Nothing like it had been seen on Britain’s streets since the late nineteenth century. Queues outside bank branches were images that most people associated with grainy footage from Germany or the United States in the 1930s. It just wasn’t British. But it was on 14 September 2007. First a handful, then a dozen and then a few more began to congregate in streets. They were queuing to get into branches of the Northern Rock bank. They were behaving in a way which was ‘perfectly rational’ according to the Governor of the Bank of England. With the official deposit protection scheme covering only a proportion of their savings, why take a risk if they had a tidy sum in a bank which needed emergency loans? Rational it might have been, but the episode proved disastrous for the country’s international image and will remain etched in the history books as a shameful chapter. International TV coverage of the Northern Rock queues, according to one horrified MP, made the UK look like Zimbabwe.
There were many causes of the Northern Rock debacle. One of the main reasons was the dramatic reversal in market conditions which took its toll on most banks – Northern Rock was among the first to be knocked over. The seizing up of financial markets in August 2007 has been well documented. Put simply, there had been a credit bubble and it had burst. In the early years of the decade, major central banks had lowered interest rates in an attempt to stimulate growth after the internet and technology boom had turned to bust and the Iraq war dented international confidence. Savings and surpluses built up in fast-growing Asian economies needed to find a home. The result was a flood of funds surging around the world markets. Official interest rates were low so the hunt was on for higher returns from more exotic investments. Banks were falling over themselves to lend. The sub-prime mortgage debacle was the result of this credit binge. Low-income US borrowers were targeted and persuaded to sign up for mortgages which they had little chance of repaying. In a constantly rising housing market defaults are not a problem as the lender can easily sell the property. But the crunch comes, as it did in 2007, when house prices start to fall. Borrowers hand in the keys and banks are left with properties worth a lot less than the original loan.
The US sub-prime disaster had such a huge impact on financial markets because exposure to vulnerable American borrowers was so widely spread around the international banking system. US lenders sliced and diced the mortgages and packaged them up as sophisticated instruments with names like ‘collateralised debt obligations’ and ‘asset-backed securities’. They were created, sold and re-sold and ended up on the balance sheets of US, Asian and European banks. When house prices started to fall and defaults rose, the music in this global financial game stopped. Suddenly everyone wanted out. They scrambled to cut their losses on the sub-prime mortgages. But they were selling into a falling market. Valuations of the assets became impossible. And as every bank began to take stock of its own problems, the next question was how badly other institutions were affected. If a bank was suspicious about the extent of a counterpart’s sub-prime losses, it would want to reduce lending to the other institution. A vicious downward spiral developed with banks reducing exposure to other banks and thus the supply of credit around the system was severely impaired.
Warning lights had been flashing in early 2007 as mounting sub-prime losses were unveiled by some lenders. In July, the US investment bank Bear Stearns announced that two of its hedge funds that had invested heavily in sub-prime securities had lost almost all of their value. On 9 August 2007 the markets really took fright. The French bank BNP Paribas froze three of its funds because they could not keep up with investor demands to get their money out. Selling the funds’ assets to raise money to repay those investors who wanted to quit was proving impossible. Global stock markets plummeted. The European Central Bank (ECB) pumped nearly €100 billion into the system to boost liquidity. The credit markets seemed, alarmingly, to be seizing up.
It is easy to blame highly paid wheeler-dealers and traders on Wall Street and in the City for blowing up the banking system with excessive risk-taking. But the first high-profile collapse was a former building society based in Newcastle-upon-Tyne. Northern Rock was not involved in sub-prime lending in the United States. It did not even have much sub-prime exposure in the UK market. It most certainly was not a high-rolling casino bank, staffed by pinstripe-suited City bankers with red braces. Its core business was providing supposedly plain ‘vanilla’ mortgage and savings products. Northern Rock had expanded aggressively since it converted from building society to bank and floated on the Stock Exchange in 1997. Increasing market share in a highly competitive mortgage market was the strategy and to achieve this, making loans easily available was the main task of management. Lending up to 125 per cent of the value of the property was not unusual for Northern Rock.
