6 min read

A soap opera - Fed's verdict on Northern Rock

The Federal Reserve has just released a load of transcripts of its meetings in 2007, the year the securitisation markets seized up and, on this side of the Atlantic, Northern Rock became Britain’s first bank collapse since Victorian times.

The transcripts make for fascinating reading, in part because we’re rarely granted a glance inside the corridors of power at moments like this, in part because they confirm the fact that the official minutes released by the Fed are always tantalisingly sanitised, and, finally, because of the inherent dramatic tension of watching this institution trundling, for the most part unaware, towards the financial apocalypse.

But from a British perspective, perhaps the most intriguing element is what the transcripts reveal about the Fed’s impression of what was going on in the UK. Britain faced the first full-scale collapse of the crisis, in the form of Northern Rock. And, based on the description relayed by Fed economist Karen Johnson in the meeting, the Americans were, from the very beginning, concerned about the Bank of England and other regulators’ chaotic response to the unfolding events.

A few choice quotes:

The situation in the United Kingdom is an unfolding drama that is just a soap opera in many respects…

…I think there is a great concern in the Bank of England, or certainly in the person of Mervyn King, with the moral hazard aspects of enabling the markets to solve their problems and deal with the consequences of their own decisions by the Bank of England’s providing them more liquidity. That lies behind some of his reluctance…

…They got it wrong on Northern Rock, quite understandably. That, too, was a function of their deposit insurance system, which is now under review because it is prone to this sort of thing. It was just, if you will, one thing after another, all of which are interacting…

And most damningly:

I think the differences of opinion among the Financial Services Authority, the Treasury, and the Bank of England aren’t helping, the differences of opinion within the Bank of England aren’t helping, and the situation remains to be totally sorted out.

Finally, there’s a slightly lame joke from Dallas Fed President Richard Fisher when Ms Johnson points out that it’s difficult to predict what might happen next. Though that’s followed by a very clear-sighted warning from Ms Johnson about Spanish banks:

MS. JOHNSON. But, I have to say—as when President Fisher asked that question about whether we know what we don’t know, to which, of course, the answer is always “no”—[laughter] five days ago, I wouldn’t have brought up Northern Rock. So, I can’t promise you that there aren’t—

MR. FISHER. Previously Newcastle, should have been called Sandcastle. [Laughter]

MS. JOHNSON. The Spanish banks, for example, and the Spanish mortgage market are places, if I were going to dig deeper and look for hidden problems, that are a possibility.

Anyway, you can find the full transcript for the September 2007 session here [pdf]. If you’d rather not wade through it all, the offending section is as follows:

MS. JOHNSON. The situation in the United Kingdom is an unfolding drama that is just a soap opera in many respects. At the root there seem to be some severe differences of opinion of what the right response is to situations in the markets. In the beginning, there was virtually no explicit action by the Bank of England to counter heightened demand for liquidity on the part of banks in U.K. markets. So the spreads of overnight pound LIBOR, relative to target, opened up widely, and they were not addressed. They were allowed to just sort of sit there. The term pound market had a problem, too. Of course, many of the dollar issues that we have spoken of—and that Bill talked about—are really being captured as a London phenomenon. But you might say that, from the point of view of the Bank of England or the U.K. economy, these dollar issues are somewhat separate from the domestic economy. There is some truth to that, but also the institutions are involved, the institutions have obligations, and the shocks to the institutions reverberate back into the domestic economy, it seems to me. That process went on for a while, and it is to some degree a function of the way the Bank of England manages its reserves and the system of reserve market interaction that exists. It has, among other features, a monthly timetable, not a two-week timetable; so even though the Bank of England operates daily in the sense that we do, it ties its own hands a bit each month. Toward the end of the month in which August 9 occurred, it announced that the subsequent month it was going to ease things just a bit in response to a lot of pressure both perhaps from disagreements inside the bank and criticisms of the bank. It has taken some steps to provide for greater flexibility within its existing system than it had for the three weeks before the month turnover in August. Indeed, the Bank of England did a two-day operation last night, or this morning U.K. time, which is the first temporary extra injection of reserves it had done on this basis. So it is moving in the direction of introducing flexibility into the market that was not there on August 9 and wasn’t there for some time after August 9.

I think there is a great concern in the Bank of England, or certainly in the person of Mervyn King, with the moral hazard aspects of enabling the markets to solve their problems and deal with the consequences of their own decisions by the Bank of England’s providing them more liquidity. That lies behind some of his reluctance. On the other hand, we now have the Northern Rock issue. That is somewhat distinct from the problems of overnight lending or even term lending, in that Northern Rock has been questionable for a while, has been looked at for a while, has been kind of talked about a bit, but has not really been on anybody’s radar screen for a while. It is an institution that funded itself to an exceptional extent in wholesale markets as opposed to from a deposit base, and yet it had grown to be a very, very large mortgage lender in the United Kingdom. One might say that it is a bad coincidence that somehow Northern Rock hit a turning point this month, but that is perhaps going too far. I think the fact that the wholesale markets were disrupted had to interact with its business plan, had to be part of the reason that concerns that have been festering for a while became acute, and so forth. The actions that the Bank of England took with respect to Northern Rock were really from its lender-of-last-resort institution-based mechanisms as opposed to market concerns. But they came out basically on the same day. They announced that they were going to introduce flexibility into their reserves management system, and a different announcement was all about Northern Rock. They got it wrong on Northern Rock, quite understandably. That, too, was a function of their deposit insurance system, which is now under review because it is prone to this sort of thing. It was just, if you will, one thing after another, all of which are interacting.

We have revised down somewhat our U.K. GDP forecast. In general, the industrial countries are where we see the weakness. That economy was, in terms of domestic demand, pretty strong. We think it can absorb some of this. But the set of factors is very complex—some of them are deep and structural, like the way they do deposit insurance; some of them have been ongoing for a while; and some of them are related to this crisis. I think the differences of opinion among the Financial Services Authority, the Treasury, and the Bank of England aren’t helping, the differences of opinion within the Bank of England aren’t helping, and the situation remains to be totally sorted out.

CHAIRMAN BERNANKE. I see a two-handed intervention.

MR. MISHKIN. Yes. Just a question, really, for Bill and Brian. One thing that is positive about all of this—although maybe I’m wrong about it—is that the spillovers into the other markets outside the United Kingdom have been very, very minor. Normally, what’s happening in the U.K. context would be an information shock that could trigger problems. The good news here is that, if anything, the markets have actually gotten a little better since this whole episode occurred, and it has been contained in the U.K. context. Is this a fair assessment?

MR. DUDLEY. Yes, I agree with that.

MR. MISHKIN. It is really an important issue.

MR. DUDLEY. Three weeks ago, if this had happened, I think there would have been a different market reaction. The market reaction has been very mild. They seem to be able to sort it out as a specific problem pertaining to Northern Rock and the U.K. regulatory regime, not something that applies to a broader market. So I agree with that.

MS. JOHNSON. But, I have to say—as when President Fisher asked that question about whether we know what we don’t know, to which, of course, the answer is always “no”—[laughter] five days ago, I wouldn’t have brought up Northern Rock. So, I can’t promise you that there aren’t—

MR. FISHER. Previously Newcastle, should have been called Sandcastle. [Laughter]

MS. JOHNSON. The Spanish banks, for example, and the Spanish mortgage market are places, if I were going to dig deeper and look for hidden problems, that are a possibility.

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