Banking Crisis Solutions Old and New

By Milne, Alistair; Wood, Geoffrey | Review - Federal Reserve Bank of St. Louis, September/October 2008 | Go to article overview

Banking Crisis Solutions Old and New


Milne, Alistair, Wood, Geoffrey, Review - Federal Reserve Bank of St. Louis


In 2007 Britain experienced its first run on a bank of any macroeconomic significance since 1866. This was not dealt with by the method that had maintained banking stability for so long: letting the bank fail but supplying abundant liquidity to the markets to prevent contagion. In this paper the authors examine why that traditional solution was not used and propose changes to Britain's deposit insurance system, to its bank insolvency regime, and in arrangements to allow customers access to banking services should their bank be closed-so that the traditional approach can once more be used to mitigate moral hazard.

(JEL E58, G21, G28)

Federal Reserve Bank of St. Louis Review, September/October 2008, 90(5), pp. 517-30.

In the autumn of 2007 Britain experienced its first bank run of any significance since the reign of Queen Victoria.1 The run was on a bank called Northern Rock. This was extraordinary; by the early 1870s, the Bank of England had developed techniques to prevent such events. Further, it was the announcement of support for the troubled institution that triggered the retail run. (We emphasize "retail" because the bank had already been experiencing great difficulty in obtaining wholesale funding.) That run was halted only when the Chancellor of the Exchequer (as Britain's minister of finance is known), then Alistair Darling, announced that he would commit taxpayers' funds to guarantee every deposit at Northern Rock.

This paper has two aims: first, to address the question of why the United Kingdom's traditional techniques for maintenance of banking stability failed-if they did fail-on this occasion; and second, to consider how these techniques may need to be changed or supplemented to prevent any similar problems in the United Kingdom.

CHRONOLOGY OF EVENTS

Northern Rock was created by the merger of two "building societies," the Northern Counties and the Rock, on July 1, 1965. Building societies were mutual organizations, owned by their depositors and their borrowers. Their deposits came primarily from retail customers, and their major (essentially sole) lending activity was to individuals to buy residences. In the 1990s these organizations were allowed to demutualize and "convert" (in the terminology of the time) to banks. Most large societies converted, and Northern Rock was among them. It demutualized on October 1, 1997.

Many of these demutualized societies were taken over by or merged with existing banks. Northern Rock remained independent. Two other features of its post-demutualization behavior were distinctive. First, it grew very rapidly. At the end of 1997, its assets (on a consolidated basis) stood at £15.8 billion. By the end of 2006, its assets had reached £101.0 billion. Even so, at the end of the second quarter of 2007, its loans were only 8 percent (by value) of the stock of mortgage debt in the United Kingdom and therefore only about 5 percent of total bank lending, and its deposits about 2 percent of sterling bank deposits. It was certainly not an enormous institution. The second feature relates to its activity. On the asset side of the balance sheet it remained close to the traditional building society model: It stayed concentrated on mortgage lending to individuals wishing to buy their own homes. There were, however, dramatic changes in the structure of its liabilities. It adopted an "originate to distribute" model of funding (the originated mortgages would be sold in wholesale markets).

The resulting dependence on wholesale markets for the large majority of its funding was what most distinguished Northern Rock from other U.K. banks. Retail deposits (and other classes of retail funds) did grow, but not nearly as rapidly as wholesale funds, so retail funds fell as a proportion of total liabilities and equity, from 62.7 percent at year-end 1997 to 22.4 percent at yearend 2006. But on August 9, 2007, there was a sharp dislocation in the market for Northern Rock's funding, with the start of a major repricing of credit risk in global financial markets. …

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