The cycle of failure and self interest

Eleven months ago, as the run on Northern Rock began, the UK public was repeatedly assured that the bank was solvent. Today, we find out that the bank ran up losses of £585 million during the first six months of this year. Today, the authorities acknowledged that Northern Rock is bankrupt. They didn't say it explicitly, but their ghastly numbers left everyone in no doubt about the true financial position of this horrific bank.

If this was all, it would be bad enough. However, the Treasury also announced that it was going to convert £3.4 billion of debt and preference shares into ordinary equity to shore up the balance sheet. Added to this, we also found out that the wreck still owes the Bank of England £17.5 billion. These are not small numbers. The recapitalization is about 0.2 percent of GDP. The outstanding debt is about 1.3 percent of GDP.

How could one medium sized regional bank with a bank network of just 70 branches create such large losses? How did the taxpayer end up paying out so much money on such a marginal bank? Should we point the finger at the Treasury? Was the government respoonsible? Did the Bank of England fail to act? Certainly, all three are partly culpable, but their mistakes pale into insignificance compared to the FSA. Here is where the problems started.

Gordon Brown made a grave mistake separating financial supervision from the the Bank of England. The old system worked well for years and within one week of becoming Chancellor, he destroyed it. Nevertheless, he charged the newly formed FSA with the responsibility of overseeing the UK banking sector. Overall, the job description was clear; prevent banking crises.

Instead, the FSA feel asleep. They developed the disastrous doctrine of "light touch" supervision, which amounted to letting the banks do what ever they wanted. So when Northern Rock came out with its 125 percent LTV mortgage last spring, the FSA did nothing. It remained silent as Northern Rock went on a mad growth spurt, extending implausible mortgages to anyone who wanted one.

As a consequence of the FSA's appalling record, the UK is now facing the prospect of a systemic banking crisis. Northern Rock was not an isolated incident. A large part of the UK banking system is close to insolvency. Attempts to recapitalize it through new rights issues was a fiasco. Arrears are rising rapidly, and losses are mounting at an shocking rate.

Make no mistake, today's announcement was a taxpayer bailout. Moreover, Northern Rock wasn't the only bank creaking under the weight of stupid lending decisinos. Other banks will fail before this mess is finally sorted out, and the taxpayer will have to pay much more than £3.4 billion. Banking crises are always expensive and we have only just begun to pay.

Nevertheless, it would be some consolation if something positive came out of this experience. If only we could be reassured that in future banks would be properly regulated, and that this crazy cycle of housing boom and bust could be finally exorcised.

However, there is little prospect of this happening. Already, we see some newspapers talking up the next bubble. Banks are pressurizing the BoE and the government to guarantee mortgage debt. The whole focus of policy is on resurecting mortgage lending rather than sorting out the distortions that generate these damaging speculative cycles.

Vested interests have too much to gain from housing speculation. Once this mess is cleared up, the UK will be ready for the next housing bubble and we will start generating the same mess all over again.