The main reason for the Rock’s downfall was not so much the quality of the lending, although that did not help, but rather the way the bank financed its loan book. Traditionally banks raised money from depositors and then lent it to businesses, mortgage borrowers and other customers. Liberalisation of financial markets and the surge in the availability of cheap credit opened up new funding avenues for banks in the early years of the twenty-first century. Rather than relying on deposits as the sole source funding, banks started tapping wholesale credit markets. They could borrow from one another ‘unsecured’, in other words without collateral for defined periods from one day to a couple of years. In addition they could parcel up their loans and ‘securitise’ them; in other words, sell them on to other investors and bring in more cash to then invest in more lending. According to one estimate, by the end of 2006, Northern Rock customer deposits covered just under 23 per cent of its loan book, the rest coming from wholesale markets or securitisations of mortgages. The Treasury Select Committee of MPs, which carried out its own inquiry, ‘The Run on the Rock’, noted that this was a sharp drop from a figure of nearly 63 per cent when the bank had demutualised and was low compared to other building societies which had converted to banks.
Put simply, Northern Rock needed financial markets to fund more than three quarters of its lending activities. And this borrowing from markets was much shorter term than the average loans made, typically 25-year mortgages. A householder will usually pay back a bank or building society at regular intervals over those 25 years. But the lending institution may well borrow to fund that mortgage over a much shorter period and keep repeating the borrowing every time repayment is due. In good times, that is straightforward. A bank can borrow short term at low interest rates and lend at higher rates to mortgage customers for longer time horizons. That way healthy profits are made and credit to keep rolling over the short-term loans is always available. But when those credit markets dry up, the short-term wholesale funding is suddenly no longer available. The lenders can no longer keep rolling over their own borrowing. That mortgage loan will not be fully repaid for another couple of decades. But the money the banks and building societies borrowed to provide the mortgage has to be paid back immediately. Northern Rock, like many others, was caught in this squeeze and found itself desperately short of funding.
The bank was also generating a high volume of short-term fixed-rate mortgages. These loans and others would be ‘warehoused’ every three months and placed into a Jersey subsidiary called Granite. They would be then be parcelled up and sold on via securitisations to outside investors. The money raised would subsequently be lent out for new mortgages, which were in turn bundled and the process repeated. The advantage for Northern Rock was that the securitised mortgages were ‘off balance sheet’, in other words, were not included in the loan book because they had been sold to outside investors. The strategy was to keep on generating new mortgages and to achieve that, the business had to grow. There was a constant need for momentum and expansion. If the production line stopped, the whole structure would become unstable. One senior policymaker said later that the model was unsustainable and would eventually fall over ‘like a car which runs out of road – a monster which was out of control’. Looking under the bonnet of Northern Rock, then, revealed a bank that might have been impossible to save even with a takeover or bailout.
Northern Rock was not the only bank to be teetering on the brink of disaster because of the near-closure of credit markets. Four German banks at various stages in August and early September 2007 were revealed to be struggling because of exposures linked to the sub-prime market. The largest US sub-prime lender, New Century, had filed for bankruptcy protection back in April. But Northern Rock was to be the UK’s first casualty and one that would have a much higher profile than the plight of institutions in other economies. As noted above, it was the televised images of the queues which brought the Rock’s problems onto the global stage and dented the UK’s reputation for financial competence. Since then a debate has raged over whether Northern Rock should have been better handled by the regulators and whether, even if it had been placed in some form of ‘special measures’, the queues and ensuing bank run could have been avoided.
Northern Rock’s vulnerability was certainly known about by British regulators before the wholesale markets started to implode in August 2007. The problem was that nobody seemed quite sure who should be responsible for dealing with it. The Labour government had reformed banking regulation soon after taking office in May 1997. The Bank of England, after a series of embarrassing failures such as BCCI and Barings, was stripped of its traditional sole responsibility for overseeing banks. This was handed to a new body, the Financial Services Authority. The Bank was tasked with the job of maintaining and monitoring financial stability without direct powers to tell financial institutions how to behave. In the years of steady economic growth and easy credit before 2007, the FSA was principally focussed on consumer protection. A light-touch approach to regulating banks, backed by all the main political parties at Westminster, was seen as the most appropriate stance. After all, the City of London was a world-renowned financial centre and an important source of jobs and wealth for UK plc. Heavy-handedness by the regulators, it was widely agreed, would make it more likely that international banks would scale back their UK operations in favour of investment in more liberal centres elsewhere.
