Saturday, September 15, 2007

BoE should have let Northern hit the Rocks

The Bank of England should not have bailed out Northern Rock .

Fiscal Prudence may seem boring but it’s an essential prerequisite for any serious financial institution and its customers.

Prudence doesn’t come free. It limits management’s capacity to “take a punt” and thus they may seem to miss out of profit opportunities in rising markets. It also means that prudent institutions are contributors to industry-wide insurance schemes such as FSCS, even though they will never need to call on such insurance.

The Northern Rocks, on the other hand, are the “wide boys” of the financial services business, claiming to be innovators, mould-breakers, more customer-focused than their fuddy-duddy competitors. Often lauded by the media who take their every press release at face value.

Northern Rock has been operating a dangerously unbalanced business model, the dangers of which have been recognised by banks for generations: using short-term deposits and interbank loans, repayable on demand or within a relatively short period, to fund 20-year mortgages leaves you seriously exposed if confidence in your bank is in any way damaged, and/or market conditions change.

The sub-prime credit crunch was unforeseen, but it’s only one of many events which might have precipitated Northern Rock’s current liquidity problems.

The Bank of England should not have bailed Northern Rock out. The business is solvent and depositors funds should not be in any real danger, even if depositors were alarmed and temporarily discommoded by a closure. In such a scenario, Northern Rock would have been bought by a competitor within weeks, if not days. However, the message to the other “wide-boys”, and the public who do business with them, would have been stark. The management team and board of directors would be immediately unemployed and their professional reputations in the industry would be destroyed. The shareholders would be looking at even greater losses, making the likelihood of investment in similar enterprises unlikely for some time to come.

By bailing Northern Rock out, the Bank of England instead sends the signal to Wide-Boy management that it’s OK to keep sailing close to the wind - and they will keep doing just that. Meantime, the prudent serious players will continue to fund insurance schemes to protect their competitors customers.

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