Money (34 page)

This was hardly a novel problem in the world of banking. As we have seen, the purest essence of banking is the business of maintaining the synchronisation of payments in and out of the balance sheet.
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The generic challenge is that the assets which banks hold—the loans they have made—are typically to be repaid relatively far in the future, while their liabilities potentially come due much sooner—indeed, on demand, in the case of many kinds of deposits. There is, in other words, an intrinsic mismatch—the bank’s “maturity gap” as it is called—that cannot be eliminated from a banking system like the one that exists today. Most of the time, the maturity gap is not a problem. Indeed, its very existence is in one sense the whole purpose of the banking system. The bank’s depositors get the freedom of being able to withdraw or make payments with their deposits at a moment’s notice, while they get interest that can only be generated by risky and illiquid loans. But it makes synchronising payments a particularly delicate art. If, for one reason or another, depositors and bondholders lose confidence in a bank’s ability to meet its commitments to them as they come due, and they therefore withdraw their deposits and refuse to roll over their lending en masse, the maturity gap presents an insuperable problem for the bank if it can only rely on its own resources.

Fortunately, however, modern banks have friends in high places. Under the terms of the Great Monetary Settlement, a bank’s liabilities, unlike the liabilities of normal companies, are an officially endorsed component of the national money supply. And since money is the central co-ordinating institution of the economy, any impairment of its transferability would impose grave costs on the whole of society—not just on the particular bank that issued it. Money must therefore be protected from suspicions concerning any one of the banks that operate it. Just as electricity is delivered through a network for which the failure of a single power station can be disastrous, the vast majority of modern money is provided and operated by a network of banks in which the failure of one can disrupt the system as a whole. In fact, even greater vigilance is required in the case of the banking system. Disruption of the electricity grid at least requires
the malfunction of physical infrastructure. In the banking system, a mere loss of confidence in one of the parts can be fatal to the whole.

Preventing liquidity crises in banks has therefore long been recognised as an important responsibility of the sovereign: as we saw earlier, it was Walter Bagehot who formalised the rules for how to cure a crisis when it occurs. If panic strikes and a bank’s depositors and bondholders withdraw their funding, he taught, the correct remedy is for the sovereign to step into their shoes. As bondholders and depositors demand payment, the bank should be permitted to borrow from the Bank of England in order to pay them out in sovereign money. More and more of its balance sheet will be funded, in effect, by the central bank, and less and less by private investors. And by the same token, private investors will hold fewer and fewer claims on the private bank and more and more claims on the Bank of England; or cash, as it is more commonly known. Bagehot’s solution became standard practice throughout the world. Even the U.S., a latecomer to the wonders of modern central banking, installed the system in 1913. This was the time-honoured palliative being deployed in September 2007 by the Bank of England—for the first time, it was said, since the collapse of Overend, Gurney a hundred and forty years earlier.
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As the months went on, it became clear that Northern Rock’s problem was not just one of liquidity, however. Many of the loans it had made were no good. This was no longer a problem of synchronising payments that were going to be made as agreed. It meant that no matter how good the synchronisation, the sums might not add up. The total value of Northern Rock’s liabilities, it seemed, was larger than the value of its assets—regardless of when one or the other was coming due. Under normal circumstances—if it has been doing its job properly—the value of a bank’s assets will be larger than its liabilities. The difference between the two is the bank’s equity capital. When it is positive, the bank is said to be solvent, and the more positive it is, the larger the decline in asset values that the bank can withstand without becoming insolvent. Northern Rock, it seemed, had been sailing too close to the wind. It had operated with a small amount of equity capital. When the housing market had deteriorated
and the economy gone into recession, the value of the mortgages that made up much of its assets had started to fall. The value of the bank’s liabilities, on the other hand, had stayed the same—as liabilities awkwardly do. The bank’s equity capital had quickly been eroded. The market price of a share in that equity had collapsed in response. From a high of over £12 in the halcyon days of February 2007, it had already fallen to around £7 in late August, and then to £3 two days after the announcement of the Bank of England’s liquidity support operation. Now it dropped to below a pound a share. In the absence of external assistance, it was clear that the market believed Northern Rock to be not just illiquid, but insolvent.