The Bank of England, for centuries the guardian of financial rectitude in the famous Square Mile of the City of London, had other fish to fry in the years leading up to 2007. Stripped of the responsibility to monitor the health of the banks and prescribe remedial action by individual institutions, the Bank focussed on its core mission – control of inflation. While the decision by the new Chancellor Gordon Brown in 1997 to transfer bank regulation to the FSA rankled at the highest levels of the Bank of England, there was great satisfaction at being handed full independent control of monetary policy. And no one was more satisfied than Mervyn King, then Deputy Governor of the Bank and before that its chief economist. Control of interest rates and a mandate to keep inflation at a target rate of 2.5 per cent (later amended to 2 per cent on a different inflation measure) was the ultimate train set for a monetary economist to play with. And King was the country’s pre-eminent monetary economist at that time.
There was no doubting Mervyn King’s academic credentials. His family background was modest – his father was a railway clerk who retrained as a teacher. After Wolverhampton Grammar School he progressed to King’s College, Cambridge, taking a first in economics, before a master’s and then a stint as a Kennedy Scholar at Harvard. His teaching career including a spell at Massachusetts Institute of Technology where he shared an office with Ben Bernanke, who later became chairman of the US Federal Reserve. After seven years as a professor at the London School of Economics, he joined the Bank of England as chief economist in 1991. King was one of the architects of the inflation-targeting regime adopted soon after Britain crashed out of the European Exchange Rate Mechanism in 1992. It was formalised with Bank independence in 1997 and has remained in place ever since. King ascended to the post of Governor, succeeding Eddie George, in 2003.
King was certainly a brilliant and widely respected economist. But to say that he did not suffer fools gladly was an understatement. He was, with good reason, supremely self-confident about his own judgement on economic affairs. Differing with him on such matters was likely to be met with a stern riposte and intellectual counterblast. One senior banker, preparing for his first meeting with King, asked for guidance from a Bank of England contact and was told not to disagree with the Governor. The banker laughed and suggested that might be difficult at times. The response from the Bank executive was ‘No, you don’t understand, do not disagree with him – he really doesn’t like it’. Another leading player in the City who sat on the Bank of England’s governing body, the Court, recalled the atmosphere inside the Bank during King’s governorship: ‘It was like boarding a plane – anyone with a double first in economics turn left and everyone else head off down to the right.’
The Governor had a frosty relationship with some close colleagues at the Bank. Paul Tucker was a Bank of England ‘lifer’ who had worked in almost every part of the institution. He was head of the Bank’s market operations, had an easy-going affinity with City bankers and was well-respected by leaders of the financial community. But he and King had not seen eye to eye for some time. At the height of the crisis they just about rubbed along together, doing the minimum required to maintain the right degree of professionalism. They may have worked together for many years but Tucker continued to address his superior at the Bank under the traditional title, ‘Mr Governor’, as did others who were part of the Bank hierarchy. Tucker was later to become Deputy Governor covering Financial Stability.
The Governor looked every inch the economics don rather than smooth City slicker. Owlish in appearance, he wore round-frame glasses which had thick lenses, giving him a beady-eyed aspect that could be quite unsettling in discussions about policy or high-level economics. King was a music lover, an enthusiasm he shared with his wife Barbara, a Finn. They were students at Cambridge and then lost touch. Thirty years later she called him from Finland, having recently divorced her first husband. King later told the BBC: ‘We met at Frankfurt airport and I felt exactly the same about her as I had in 1970 – the moral of this story is never change your telephone number.’
King’s enthusiasm for sport was well known to journalists who sat through his press conferences and others who listened to his speeches. Sporting metaphors and allusions would frequently be woven into complex arguments about economic policy, sometimes leaving lesser fans scratching their heads. As a lifelong Aston Villa supporter, football was one of his passions. In one speech King managed to compare a brilliant World Cup goal by Maradona against England to the conduct of monetary policy – the Argentinian star had run in a straight line while the England players moved left and right anticipating what he might do rather than what he actually did.
