What a triumph. Bank shares are rising, the FTSE 100 index is back where it was a week ago, and the queues have evaporated. Not many people are putting new deposits in Northern Rock, but a few are taking a punt on its shares. Order is restored. Actually, that 8o//00 rise in Northern Rock’s share price is very embarrassing for the authorities. It reflects the fact the bank is worth more because its deposits are guaranteed by the Treasury. That looks like a straightforward bail—out for Northern Rock’s shareholders, exactly the outcome the Bank of England has warned would store up trouble for the future.
The Bank is right, of course. If all deposits at all banks were to be guaranteed—which seems to be the implication of the chancellor’s statement—the state is potentially accepting an enormous liability. Worse, an odd incentive is created: managements who are insulated from a run on their bank might be inclined to take wilder risks with the cash. The chancellor and the Bank also know that, which is why Monday’s emergency sticking plaster will be replaced by something more permanent and more sensible once the storm passes.
The US model seems to be the one the Bank has in mind. Over there, 100% guarantees are given on sums up to $100,000 (￡50,000) and deposits are returned within days of a bank’s failure. There is little need to fill in forms, which seemed to be another worry for those queueing at Northern Rock’s branches. The US-style system seems infinitely fairer on customers, who can’t reasonably be expected to assess the merits of various banks’ business models before deciding where to place their savings. It should also prevent bank runs that last for days and provoke panic at more solid outfits.
But what about the incentive to managements to bet such guaranteed deposits in wacky ways That is where reform becomes complicated. If deposits, up to a certain sum, are to be guaranteed by the state, then the state needs to be compensated for taking on that risk. How about a higher rate of tax on banks’ profits, or some other form of annual charge based on a bank’s capital ratios Banking bosses and their investors would scream at the idea, but it’s perfectly logical. In fact, as part of the deal, the state should probably also demand tighter regulation of banks’ activities. That means rethinking the role of the Financial Services Authority, which has responsibility for banking supervision. Until now, the FSA’s "light touch" approach has been applauded around the world, especially on Wall Street, where bankers look enviously at a British system based on the sensible application of principles rather than hard—and—fast rules.
But Northern Rock is not a terrific advert for the FSA’ s style of doing things. It is unfair to say the regulator was asleep—it has warned as much as anybody of the risks posed by the complexity of modern financial markets. But it is fair to say that banks and financial institutions are less inclined to listen to a watchdog that prefers to bark rather than bite. Overkill would be even worse, but the balance may have to be addressed.
Over in the US, they have a different way of dealing with the global credit crunch which caused so many problems for Northern Rock. They cut interest rates at the first sign of trouble. True to form, the US Federal Reserve cut rates by 0.5% last night. The stock market loved it. But snap reactions are often wrong. The Dow Jones Industrial Average soared at news of the cut. It was reminiscent of January 2001 when a cut of the same size- designed to ease the effects of the deflating dotcom bubble-provoked a one-day, 299-point rise in the Dow. Over the next eight weeks, however, the Dow fell by 1,600 points. Why Simply the realization that the Fed’s fears of a recession were well-founded.
Could we see a similar storyline this time Quite possibly. The danger in a 0.5% cut is that Ben Bernanke, the Fed chairman, does serious damage to the value of the US dollar, which is already at an all-time low against the euro. The US is struggling to attract investment from overseas to fund its current account deficit; Bernanke has just made the task harder. He is also sending a direct signal that the risk of recession in the US is real. The idea that an aggressive cut is good news may not last long, and indeed the Fed’s statement spoke about promoting economic growth over time. The phrasing was hardly bullish.
Why does the author mention the bank of Northern Rock at the beginning of the passage