Coming Clean On Northern Rock

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Bank of England Governor Mervyn King speaking to the Treasury Committee

Amid the chaos and confusion that has accompanied the credit crisis at British bank Northern Rock, Bank of England Governor Mervyn King has remained tight-lipped. There was barely a word from him when the Bank, as Britain's lender of last resort, made emergency cash available to Northern Rock last week. When that triggered a run on the High Street lender, with customers lining up for days to take back their savings, King still failed to utter a word. And when the government finally stepped in Monday to offer a gilt-edge guarantee for spooked depositors in the form of cash, the silence was deafening.

Until late this week. Appearing before a committee of British M.P.s Thursday to explain the Bank's handling of the crisis — the first run on a U.K. lender in living memory — King finally opened up. The Governor, the bank's former chief economist and an academic who's taught at Cambridge, Harvard and MIT, first got wind of problems at Northern Rock on Aug. 14. The Newcastle-based bank — Britain's fifth-largest mortgage provider — leaned heavily on wholesale money markets to fund its own mortgage loans. When those inter-bank markets started to freeze up in recent weeks amid a global credit squeeze triggered by the subprime mortgage crunch, so too did the source of 75% of Northern Rock's funds. "At that point," King said, still hopeful the market would step in to help out the troubled bank, "there didn't seem much point in blowing up the train before it hit the buffers."

Fast-forward a month, however, and things looked grim. Still short of credit in those tight money markets, Northern Rock had little choice but to approach the Bank of England for cash. And that — the emergency credit that King duly put up — was supposed to be that. It wasn't. Far from reassuring savers, the central bank's efforts amounted to "the equivalent of screaming fire in a crowded cinema," offered John McFall, chairman of the Treasury select committee. King could hardly quibble with that, but coming to his own defense, the Governor made clear it hadn't been his favored remedy. And here, he said, he was let down by the law. His preference for giving Northern Rock covert help — only letting the public in on the move when the crisis had blown over — ran up against E.U. rules outlawing such action, King said. And any thoughts of a speedy takeover at the hands of another lender were also undermined by Britain's takeover regulations, King added.

Still, playing by the rules — annoying though that can be sometimes — wouldn't have mattered if Northern Rock customers had believed their savings were safe amid the bedlam. They didn't. Many were aware the U.K.'s industry-funded Financial Services Compensation Scheme only guaranteed deposits up to around $63,000; in the U.S., savers can expect to get back as much as $100,000 should their bank go under. The British scheme, King said, was in desperate need of an overhaul.

But if the legal straightjacket took some of the heat off the Governor, there was plenty else to answer for. A day before his appearance in front of the committee, the Bank of England announced plans to pump $20 billion into the money markets, to help thaw the freeze on liquidity and push down the bloated rate banks are charging to lend one another cash. It also broadened the kind of collateral those banks could put up in return for accessing the central bank funds. In itself, that wasn't controversial — the European Central Bank and U.S. Federal Reserve have both pumped cheap cash into the markets in recent weeks to help institutions out.

But here's the snag: only a week ago, King wrote the Treasury committee explaining, "the provision of such liquidity support undermines the efficient pricing of risk." He went on: "That encourages excessive risk-taking, and sows the seeds of a future financial crisis." Why the change of heart? "Decisions about the balance between liquidity and moral hazard is a judgment we are making almost daily," he told the committee, referring to the danger that lending to banks in this way only encourages them to take risks knowing the central bank will bail them out. Speculation he was leaned on by the government to inject the cash got short change. "This operation was designed entirely in the Bank," he hit back. "I give you my personal assurance that I would not do anything unless I thought it was the right thing to do."

Much of the British press took a different line, accusing King of a clumsy flip-flop; some even suggested he should ponder his future. Both suggestions seem unfair. The cash made available to the banks is being put up at a punitive rate, meaning those that access the funds will be charged interest well above the central bank's base rate of 5.75%. And it's hardly a jackpot; banks are limited in how much they can draw on. The cash boost, says David Buik at BGC Partners in London, is "purely symbolic." Besides, Buik says, how much help the funds would have been to a beleaguered Northern Rock is something "we'll never know."

One thing we do: the fallout from the Northern Rock crisis will flush more than just King out into the open. While it falls to the Bank of England to shore up stability in the country's banking sector, it's the job of the Financial Services Authority (FSA) to supervise individual banks. Callum McCarthy, the regulator's chairman, and CEO Hector Sants are now set to appear in front of the parliamentary committee next month. Alistair Darling, the U.K. Chancellor, is expected to show too. Expect the FSA to come in for even more criticism than King, reckons Buik. In the longer term, though, King's banking that the crisis leaves no serious harm done. "Headlines come and headlines go," he said Thursday. "I can't believe and I do not believe that there is any lasting damage to the reputation of the British banking system." After days of silence, at least we know what he thinks.