Cricket was another passion of the Governor. He took great pride in selecting former Test stars, including Graeme Hick and Andrew Strauss, to join his team for the annual match against the Bank of England’s regular side. He would tell colleagues, only half-jokingly, that such a prerogative was highly likely to ensure victory for his Governor’s Eleven. It was tacitly accepted by the Bank’s team that getting the Governor out cheaply or smashing his slow left arm bowling around the ground was not the done thing. Watching his county (Worcestershire) play or keeping tabs on England’s progress in Test Matches were always King priorities. He devoted time and energy to a cricket charity which aimed to promote the game in state schools. The Governor was sometimes criticised for popping up in the Royal Box at Wimbledon while some financial crisis was raging. This always seemed a trifle unfair as King was on the committee of Wimbledon’s All England Club and would make only brief visits to the tournament.
The Governor had little time outside work, sport and music for socialising in the City. He recoiled from the idea of glad-handing bankers. Senior hands in the City remembered with exasperation being invited to a dinner with him in Threadneedle Street. They were bewildered when King stood up after the starter and said he had to leave to deal with important business, leaving his guests to continue with the rest of the meal. When the crisis descended on the Bank in August 2007, the banking industry was frustrated that the Governor seemed aloof and unsympathetic to their plight. They felt that Eddie George and his predecessor, Robin Leigh-Pemberton, had been more willing to hear them out, often over a whisky in the Governor’s parlour. They believed the Bank of England’s job was, at least in part, to stand up for the interests of the City of London and that the Governor was failing in his duties. King – and he probably had considerable sympathy beyond the City – never felt it was his responsibility to look after the trade union of bankers or follow their agenda.
In the midsummer of 2007, all seemed well with the world. The economy was growing steadily, with six successive quarters above the long-run average rate of expansion, and inflation was gliding down towards its 2 per cent target. Mervyn King could reflect with some satisfaction that the Bank was getting its job done, quietly and efficiently below the radar of most political and financial comment. And that job, as far as King was concerned, was keeping the lid on inflation. Monitoring conditions in the banking markets with a view to maintaining financial stability was not something the Governor gave much thought to.
Gordon Brown’s long campaign to take the mantle of Prime Minister from Tony Blair had finally borne fruit in June 2007. He moved from the Treasury to 10 Downing Street and appointed Alistair Darling, a long-standing ally from Scottish politics, to the post of Chancellor. A shake-up of junior ministerial posts saw Kitty Ussher join the Treasury. A professional economist and former adviser at the Department of Trade and Industry (as it was then named), she had been elected as Labour MP for Burnley in 2005. Ussher’s ministerial brief was to cover the City and financial markets and soon after her appointment she was invited to the Bank of England for a ‘get to know you’ breakfast with the Governor. King was pleasant and welcoming but suggested there was not much to talk about in areas covered by Ussher’s post. Financial stability, he suggested, was a low priority and there were no obvious problems looming. The Governor noted that the team at the Bank covering stability in markets had been cut back as there was a reduced need for their services. Ussher was surprised, but acknowledged later that ‘we weren’t on the case either’.
By late July, though, a stronger breeze was ruffling the calm waters around the Bank and the City of London. The sub-prime mortgage woes of the United States were beginning to be seen as a threat to markets on both sides of the Atlantic. The scale of losses at the stricken Bear Sterns hedge funds was becoming clear. The Federal Reserve chairman, Ben Bernanke, warned that losses linked to sub-prime could mount to $100 billion. World stock markets wobbled and shares plunged in the final week of the month. That same week saw Northern Rock announcing an upbeat set of half-yearly results, mortgage sales up by 47 per cent over the year and an outlook described as ‘very positive’. But some senior policymakers were having doubts about the Newcastle-based bank.
