financial center. With finance a global growth industry, this is a great strength to have. But it is a uniquely mobile industry, and one in which reputation is particularly important. So the still unresolved failure of the U.K. mortgage bank, Northern Rock, is more damaging for Britain than a similar disaster would be for any other country.

Bank failures are bound to happen from time to time. But unlike failures in other industries, a high-profile bank failure can lead to a loss of confidence throughout the banking system, with potentially devastating consequences for the rest of the economy. For this reason, central banks must stand ready, in the case of a potential systemic risk of this kind, to step in as lender of last resort to shore up the failed bank until the crisis can be resolved. In return, banks have to submit to a degree of official supervision unknown to other businesses in a market economy.

It is unfortunate, to say the least, that one of the first actions of Britain's present Prime Minister, Gordon Brown, when he became Chancellor of the Exchequer in 1997, was to remove the task of bank supervision from the Bank of England and entrust it to the agency responsible for the regulation of U.K. financial markets — perhaps under the erroneous belief that financial regulation and bank supervision were much the same thing. In fact, they are fundamentally different. In any event, although Northern Rock was pursuing a conspicuously high-risk business strategy, which enabled it to increase its share of the mortgage market very substantially, the new regulator proved to be asleep on the job, and the danger was completely overlooked until crisis overtook the bank last September. As a result, it had to be bailed out by the Bank of England, and an adequate deposit-protection arrangement had to be put in place to remove the threat to the rest of the U.K. banking system.

These things can happen. What is important is how they are dealt with when they do. There was a serious bank failure in the U.K. when Johnson Matthey Bankers collapsed in 1984, while I was Chancellor of the Exchequer. After a few days of abortive attempts to find a genuine private-sector rescue, I authorized the Bank of England to take over JMB, close the business, and sort out the mess, which it duly did. Northern Rock is a larger and more complex case, but the principles are the same. Instead, Brown and his Chancellor, Alistair Darling, spent five months unsuccessfully trying to find a private-sector solution, which was never in any genuine sense going to be possible, least of all amid the turmoil of today's financial markets. While the situation deteriorated, the taxpayers' exposure grew, and the bank was allowed to continue its high-risk lending. (High-risk borrowing had undone it, but its lending was, and still is, almost equally risky.)

Now the government has very belatedly concluded that a state takeover of Northern Rock is the only option. But even that has been badly mishandled. What should have been done was to put in a management with a remit to close the bank to new business, to stop all future lending, and to confine itself to managing the existing loan book and selling it off piecemeal to private-sector buyers as market conditions improve. After all, by one estimate, there is now some $200 billion of taxpayers' exposure to protect. Nor, of course, is the survival of Northern Rock of any strategic or other importance to the U.K. economy. Indeed, it has become a source of weakness.

Instead, the new management has been given the remit of carrying on business as usual, competing in the market for loans, to the dismay of the commercial banking sector, which must now go head-to-head against a state-owned and state-guaranteed competitor, which they are promised will one day be privatized.

So why take this worst possible course? The only plausible answer is so as to avoid the short-term political cost of a run-down of the bank, a major employer in the northeast of England, which is one of the Labour Party's heartlands. But the longer-term political cost to the government is likely to be very severe. Governments, like financial centers, need to be jealous of their reputation. The U.K.'s reputation as a financial center is sufficiently soundly based for it to recover from the blow inflicted by the Northern Rock affair. Whether the government's reputation can recover is far more doubtful.

Lord Lawson was Britain's Chancellor of the Exchequer under Margaret Thatcher