Deposit Insurance and Northern Rock

The flurry of comments and discussion that followed Mervyn King’s interview to the BBC on November 6, 2007 have led me to the conclusion that the true lessons from Northern Rock are largely about deposit insurance and not about bank supervision.

Mervyn King’s interview about the handling of Northern Rock prompted a series of comments last week in the Financial Times by Philip Stevens, Willem Buiter and Martin Wolf. This has prompted me to revisit Northern Rock which I blogged about last month here and here. I am even more convinced than before that the Northern Rock episode does not reveal fundamental flaws with the model of unified regulation and separation of monetary policy from bank supervision. I also think that King’s decision to provide liquidity only at penal rates and against top class collateral was quite correct. Mervyn King said in his interview:

If you look at what the European Central Bank lent to banks through their auctions that they conducted, relative to the size of the banking system they lent an average of 230 million pounds per bank participating in their auctions. Northern Rock needed something closer to 25 billion, 100 times larger than the average amount which the European Central Bank was lending to banks through their auctions. The scale of the funding that was needed was staggeringly large.

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So could we have had an auction that was sufficiently large that all the banks would have got 20 to 30 billion and Northern Rock wouldn’t have been noticed in that process? Well, that would have been an auction on a scale 50 odd times that which any other Central Bank had engaged in. And I’m absolutely convinced that the first question you would have asked on that day is: “What on earth must have happened to the entire British banking system to have merited an auction of that size?” We were doing this not to bail out the British banking system, which didn’t need bailing out, but actually to get money into one institution that needed it.

In my view, the lessons from Northern Rock are:

• In the age of television, even a small bank with retail deposits is systemically important. When television starts relaying images of depositor panic, there is a risk that investors worldwide are going to think that there is a problem with the entire banking system of the country in question. This means that the only politically feasible solution is to regard almost all retail deposits as de facto insured. The only question is whether the deposit insurance is ex ante or ex post. The realistic solution is a ceiling for deposit insurance approximately equal to the level of financial wealth at which financial regulators stop worrying about investor protection and treat the individual investor on par with institutional investors. In most developed countries, this would imply that the ceiling would have to be in the range of 1 to 5 million US dollars. To be non distortionary, such a large deposit insurance would not only have to be risk based but would also have to be funded by a tax on all bank deposits. The point is that the negative externality of banking is so large that it needs to be addressed with a large tax.
• There is a problem when a bank with some retail deposits has disproportionately large wholesale liabilities. Since wholesale lenders usually recognize a problem sooner than either retail lenders or regulators, uninsured wholesale liabilities are effectively senior to insured retail deposits. Thus wholesale lenders obtain the advantage of deposit insurance without paying for it. Therefore, regulators need to see liquidity management not as a problem for bank management, but as the primary mechanism by which uninsured wholesale lenders are prevented from free-riding on the deposit insurance provided to retail depositors. One way to make this happen is to make deposit insurance prohibitively expensive when wholesale liabilities become disproportionately large. This would have shut down Northern Rock long ago or forced it to become a pure wholesale operation. Either way, the problem would have been avoided.

Posted at 5:44 pm IST on Sun, 18 Nov 2007         permanent link

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