Northern Rock’s funding model and vulnerability was well known amongst regulators. A share price fall of 10 per cent on one trading day in June, following a management warning that funding costs were rising, showed that there was nervousness in the market too. The Deputy Governor of the Bank of England with responsibility for financial stability, Sir John Gieve, was among those in the high level group known as the triparite (the Treasury, Bank of England and Financial Services Authority) who had been aware of the issue since the previous year. Gieve was an affable former civil service mandarin. At the Treasury he had worked for Chancellors Lawson, Major and Lamont, and then had taken the top job at the Home Office. His tenure, at a department where damage limitation was often the main focus of efforts, had been undermined by rows over foreign prisoners not being deported after serving jail sentences and management of departmental funding. Gieve knew his way around government and had long experience of financial policymaking but had a difficult relationship with the Governor, probably reflecting King’s disdain for financial stability issues.
Staff at the Bank had drawn up a paper in the autumn of 2006 highlighting the vulnerability of some British banks to the possibility of the wholesale funding market drying up. Officials ranked the banking institutions in order of exposure to this credit market. Alliance & Leicester was at the top of the list because of its reliance on short-term borrowing from other banks and financial institutions. Northern Rock was a bit lower down because it depended more on securitisation – the bundling-up and sale of mortgages to raise money to lend to new customers. Securitisation at that stage was seen as a more stable source of funding than inter-bank borrowing. When the credit crisis struck the markets the following year, however, Northern Rock was forced to resort to short-term wholesale borrowing. This paper, signed off by Sir John Gieve, was sent to the FSA. It was duly noted but no action was taken. The Bank of England’s Financial Stability report published in April 2007 had talked in more general terms about the risks of banks’ reliance on funding other than customer deposits: ‘Securitisation still leaves the UK banks exposed to a deterioration in market conditions. If they were unable to securitise existing assets, new lending would need to be financed through other wholesale sources, which may be difficult or costly to access during times of stress.’
Gieve was ultimately responsible for the Financial Stability reports, published bi-annually. He had asked Bank staff working on the analysis to produce a slimmer, more readable document than hitherto and one which was more accessible to the markets and the media. He later reflected that the Bank did not realise at the time how telling the analysis was: ‘We did spot elements of the vulnerability quite well but we didn’t see how big or how imminent the threats were.’ With hindsight, he admits they should have done more to highlight their opinions with counterparts at the FSA and in the Treasury rather than writing reports and then not following them up. The problem at the time, though, was that there was an assumption at the highest levels of the Bank that their responsibility was to flag up concerns rather than to take action.
The FSA later owned up to failings over the policing of Northern Rock before the crisis. In March 2008, it published details of an internal performance audit. The chief executive, Hector Sants, said at the time: ‘Our supervision of Northern Rock in the period leading up to the market instability of last summer was not carried out to a standard that is acceptable.’ A litany of errors was set out, including neglecting to hold enough meetings with Northern Rock and to follow up concerns about the funding model. A high turnover of regulatory staff, some lured to higher paid roles in financial services, was also cited as a factor in the failure to hold the bank to account. Sants, however, argued that it was impossible to say whether the FSA’s failings affected the outcome at Northern Rock. Defenders of the FSA have consistently argued that it was not the only global regulator caught short when the credit markets froze. They also stress that political leaders of all parties wanted light-touch ‘principles-based’ regulation rather than the heavy-handed enforcement of rulebooks.
The complacency of regulators infected Northern Rock itself. The bank had ploughed on through the summer of 2007 with few reasons to be concerned about the future. The chairman was Matt Ridley, an intellectual scion of an aristocratic Northumberland family. He was the nephew of the late Conservative Cabinet minister Nicholas Ridley and would later inherit the title Viscount Ridley on the death of his father, who in his time had also served as chairman of Northern Rock. Matt Ridley, who was tall, bespectacled and looked suitably boffin-like, had worked as a journalist and written extensively on zoology and political philosophy. By his own admission he saw himself as a non-executive chairman without banking expertise and relying on seasoned operators in the financial world serving as non-executive directors.
Ridley and his non-executives had discussed Northern Rock’s funding model from time to time. They were aware that the bank was heavily reliant on wholesale markets functioning normally. But on each occasion someone in the group had pointed out that regulators seemed unconcerned and if they were not voicing any worries there could hardly be any reason for the bank to change policy. A friend of Ridley’s from a business background had warned him that the bank was dangerously exposed. But that was the only Cassandra-like voice. The Northern Rock chairman had a good relationship with Mervyn King as the Governor had read some of Ridley’s books and warmed to a fellow intellectual. A dinner with King in early 2007 attended by some of the Northern Rock directors had got round to the subject of liquidity in the system. The Governor had not demurred from a consensus that there was no obvious threat to the smooth operation of that part of the financial machinery.
