Presented by Jonathan Ford and Neil Collins.
With Alistair Darling, Anat Admati and Dan Davies.
Produced and edited by Nick Hilton for Podot.
Additional editing by Ewan Cameron.
Sponsored by Briefcase.News
Hosted on Acast. See acast.com/privacy for more information.
Jonathan Ford 00:06
Hello, and welcome to a long time in finance with Jonathan Ford and Neil Collins, in partnership with briefcase dot news, the service that brings intelligent curation and analysis to your media monitoring.
Northern Rock is carrying on business in the normal way. And it can do that, because we have a stable banking system.
If they’re not in trouble, why are they having to borrow from the government. Nobody’s given an absolute guarantee that the money is safe in this bank.
Jonathan Ford 00:38
So, this is the second part of our series on the fall of Northern Rock. So in the first part, we talked about how a small ex-building society from Newcastle briefly became the most famous bank in the world. We also talked about how the crisis that failed it came out of an apparently clear sky and how it was caused by problems in the housing market in the US. Even though Northern Rock wasn’t lending to American homeowners. If you haven’t listened to it, I strongly suggest you do as it will fill in some of the background to the story that follows.
And as we discussed, this was a funding crisis. So a large part of the money Northern Rock used to back its mortgages didn’t come from traditional sources, like British retail depositors, but came from American investors, who suddenly found themselves exposed to huge losses from US subprime mortgages and were cutting back across the board. Northern Rock wasn’t the only bank that had become addicted to this sort of short-term funding, it was just a very extreme case, which was why it was a first in what was to become a long line of banks getting fiercely squeezed, as the investors pulled back on mass.
Neil Collins 01:48
There are a lot of other ingredients in this. But of course, the top of the list, as always, is greed and a belief that life would always go on the way it was, and they could get bigger and bigger.
Jonathan Ford 02:02
And your old bugbear, which is about this idea that you can have high returns without taking risks.
Neil Collins 02:08
Absolutely, it is not possible. You cannot have a higher return and a low risk. The two things are different sides of the same coin.
Jonathan Ford 02:18
So Collins iron rule number one. So at the end of the last episode, we talked about the official response, which initially was hesitant and slow. And this seemed at one point to be so behind the curve that it might even bring down the government as that then Chancellor of the Exchequer Alistair Darling told us. But in the end, the authorities did rally, and ended up guaranteeing northern rocks deposits and later nationalising the bank because no one else wanted to buy it. And critically, they also took powers to take over failing banks. And these subsequently became very important when the crisis spread to larger British banks, like Royal Bank of Scotland, and Lloyds the following year. And what became clear was pretty much all the banks were excessively leveraged, had funded almost all their assets with borrowed money, which has to be paid back on the nail, rather than equity, which can absorb losses, and that made them extremely brittle.
Neil Collins 03:14
When the dust settled on Royal Bank, which at one stage was the largest bank in the world by balance sheet, they discovered that its equity was only 3% of its total liabilities. So the liabilities could fall by 4%. And it would be bust.
Jonathan Ford 03:33
Well, as we’ll see, that’s not such an amazingly small number. But you must remember all of that you must…
Neil Collins 03:42
I do. I was there at the time, it was quite extraordinary. The market didn’t really know what the hell to make of it. But certainly, when it came out that Royal Bank was within hours of failing because it had run out of money. I think that’s what concentrated the minds of the politicians and realise that they actually had to step in, there was no choice – they couldn’t let the system go.
Jonathan Ford 04:07
Yeah, and guarantees and equity injections by the state would become one of the big features of the financial crisis. In this episode, we’re going to talk about the aftermath. And looking back 15 years from the collapse of Northern Rock, asked what lessons were really learned from this debacle. And are we in a safer world now?
Neil Collins 04:28
The answer is not obviously, yes, I’m afraid.
Jonathan Ford 04:33
So we’ll start – I suppose best place to start is with Alistair Darling, who was the chancellor during the time Northern Rock imploded. Now he, when he talked to us, was pretty clear on the main lessons he drew from the crisis, which was that banks did need more equity capital, and also needed to be more closely watched by regulators because markets were fallible, and well, you could never be sure what shenanigans bankers might get up to.