Luckily for Northern Rock—or at least for its bondholders, depositors, and other customers—external assistance was at hand for the second time. Once again, the U.K. sovereign stepped in, but this time into the shoes not of the bank’s lenders, but of its shareholders. New equity capital was required in order to make good the gap between the value of the bank’s assets and its liabilities—and to provide an adequate buffer against potential further declines. The liquidity support operation had consisted of the sovereign merely agreeing to give one fixed promise to pay—a claim on the Bank of England—in return for another fixed promise of supposedly equal value—a claim on Northern Rock. What was now required, however, was something quite different. The sovereign would give its fixed promises to pay in return for equity: a residual claim on the uncertain difference between the value of Northern Rock’s assets and its liabilities. The liquidity support, at least in principle, had involved no risk of profit or loss—just a transfer of liquidity risk from private investors to the sovereign. This new operation would involve, by contrast, a transfer of credit risk. If losses ceased to mount on Northern Rock’s mortgages, the sovereign might not lose money. But if they did not, the sovereign, as equity owner, would be on the hook. This was not a job for the Bank of England—the monetary authority. If the sovereign is deliberately going to put taxpayers’ money at risk, better to ensure that it is its democratically elected government that is doing so. The purchase of Northern Rock’s equity was therefore made by the U.K.
Treasury—the fiscal authority. On 17 February 2008, the bank was nationalised.
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Amongst the general public, the initial reaction was one of mystification, even indifference. The bank had failed and had been bailed out—by which arm of the state and how was frankly much of a muchness. Policy-makers and financial professionals, however, recognised the U.K. Treasury’s decisive action as a radical new policy—one which spoke ominously to the potential scale of the crisis ahead, and which set a radical precedent for the policy response to it. By nationalising Northern Rock, the U.K. sovereign had revealed that it felt it necessary to provide not just liquidity, but credit, support to the banking sector. The Bank of England’s lending from September to February had kept depositors, bondholders, and the bank’s existing equity-holders unscathed—on the assumption that there was some value in the bank’s equity. Once the bank’s equity capital had been eroded by losses, the luck of its shareholders had run out. In the normal order of things, its bondholders would have been next in line. Instead, it now transpired, they were able to call on a second line of defence: the U.K. Treasury’s previously undeclared insurance of bank investors against credit losses. Courtesy of the Chancellor of the Exchequer, the British taxpayer was on hand to assume the risk of further losses that would otherwise have had to be borne by Northern Rock’s bondholders.

What, observers asked, could have prompted the U.K. sovereign to such extraordinary generosity? Liquidity support was one thing—it had been official policy at least since Bagehot’s day and unofficial policy even before that. But credit support and bank recapitalisation with direct costs to taxpayers—these were clear and controversial policies historically reserved for the direst circumstances. They were the stuff of the Great Depression—when a special government-funded body, the Reconstruction Finance Corporation, had been established to recapitalise banks in the U.S.—or of the near-collapse of the U.K. economy in the 1970s, when the government had stepped in to provide capital to the secondary banks when private investors would not. Moreover, credit support was historically shunned for good reason. If moral hazard presented a dilemma for the central
bank’s role as lender of last resort, how much more of a dilemma did it present for the National Treasury’s role as shareholder of last resort? If every banker—and, just as important, every investor that funded his bank—knew that the sovereign stood ever-ready to cover his losses should things go wrong, what possible discipline could there ever be on lending standards and volumes?