When the financial volcano erupted on Thursday 9 August and the European Central Bank pumped emergency liquidity into the markets, British policymakers did not make much noise. As a deliberately planned strategy it might have had some merit because of the need to maintain calm and refrain from excitable media interventions. But the truth was more prosaic – the Chancellor was on holiday in Majorca and did not know what had happened till he caught sight of a Financial Times the next day. Kitty Ussher was on duty at the Treasury but she was on other business on the day in question. Like Darling she realised there was a problem in the markets only when she picked up a newspaper the following morning while waiting to do a radio interview at the BBC’s Westminster studios. Treasury officials had not thought it necessary to disturb the Chancellor on holiday or provide a briefing note to the junior Treasury minister.
At the Bank, King was in his office and monitoring developments. The previous day he had told journalists at the quarterly Inflation Report media conference that ‘our banking system is much more resilient than in the past’, though he did not deny that he and other Bank policymakers had discussed developments in the markets at some length. Gieve was away. The Deputy Governor’s mother had died and he had been organising the funeral. After that he took a long, planned holiday. Gieve phoned in each day and offered to come back from his leave but was encouraged by the Governor not to break his trip as there was no evidence at that stage of a systemic crisis. The Bank had been taken aback by the speed and scale of the European Central Bank’s response on 9 August. Some senior sources in the tripartite believed the ECB had panicked by turning on the funding taps that day and claimed later that the US Federal Reserve had been furious. The ECB, it was argued, had generated a sense of crisis with its unexpected and large-scale intervention.
The following day, Friday 10 August, saw a stock market rout and the beginnings of a severe contraction in the availability of short-term bank funding. Federal Reserve policymakers had taken a similar stance to the Bank of England at their regular meeting three days previously. They had held interest rates and played down the idea that the sub-prime drama might hold back what was otherwise a growing economy. By that Friday, though, it was all change at the Fed and emergency funding was being hosed into the US market with one of the central bank’s lending rates reduced. The Bank of England did not follow suit. There was no special extra liquidity operation. It was not long before Mervyn King would face a rising tide of criticism for refusing to turn on the Bank of England’s taps to flood a credit market that was drying up.
Crisis or no crisis, it did not take long for Northern Rock to realise that the game had changed dramatically. The bank was preparing to launch a new securitisation exercise that would see another tranche of mortgages sold in the markets to raise funding to cover impending liabilities and new lending. But that was several weeks away. In the meantime, plans to raise short-term funding had suddenly turned sour. Persuading lenders to roll over loans rather than demand repayment had become considerably more difficult. The inter-bank funding market had seen benchmark lending rates, known as LIBOR, escalate over two days. Northern Rock was going to have to use those markets to keep plodding along but they had become dramatically more expensive.
The Northern Rock board decided quickly that a takeover by a bigger bank was their only escape route. The bank’s brokers were instructed to put up a ‘For Sale’ sign and find buyers. Barclays, RBS and Santander were all approached as obvious candidates for a deal with Northern Rock. But the timing was unfortunate. All three potential suitors were embroiled in another corporate battle, as bidders for ABN Amro. The message back to Northern Rock from all three of the banks was positive but with a suggestion that the issue be postponed until October, by which time the ABN Amro situation would be resolved. But October would be too late for Northern Rock. It was another piece of bad luck for the Newcastle bank.
In the week beginning 13 August, the Rocks’ bosses were contacting the FSA to alert them to their problems. The bank regulators, however complacent they might have been in the months before, were now on high alert. Northern Rock was code-named ‘Elvis’ and the Newcastle headquarters ‘Memphis’ as FSA executives began to draw up contingency plans. Matt Ridley, given his personal rapport with Mervyn King, put in a call directly to the Governor to notify him of the bank’s troubles. The Northern Rock chairman was anxious not to spook the Governor while not downplaying the board’s concerns – he also wanted politely to enquire whether the Bank of England might do more to boost the supply of liquidity.