Alistair Darling 05:00
I think there’s a fundamental issue here. And that is, to what extent does government either directly or through its regulatory system, interfere or start instructing how businesses are run? You know, the classic if you like, right-way analysis; this has nothing to do with government, this is all to do with the private sector and the markets will sort it out. I think the difference here is, there’s two things. Firstly, the financial system is so integral to the survival, or the ability of an economy to flourish, that it is not something that the government should ignore, it has to put in place a regulatory system, that is its job to spot things that could go wrong. Now, you’d hope it would do that most of the time. But you know, you will make mistakes from time to time. And of course, in retrospect, looking at the surprisingly small amounts of capital, that banks were allowed to trade with – RBS is a classic example – that’s clearly something they got very wrong. Equally, if you’re looking back, why didn’t nobody, you know, looking at subprime mortgages, not think at the very least of the called subprime, there must be something a bit dodgy about them. So, you know, I think you can fairly point the finger at that. But you know, the case for regulation, I think, you know, 15 years later, I think, you know, certainly, banks are much better regulated than they were, then they carry far more capital.
Jonathan Ford 06:23
So more capital, better regulations. But who could argue with that, Neil?
Neil Collins 06:26
Absolutely nobody did at the time, it was a jolly good idea. But unfortunately, it was easy to say, but it was rather hard to achieve.
Jonathan Ford 06:35
Yeah, well, we’ll come on to the question of what exactly it’s been achieved. Apart from the rhetoric.
Neil Collins 06:41
You know, relying on regulators always sounds good, and you’ve got tough regulators. But to try and ensure that a regulator knows exactly what’s going on, when probably most of the people in the banks don’t know what’s going on, I think is asking much too much.
Jonathan Ford 06:59
I think that’s an important point. And the point is basically, if you have a system, which is so complicated, that people like you and I who at least have tried to understand a little bit about what’s going on, even be paid to do it. We haven’t got a clue. Effectively what you’re saying is that it’s all got to be delegated to some all-seeing genius in the FSA or the Bank of England. And do such people really exist?
Neil Collins 07:23
Of course they don’t. And if ever they emerge, one of the banks would very quickly and often enormous amounts of money to go and work on the other side of the line.
Jonathan Ford 07:33
I’m afraid we are in a world not a poachers turned gamekeepers, but the other way around, because that’s where the money is. Other people we spoke to also felt that all authorities had learned from the crisis. So Dan Davis, the banking expert, we spoke to pointed out that you simply couldn’t have a bank as fragile as Northern Rock was today because of specific changes that have been made to the regulations. Remember that Northern Rock collapsed after investors who are backing its 25-year mortgages with short-term funds suddenly pulled out?
Well, the regulators have since introduced something called the net stable funding ratio, which specifically prevents banks from borrowing so much short-term money to back long-term assets like mortgages. Let’s pause, and illuminate what has changed. Banks are supposed to hold more equity or loss-absorbing capital, which means they can survive a wave of losses when things go wrong. And some of the regulations will catch the sort of shenanigans that Northern Rock got up to. And then there’s a third element which is the willingness of the Bank of England to step in. And I think there Neil, I think we have to agree that there has been a change which is back in 2007, Mervyn King was very squeamish about stepping in because he felt the banks have behaved foolishly. But nowadays, that’s no longer the case, is it?
Neil Collins 09:43
I think that’s right. There were no mechanisms to take over a bank, essentially confiscated from its shareholders. I think that is a step forward that they can now do that. And also, I think that we’ve seen very recently that the bank has discovered that it really has a big stick if it chooses to use it. And we saw this with the, with the pensions crisis, threatening to buy up 65 billion pounds worth of long-dated gilts if necessary. So that I think is a step forward.
Jonathan Ford 10:22
But exactly that. So the bank, which had sort of stood aside and said, when Northern Rock was on its knees, you’re a bunch of very silly boys, and you should learn your lessons and eat some worms, now says, ‘Oh, my goodness, there’s a problem in the markets’, which indeed, there was in 2007, and steps in more quickly, to ease the pain. And as you say, I mean, that must make a crisis of the sort we saw in 2007, less likely than it was.
Neil Collins 10:53
Yes, I mean, each crisis looks slightly different from the previous one, no, two crises are the same. But nevertheless, I think, as I said a moment ago, this is certainly a step in the right direction , and will allow the bank to step in earlier.