The market began to suspect that there was something terribly wrong. Why else should the line between liquidity and credit support have been crossed, and the natural political reluctance to have taxpayers bail out banks have been trumped? The policy-makers knew only too well the gravity of what they had done, and tried furiously to dispel what they knew would be the fatal impression that no one need any longer watch their backs. “Banks,” announced the U.K. Parliament’s Treasury Select Committee in a desperate attempt to shut the stable door, “should be allowed to ‘fail’ so as to preserve market discipline on financial institutions.”
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But the horse had already bolted. Only the most terrifying warning might chase it back in again. So it was that when Bear Stearns, the fifth-largest U.S. securities dealer, ran into trouble in March 2008, the U.S. authorities made it clear that liquidity support alone would be forthcoming. When it emerged that Bear Stearns was on the brink of failure, it was a private investor—the universal bank, J. P. Morgan—that stepped in to buy its equity. The policy-makers were encouraged. Perhaps the horse had been scared back into its stable. When a second major U.S. investment bank, Lehman Brothers, began to suffer a catastrophic run almost a year to the day after the run on Northern Rock, the emboldened U.S. authorities held their nerve. Alas, the horse was not back in the stable after all. “They can shoot a Bear,” was the gag doing the rounds in the financial markets on Friday, 12 September 2008, “but they can’t shoot the Brothers.” Despite the stand on Bear Stearns, bankers and their investors remained convinced that the policy-makers would fold. The strength of their conviction was measured by the sheer panic which ensued when on Monday, 15 September, credit support from the sovereign was refused, and Lehman Brothers filed for bankruptcy.

The collateral damage to the financial sector and the real economy
caused by the failure of Lehman Brothers was beyond all expectations. The heroic attempts of the policy-makers to deny the doctrine of blanket credit insurance disintegrated. What, after all, was the point of trying to preserve market discipline when the markets themselves were no longer functioning? The End of the World—or at least the End of the Banks—was nigh, and had to be prevented at any cost—or at least, any cost to the taxpayer.
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In an instant, the nationalisation of Northern Rock became not an embarrassing aberration, unmentionable in polite society for fear of giving the bankers unsuitable ideas, but the model of good policy. The result was a level of sovereign credit support for the world’s banking sectors unlike anything ever witnessed before. Twenty-five countries experienced major banking crises between 2007 and 2012: two-thirds of them resorted to providing credit support to their banks.
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The sheer scale of some of the interventions was unprecedented. The U.S. spent 4.5 per cent of GDP recapitalising its banks—equal to its entire annual defence budget in the midst of a major war.
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In 1816, Thomas Jefferson had warned that “banking establishments are more dangerous than standing armies.”
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His verdict was proving alarmingly close to the truth, if not in the sense he had intended. The U.K. spent 8.8 per cent of GDP—considerably more than it spends annually on its much-vaunted National Health Service.
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The Irish sovereign spent over 40 per cent of GDP—more than the typical annual budget of every department of government put together. There could no longer be any doubt. The sovereign had the bankers’ backs.

When the dust had settled and the Great Recession set in, the public began to realise what had happened. The banks and their investors had been making a one-way bet. Their business was—just as it always had been—to manage liquidity and credit risk. But if they proved unable to synchronise their payments, the central bank would step in with liquidity support. And if their loans went bad and their equity capital was too thin, the taxpayer would backstop their credit losses. The consequences were, in retrospect, utterly predictable. Around the world, banks had grown in size, reduced their capital buffers, made riskier loans, and decreased the liquidity
of their assets. More and more had become too big to fail. As a result, the level of credit insurance that sovereigns had implicitly been providing had ballooned. Only when the crisis had struck, and the policy-makers’ initial efforts to control moral hazard collapsed, had the true scale of the subsidy become clear. In November 2009, a year after the collapse of Lehman Brothers, total sovereign support for the banking sector worldwide was estimated at some $14 trillion—more than 25 per cent of global GDP.
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This was the scale of the downside risks, taxpayers realised, that they had been bearing all along—whilst all the upside went to the shareholders, debt investors, and employees of the banks themselves.