Northern Rock and Unified Regulators

In my previous post today, I described what I had learnt about managing liquidity risk from studying Northern Rock; in this post, I shall discuss the implications for the regulatory architecture (separation of bank supervision from the monetary authority).

Many observers appear to think that Northern Rock has revealed the dangers of the UK system of separating bank supervision from the central bank. In my view, it has on the contrary, revealed the strengths of this system. It is clear from the evidence, that the banking supervisor (Financial Services Authority) was keen to solve the problem of Northern Rock by making changes in monetary policy while the monetary authority (Bank of England) was unwilling to do this. If the central bank were in charge of both monetary policy and bank supervision, there is little doubt that monetary policy would have been changed to save Northern Rock. The deficiences if any in banking supervision would then have never come to light at all. This is a form of regulatory moral hazard – regulators will tweak the regulatory system to hide their failures. The UK system where the central bank is not the bank supervisor is less vulnerable to this kind of moral hazard.

That the UK had not had a bank run for 140 years prior to Northern Rock is to me a troubling thing. Banks are highly fragile institutions. If in 140 years including two world wars, a great depression, the loss of a vast empire and over three decades of chronic exchange rate difficulties, the UK did not have any bank runs, then it tells us not that banks were well regulated but that they were saved covertly. In these covert operations, doubtless the reputations of bank regulators (and perhaps bank managers) were also protected at the tax payers expense. That Northern Rock has dented many reputations is not such a bad thing by comparison.

Posted at 7:20 pm IST on Sun, 28 Oct 2007         permanent link

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