King’s response was surprising. He quoted the Nobel prize-winning economist George Akerlof’s ‘The Market for Lemons’, a treatise based on the second-hand car market. The theory was that a seller should never under-price a poor second-hand car (known in the US as a ‘lemon’) as buyers would assume it was dodgy. If the price is too low, nobody will make an offer. King’s advice to Ridley was not to appear too desperate in the wholesale money markets by being prepared to pay more than others to secure funding. In the same vein as the ‘lemons’, nobody would be prepared to lend to Northern Rock if the interest rate looked too high.
Though few in the City beyond Threadneedle Street were thinking of lemons at the time, most bankers were aware that offering too high an interest rate in a stressed money market would raise eyebrows. Paying too much would smack of desperation. There was a clear incentive for a bank to talk down the rates it paid in the LIBOR market. These rates were reported each day to the compilers of the LIBOR data. It was an issue which exploded into scandal when it was alleged that Barclays was under-stating the rates it paid to borrow. An FSA investigation concluded five years later revealed that managers at Barclays had instructed staff who submitted data on borrowing costs to reduce the figures to avoid negative publicity in the markets. The findings resulted in total fines, including US regulators, of nearly £300 million. Other leading banks, including RBS and UBS, were also fined over LIBOR by authorities on both sides of the Atlantic.
From the middle of August, Northern Rock’s bosses were concerned about their predicament. But it would be another four weeks before its problems became public knowledge and its battle for survival as a private sector bank was over. Right up until the end of the month, the Rock’s directors hoped that the funding markets would warm up again and a mortgage securitisation might be possible. They felt they had enough cash to keep going at least until the middle of the following month. Within the tripartite group there was scepticism about that but there was still hope that a takeover by another bank might be engineered. The traditional way of doing things in the City was for the Bank of England Governor to call in members of the bank bosses club over a weekend, bang their heads together and leave them to come up with a lifeboat solution for whichever institution was in trouble. Older City hands remembered when the distressed bank Barings was rescued by ING of the Netherlands, with the then Governor Eddie George getting both sets of directors round the table at the Bank and a symbolic £1 being passed from purchaser to seller.
At the Treasury there was mounting frustration at what was perceived as Bank of England inaction. The Governor, it was felt, had the powers to intervene and boost the supply of funding to help Northern Rock under a blanket liquidity window opened to the whole market but was refusing to do so. As one source put it: ‘People would stomp up and down corridors saying “Bloody hell, the Bank must do this – we have got the risk and they have got the levers”’. Kitty Ussher was not the only one at the Treasury who was perplexed that the Bank of England was not making use of the extensive powers at the disposal of a central bank. On one occasion while in the car driving back to Westminster after a meeting with Mervyn King, she had discussed with a senior Treasury official the Bank’s apparent reluctance to get more involved. ‘What will it take to make the Governor change his attitudes?’, she asked. ‘Probably a run on a bank’, Ussher answered her own question flippantly.
A Bank of England-engineered solution involving a bidder being sounded out for Northern Rock looked tricky given the febrile state of financial markets. But feelers were put out to two would-be suitors, RBS and Lloyds. Interest at RBS quickly waned but Lloyds, at that stage cautiously run and well-capitalised, was certainly ready to do business with Northern Rock. For a little while, talks between the two over a rescue takeover proceeded smoothly. The difficulty was that the Lloyds board had identified a funding gap of £60 billion. Lloyds was prepared to cover half that liability but believed it needed a guarantee from the Bank of England to provide up to £30 billion of funding until the wholesale markets reopened and Northern Rock could finance itself again. This opened a hornet’s nest as far as the Governor and Chancellor were concerned. There was reluctance to extend credit lines to one bank in a commercial deal with another. This, it was feared, would penalise other banks who had not had the same opportunity to borrow on the same terms. And for King, the theory of moral hazard was a guiding principle – bailing out banks on less than punitive terms would only encourage the others to take more risk in future in the knowledge there was always a Bank of England safety net.
