He’s an LSE professor, former chief economist at the EBRD and a former member of the Bank of England’s monetary policy committee. So we should take Willem Buiter seriously.
On his Maverecon blog he also describes himself as “citizen of the world and member of the human race.” So when he declares that Northern Rock should have been allowed to fail – wiping out shareholders, jobs, and a portion of depositors money – we must assume he means it.
Northern Rock’s shareholders would, of course, lose everything and the remaining creditors (including depositors with balances in excess of the deposit insurance limit) would have to wait to see how much the realisation of the assets generates. Top management would lose its jobs. All this is as it should be.
Buiter’s beef with the Bank of England’s decision to throw Northern Rock a lifeline is that the mortgage bank’s crisis just didn’t meet the Bank’s own bailout criteria. He cites paragraph 14 of the memorandum of understanding between the Bank, the Treasury and the FSA:
14. In exceptional circumstances, there may be a need for an operation which goes beyond the Bank’s published framework for operations in the money market. Such a support operation is expected to happen very rarely and would normally only be undertaken in the case of a genuine threat to the stability of the financial system to avoid a serious disturbance to the UK economy.”
First, Buiter argues, it is by no means obvious that Rock suffered just from illiquidity rather than from the threat of insolvency.
The organisation has followed an extremely aggressive and high-risk strategy of expansion and increasing market share, funding itself in the expensive wholesale markets for 75% of its total funding needs, and making mortgage loans at low and ultra-competitive effective rates of interest. No matter how efficient you are, or how safe your assets are, if the effective interest rate on your borrowing exceeds that on your investments, you are unlikely to be a long-term viable proposition, no matter how impressive the growth of your turnover.
Second, he says it is hard to argue that the survival of Rock is necessary to avoid a genuine threat to the stability of the UK financial system, or to avoid a serious disturbance to the economy.
The bank is not ‘too large to fail’. As the fifth largest mortgage lender in the UK, it is not systemically significant. When all else fails, the ‘threat of contagion’ argument can be invoked to justify bailing out even intrinsically rather small fish, but irrational contagion, that is, contagion not justified by objective balance sheet and off-balance sheet realities, is extremely rare in practice, and could have been addressed directly had it, against the odds, occurred, following the insolvency of some bank.
In the event, moral hazard has received a boost and the Bank looks all the weaker for it:
Following the bail out of Northern Rock, I can only conclude that the Bank of England is a paper tiger. It talks the ‘no bail out’ talk, but it does not walk the talk. It does not matter whether the decision to bail out Northern Rock was initiated and/or actively supported by the Bank, or whether the Bank was bullied into it by the Treasury and the FSA…
We will all pay the price in the years to come, when the next wave of reckless lending washes over us. Let’s hope that the collateral requirements and penalty rate charged on the credit line will be tough enough to limit the damage.