In the aftermath of the disastrous run on the Northern Rock Bank during September 2007, the Bank of England began to realize the enormity of the calamity which had unfolded.
Instead of pumping money into the banking sector in order to avert the impending liquidity crisis, the Governor of the Bank of England signalled to the markets that banks which have become weakened by imprudent actions may be allowed to fail.
When the run on Northern Rock was eventually halted by a government guarantee to all depositors, there was pressure on the Bank of England to act in order to ensure that no other bank would be at risk.
Mervyn King, the Governor of the Bank, announced on 19 September a series of auctions designed to provide loan funds for a period of 3 months. The funds would be secured on a flexible package of collateral, including mortgages. The rate of interest would be 6.75%. US$20bn was on offer on each of the 4 auctions, during the period 26 September to 17 October, making a total of US$80bn.
Financial markets have been rife with rumours that several other UK banks are at risk. The most likely candidate appears to be Alliance and Leicester whose share price has fallen from GBP11 to GBP6 during 2007. The cause of the problem is the same as Northern Rock, namely, it requires significant funds from the wholesale market in order to top up money held from depositors. However, there are persistent rumours that larger banks, such as Barclays, are in trouble.
If these banks are in such dire straits, it is remarkable that there were no applications received by the Bank of England for the US$80bn of funds on offer.
Admittedly, the funds were being offered at around 6.75%. Compared to the bank rate of 5.75% and interbank rates of around 6.2%, the interest rate was not generous. However, if borrowing money at 6.75% for 3 months, and possibly longer, could ensure the survival of a bank and allow the directors to sleep at night, it is surprising that there was not a single applicant.
In a slightly different context, if homeowners, who had defaulted on mortgage capital repayments, were offered an interest only loan of 6.75% for 3 months, the offer would have been welcomed, and home repossessions would be reduced dramatically.
The reason why no-one responded to Mervyn King's offer is due to the collapse in confidence and credibility of the Bank of England.
Mervyn King justified the Bank of England's lack of intervention with respect to Northern Rock by reference to 'Moral Hazard'. By this the Governor meant that he did not wish to send a signal to other banks and financial institutions that the Bank of England would bale them out should they experience difficulties in the future due to poor policies or imprudent lending.
While it is useful for the Governor to caution banks against the dangers of risky business models and the dubious practice of making loans to customers with low credit status, it is singularly inappropriate for him to make such remarks during a banking crisis.
Prior to the crisis at Northern Rock becoming public, it is clear that Lloyds TSB wished to initiate buyout talks. It appears that they were seeking a Bank of England loan of up to GBP20bn over 2 years. This sum was roundly rejected. With the benefit of hindsight, this was a reasonable offer from Lloyds TSB as the Bank of England has subsequently handed Northern Rock some GBP28bn and the crisis remains far from over.
While Mervyn King was considering 'Moral Hazard', both the European Central Bank and the US Federal Reserve were quietly increasing liquidity in financial markets. Indeed on September 19th, the Federal Reserve cut interest rates by 0.5% from 5.25 to 4.75. This was followed by another cut at the end of October to 4.5%.
In addition to the stupidity of the policy, talk of 'Moral Hazard' seems a little peculiar. If the Bank of England was planning to open a massage parlour or lap dancing club in Threadneedle Street, then this may well constitute a moral hazard for Mr King and his colleagues at the Bank of England.
Mr King also made several references to the desirably of 'Covert Action' in dealing with the Northern Rock crisis, but claimed that he was prevented from acting in this way by UK legislation. This was an odd claim as neither Mr King nor his colleagues are on record as pointing this out during their 10 years of independence from the UK Treasury. Perhaps Mr King was slightly befuddled and was confusing his role with that of MI5 or the CIA.
However, the main impediment to any bank taking up the Governor's offer was that the guarantee of confidentiality was not deemed to be worth the paper it was written on. Based on the culture of blame and leaks from the tripartite agencies of the Bank of England, the Financial Services Authority and the UK Treasury, no bank was prepared to take the risk of borrowing a large sum from the Bank of England.
The essence of banking is confidence. Unless depositors consider their funds to be safe, there will be a run on any bank, no matter who it may be.
Should a bank's need for cash become public, then the bank may unwittingly invite a run on its funds. A leak from the Bank of England would transform a crisis into a disaster. The bank would become a second Northern Rock.
Finance 