On 30 August, Ridley came to London for a meeting at the Bank of England. The FSA got to hear about it and demanded that he spend time with its senior regulators. The FSA was still hopeful that the Lloyds deal could be successfully negotiated and offered support to the Northern Rock chairman in his attempts to pursue it. But when Ridley sat down at Threadneedle Street with the Governor, he got a very different impression. King informed Ridley that the Lloyds offer was too low and Northern Rock deserved to continued as an independent business. The Governor had earlier voiced his confidence that Northern Rock would be successful with its securitisation exercise in September. Ridley left confused at the mixed messages he was getting from different parts of the tripartite authority and concerned that his bank would be allowed to fall between the different stools.
Up in Newcastle, there was still optimism that the Lloyds deal could be made to work and would get the nod from the authorities. Lloyds had a 100-strong team combing through the Northern Rock books in a specially constituted data room. The ‘Black Horse’ bank was known to be cautious. It had shied away from takeovers in the past and did not have the same aggressive approach as RBS. Late on Friday 7 September, Lloyds did begin to draw back. But, encouraged by the FSA, the talks were revived over the weekend with a Bank of England guarantee still on the table. Nervously, Ridley, the Northern Rock chief executive Adam Applegarth and other directors waited by the phone in the North-East. On the Monday came the call which they had dreaded – the tripartite authority could not approve the Lloyds deal.
Fingers were pointed at Mervyn King for refusing to agree to the request for a £30 billion loan. He later made clear that the Bank of England could not agree to such a drain on its balance sheet without the approval of the Chancellor. The ball, as far as the Governor as concerned, was in Alistair Darling’s court. If the Chancellor wished to give a guarantee to the Bank of England to backstop the credit line then of course it was possible to provide it. Darling’s recollection was that none of the other banks was interested in Northern Rock and that Lloyds never made a serious offer: ‘There is always someone sniffing around something – never at any stage did they come and say they were interested in even half an offer – if they had come and said they are serious about buying this that would have been helpful.’
An added brace of problems which contributed to the failure of the Lloyds plan was what should be revealed to financial markets and what might constitute state aid under European Union rules. As Northern Rock had told markets before 9 August it was confident of its sources of commercial funding, the fact that it now needed help from the authorities represented a material change in its circumstances. The secret talks with Lloyds would have to be declared to investors at some stage to avoid a false market for Northern Rock shares developing. EU rules might well bar such a large guarantee being given by a central bank to a single institution. In the end trying to make a takeover of Northern Rock work part-funded by the Bank of England proved beyond the wit of the regulators and lawyers. With hindsight, though, many have said the Governor, backed by the Chancellor, should have gone ahead and brokered a deal rather than bowing to the views of lawyers. The extent that the possible Lloyds bid was ever a runner fell at a fence some way from the finishing line.
The FSA’s chief executive Hector Sants was convinced a marriage could have been arranged, so avoiding the ensuing debacle, and he told the BBC five years later: ‘I think things would have been very different if the government and the Bank had taken my recommendation that they should provide liquidity support to Lloyds to purchase Northern Rock’. But some senior players at the Bank of England and the Treasury were never fully convinced. They have since argued that because the Northern Rock business model was so fundamentally flawed, a deal with Lloyds and support from the Bank of England would only postpone the day of reckoning. One senior regulator described it as ‘a bridge to nowhere’.
The Northern Rock train was now hurtling out of control of the regulators. The board threw in the towel and asked the Bank of England to act in its traditional role of lender of last resort. King and his colleagues agreed. On Wednesday 12 September, the Bank published a letter the Governor had written to the Treasury Select Committee chairman John McFall. King, in what seemed like a high-brow treatise, argued his case for not risking moral hazard by lending banks money just because they had made bad decisions about strategy. But one sentence tucked away in the letter appeared to make an exception:
“Central banks, in their traditional lender of last resort (LOLR) role, can lend ‘against good collateral at a penalty rate’ to an individual bank facing temporary liquidity problems, but that is otherwise regarded as solvent.”
The Governor appeared to be clearing the intellectual road to a bailout of Northern Rock. While rejecting the blanket demands for more liquidity that had been made by the banking industry, King was explaining how the Bank could make an exception for a single institution which was the victim of temporary and unforeseen factors rather than the legacy of rash lending. It was an elegantly written document, typical of King’s intellectual approach to banking and markets. But it would not save Northern Rock.