Jonathan Ford 11:12
So okay, on the intervention point, well, we saw this recently, after the mini-budget, when the Bank of England intervened to bail out the pension funds. This was the point that was made by Dan Davis.
Dan Davis 11:23
It’s not the same dynamics as a bank run. But if you are facing calls for cash, while you’ve got assets, that you can’t turn into cash at a moment’s notice. That’s the same kind of problem as a bank run. And it’s noticeable that when that showed up, the Bank of England was a lot quicker to react. And then to point out that its reaction was time limited. And I think they learned a lesson about the tendency of people to remain in denial in liquidity crises, because Andrew Bailey then stood up to say, take the support when it’s offered, don’t regard it as an option. And you’ve got three days, and then it’s over.
Neil Collins 12:07
Jonathan Ford 12:08
Not everyone is sure that the system really has been made safer since it was than it was in 2007. So, Anat Admati is a professor of finance and economics at Stanford University business school, and an author of a book about the financial system called The Banker’s new clothes, which doesn’t sound very pro-banker to me.
Neil Collins 12:30
I would say she could be described as a thorn in the side of the banks.
Jonathan Ford 12:34
Yeah. Anyway, she argues that notwithstanding some of the changes we’ve heard about to the regulations in the UK, many of the pathologies that caused the Northern Rock crisis are still very much present in the system.
Anat Admati 12:48
The system hasn’t changed much at all. If you look at a number of indicators, like the size of the largest banks, like any measure of the interconnectedness of the system, at any way to gauge how much we really know about the system, and where trouble might start, and exactly how it will evolve in the market, we’re really nowhere that different than where we were back in 2007. So yes, there’s a lot been a lot of chatter about the tighter regulation. Yes, you can point to a few things that may have improved other things. Most things, even if they added rules, when you look closely, it’s not clear, they’re really worth all the trouble. So it’s gotten complex, and then we can’t evaluate even how good these rules are. And some of the most straightforward things that absolutely must be done, haven’t been done. So the bottom line is, no, the system hasn’t been reformed in terms of incentives of the people involved. They have the incentives that business people always have. You know, they follow the standard maxim make as much money as possible, you know, while maybe trying to obey the rule or try to find ways around the rules to do that.
Jonathan Ford 14:12
So I think here, we need to talk a bit about leverage, which is what an app is talking about here. And that’s the amount of debt in the system versus the amount of equity or capital that you know, is available to bear losses that may come through the system.
Neil Collins 14:26
Yeah. And the point about that is that equity can be wiped out without consequence, as long as there’s some left. Whereas a debt is an obligation which you have to meet.
Jonathan Ford 14:37
Yeah, you have to pay it on the nail. Now with Northern Rock, the leverage ratio, that it had reached something like 50 times in 2006, just before the crisis, and what that means is that for every 100 pounds of assets that it had, it could only afford to lose two pounds on the value of those assets before it fell into negative have equity or if things get really bad insolvency. So nowadays the rule on leverage is a bit better, but it’s still not exactly munificent. I mean, it’s 3.25 for every 100 pounds of debt in the modern banking system. I mean, some may do a bit better than that. But that’s it. That’s a pretty low hurdle to get over, isn’t it? I mean…
Neil Collins 15:20
I think it is. But if you have a bank where the assets that you’ve got our only worth 96 and three quarters percent of what you thought they were, yeah, on that basis, 3.25 is not enough. And you’re bust!
Jonathan Ford 15:49
Yes, not good news for the system, or the shareholders were bad news for them. That’s fair enough, but not good news for us as customers if the bank starts to fall into the same problems that they did in 2007, with the empty ATMs and all the rest of it.
Neil Collins 16:03
Yeah. Which is why of course, we now have government guarantees of retail deposits, which is, as I say, rather unsatisfactory way of dealing with the problem.
Jonathan Ford 16:14
Well, it’s a very Victorian view, if I may say so. But anyway, but the real problem with high leverage is is is that it leaves the system exposed to the sort of panic that ran riot through the whole banking sector in 2007 and 2008. And here’s an Anat Admati again, explaining this;
Anat Admati 16:34
When there’s a lot of leverage in the system. That means that the participants are very sensitive, their financial position, their health is very sensitive to small changes. If you bought a house with almost no equity, then you’re you can go underwater with a very small decline in housing prices. That’s the same as what could happen to corporations along the chain. And they can knock each other down from their connection, their contractual connections, as well as from that dynamic of a run. That then everybody attributes to liquidity problems, but in fact has to do with fears of insolvency or fears of default, along with a chain. And once you start being afraid – if you will have a way to get your money out, you will. And that’s the sort of run dynamics, that’s a feature. So if we want to prevent runs, as well as keep a system from unravelling on a short fuse, then we must really go for much reduction in the extent of leverage in the system. The way we have safety nets only encourages this recklessness.
Neil Collins 17:40
Leverage is not something which is confined to the banks, it is throughout the financial system. And oddly enough, it has popped up in the last place, you would expect to find it, which is in the pensions industry, pension funds are not allowed to borrow specifically, they have got round this by essentially buying the sort of derivatives, which in the event of a large movement in the price of government stocks suddenly require support in terms of more cash, and they may not have it, and which is why we had a scramble and a panic two weeks ago, the leverage will come out somewhere. And it comes out in all sorts of unexpected places.
Jonathan Ford 18:30
What is less surprising, I suppose is after 15 years of pretty much flat interest rates on the floor. It’s not surprising that investors have been chasing riskier high-yield investments to try and get their income up. And the trick in all of this is always that some clever intermediary from a bank or in this case, a pension fund consultant will tell them they can do this without actually taking any real risk. So we’re back on your great bugbear.
Neil Collins 18:59
Yes, I’m afraid so. The interesting point or one interesting point it seems to me is that you would have thought that if banks were making out like gangbusters because they had so little equity, that little equity would be very highly rated. Because the chances of a good return on it will be very high. In fact, ever since the crisis, banks have been very lowly rated, particularly in the UK, and the investors have fought shy of them, and been extremely careful to avoid chasing them up. And indeed, the recovery from the very lowest point is pretty modest, and it’s far… the prices are far below. Share prices are far below where they were before the crisis arose.
Jonathan Ford 19:49
This is a very interesting point and one where we had differing perspectives from the people we spoke to. Dan Davis, the bank expert who we talked to about, suggested the kind of weariness that the stock market had about banks was, in a funny way, a sign that the risks in the sector had subsided in that there were no great characters like Adam Applegarth, the boss of Northern Rock, making an absolute fortune and getting his stock price up anymore. And he explains, you know, that sort of sign that it become boring and normal again.
Dan Davis 20:25
I mean, Applegarth was quite an arrogant man, in my experience, but he was not some kind of aberration in the UK banking system at the time. We had Fred Goodwin, we had Andy Hornby. There were lots and lots of people who also believed and were told by others, that they were geniuses because it was a bull market – for a reason that Northern Rock and Royal Bank of Scotland and (inaudible). And all the crash of 2008 stories, thought they were great, and thought they could take as many risks as they liked, was because they were successful. They were delivering share price rises, year after year, they were delivering profit increases year after year. We don’t have any of those characters at the moment simply because who in British banking has got such a fantastic record of success that they’ve got any ability to be arrogant? You know, you look at the chief executives of the clearing banks right now. They’re just not the rockstars. I don’t even know who’s chief executive of NatWest right now, at some point in the future, banking will become profitable again. And that’s when we will get these sorts of characters back. Because my long-term answer is no, we haven’t really produced any cultural change.
Jonathan Ford 21:38
So the other perspective we got on this was came from a Anat Admati, you can imagine was a little bit more waspish about the bank sector. And she was convinced that the general moribund state ie the fact that these high declared profits didn’t lead the stock market to buy the shares very much. She didn’t think it was a good thing, she thought, effectively, what it showed was that the whole system was on its knees.
Anat Admadi 22:02
The banking system is actually has a lot of excess capacity. So they’re all fighting for survival, and their business model remains weak. In my actual diagnosis, if you want me to be the corporate doctor, they’re insolvent all the time, the fact that they even have a positive price is only because they can’t really fail. So the investors will not be down at zero. But on the other hand, you know, they’re supposed to absorb losses on risks that they don’t see. And the business model is poor.
Jonathan Ford 22:53
And I don’t know which one of these two do you think is more convincing? I’d say I’m bit on the side of Anat here.
Neil Collins 22:59
Well, if I had to jump one way or the other, I would say, look at the prices in the market. And they are telling you something that the bank numbers don’t tell you.
Jonathan Ford 23:11
So there are a couple of other things we might also want to think about here. A feature of the Northern Rock crisis and the financial kind of bailouts that happened afterwards, was of course, they involved a lot of public money and public support, which as we discussed in the first episode was quite controversial. But where we are now, of course, 15 years on, is that public debt in the UK has risen, thanks to COVID and other things to pretty enormous levels. So the idea that the government wants to start throwing another 50-100 billion to the banking sector to stop it collapsing would bit harder to imagine. Or are you still sanguine?
Neil Collins 23:52
I’m afraid I still think that that’s what would happen, if there was a real crisis in the banking sector, they would step in, and we would be faced with exactly the same position we are now in the public debt markets. The markets will buy a lot of UK government debt if they have confidence that the policy is sound. And of course, if you had to make very substantial bailouts for banks, then the only people who will pay in the end are the poor bloody taxpayers.
Jonathan Ford 24:26
Yeah. And the other aspect of this – do you remember there was a thing which people used to talk about in the naughties, which was a thing called the Greenspan put? And the idea of the Greenspan put was, every time the stock market went down, Alan Greenspan basically cut interest rates to prop up stock prices. So after a wild sort of investors, hedge funds and the like, figured out that there was no way that stock prices could ever fall. So they took more and more risks because they thought yipee, we’re always going to be backstopped by derailed Alan Greenspan. I think there’s a case to be made that with QE and other unconventional measures since 2008, we have sort of created the same thing in the financial system, the banking system, that the participants, the banks, pension funds, and others, kind of figure that they can never be allowed to be caught out by the market. Because effectively, every time anything goes wrong, the Bank of England or the Federal Reserve in the US will step in and bail them out.
Neil Collins 25:37
I think it depends on the size of the problem, I think that the authorities would be quite happy to see a few smaller businesses go bust and cause problems there. But I think you are quite right. In the current climate, I don’t think that any government either in the UK or the US could actually walk away from a seriously failing bank, or other financial institution, they would have to get involved one way or another, either by slashing interest rates again, or by an actual injection of cash from the, from the taxpayer. And I think that that hasn’t changed. There’s a lot to be said for it changing. But I don’t think that the political will, is there on either side of the Atlantic to do that.
Jonathan Ford 26:29
You know, the government increasingly, all the authorities increasingly look on the financial system as a Jenga tower, where they don’t want to pull any, any of the blocks out. I suppose the Federal Reserve in 2008, taught Lehman Brothers was a thing that they could afford to let go. But they discovered to their horror that they couldn’t, if things had really significantly changed, you would feel that there was less of a sense that we were groping in the dark with this formidably complicated system, which you didn’t want to knock anything over in case the whole thing crashed down your head. But I then actually honestly think that that’s where we are at all.
Neil Collins 27:05
The underlying problem is that in the last decade, there’s been a huge increase in borrowing generally, for mortgages, for gearing up to indulge in private equity. Now, wherever you look, there is too much debt, too much leverage. And I think that’s an understandable consequence of these ridiculously low interest rates, which might have been appropriate immediately after the banking crisis but have been inappropriate for several years now. And we are still clawing our way back to what I might describe as a more normal interest rate structure.
Jonathan Ford 27:49
Just to come back to the politics of all this, I think, if we do take the view, that government could have gone further, in reforming the system, it’s worth thinking about, you know, what inhibited them, you know, surely no prime minister or Chancellor would want to go through what Brown and darling went through in 2008. And I think here, the problem is just the scale of the financial system and, and how it remains such a hugely important part of the economy. And here’s Alice Adani, explaining how he sees it.
Alistair Darling 28:21
I was an Edinburgh MP, I live in Edinburgh, you know, I still do. This city was extraordinarily dependent upon the financial services sector, for employment for wealth, house prices, and all the rest of it. You know, equally, if you take the post-Brexit argument, are we going to find jobs, you know, going to Europe? We’re not seeing a great, great stage at the moment. But, you know, I think any government, you know, given that the services sector is what keeps Britain afloat, and where most of our revenues come from, you wouldn’t give it away lightly. To me, what it points to is making sure that that thing is properly regulated, and it’s properly supervised.
Neil Collins 28:58
It’s worth making the point that things have gotten a great deal worse since he left office, right through the system, there’s a great deal more debt.
Jonathan Ford 29:07
Well, I suppose if one’s to be fair to politicians, you know, really tough regulation is always going to be quite a challenge against such an effective and well-funded lobby as the banks, I’m sure you remember, in the immediate aftermath of the financial crisis, when there was a bit of bashing going on, as it were, the banks just simply turned around to the government and the Bank of England and others that well, ‘if you do impose all these tough regulations on us, we simply won’t lend any money anymore because it won’t be in our interest.’ And so they hold this gun up to the system. So we talked to Anat Admati, and she gave that whole idea a pretty short shrift.
Anat Admati 29:46
That’s ridiculous. They don’t even make loans with much of this money. It’s like a hedge fund. I mean, they, you know, when we unpack them into JP Morgan balance sheet for our book, they had over a trillion dollars of deposits. And what they call the loans was only 700 billion. So the marginal dollar doesn’t go to a loan. It goes, it sloshes around within the system anyway, it’s doing all kinds of things, it owns commodities, and who knows whatever else, derivative, other traded assets, that have nothing to do with lending to the real economy.
I mean, Adair Turner also spoke about, you know, how much of the whole system goes actually out to the economy. It’s a bullshit line. I mean, I like to quote, Paul Volcker on this, and I say the word bullshit because he said it. Paul Volcker told the senator back in 2010, anytime you threatened to do anything, the banks will always say it will harm, credit and growth. And he said to him, it’s all bullshit.
Jonathan Ford 30:43
So 15 years on, we still have the super-sized financial system that feels pretty creaky. What’s your judgment, Neil?
Neil Collins 30:50
I’m afraid not fixed. The difficulty is, it is now so complicated and so large, that it’s impossible to say where the next crisis will come from. And I do think that we will have another one. And I think that putting our faith into regulation is a comfortable delusion.
Jonathan Ford 31:13
I think that’s true… I think… I think… I didn’t want to stand on end on a note that’s too chilling. But I would say we are now, why it’s worth thinking about these things now, is that we are at a, a more dangerous point in the cycle, the cycle where interest rates start going up after a very long period of being low and quiescent. And that’s the point at which as an asset, as Admati points out here, that bad stuff can start to happen.
Anat Admati 31:47
Stand back is what I say because interest rate increases have been at the sort of pre crisis of many important crisis over the years over the decades, the savings and loans, international debt crisis, especially when sent different, you know, when people borrowing not their own currency governments… So you raise interest rates, and this system is going to start showing its fragilities. We already started seeing this, obviously in the UK, suddenly coming out of you know, pension contracting with you know, derivatives that require the, you know, a sort of stepping in of the Bank of England in an emergency basis in a reversal or let fall down of the government in the UK. And that may be just the preview, the canary in the coal mine, as they say, you know, the way we were talking about Northern Rock, we, you know, the events of the crisis 2007 to 2009 were already starting a year before. I mean, by spring 2007, summer 2007, the subprime crisis already started in terms of the housing declines in the US, and some of the ramblings related to that. Hedge funds like Bear Stearns were failing on and on and on, and then eventually, and there was an interest rate increase, just prior to that – 2004 to 2007, interest rates increased, and that exposed the fragility of the household sector, and then it started defaulting on the bank and a small decline and adjustment in housing prices took down the whole global system. With a system that we have that still, the same increases in interest rates could really cause major upheaval, major turmoil.
Neil Collins 33:34
I think that’s correct. The trouble is that 10 years is a long time in the city. 12 years is longer. And a lot of the people who can remember the time when we had serious interest rates have long since retired. And there’s a whole generation of people in the system who think that ridiculously low-interest rates were the norm. And you could borrow almost free money to do more or less whatever you liked. And in the last few weeks, we’ve had a rather rude awakening. And I fear that that has got some distance still to run before we get to anything that could be described as a steady state.
Jonathan Ford 34:16
And what we need I think, is people who have had a long time in finance. They’ve all buggered off!
Neil Collins 34:24
Leaving a poor a couple of poor journalists left to pick up the pieces.
Jonathan Ford 34:40
That was a long time in finance with Jonathan Ford and Neil Collins, editing and production by Nick Hilton. And our sponsorship partner is briefcase dot news. Join us again next week.