February 18, 2008 | posted by Michael Baxter in Banking |

It’s so easy to blame the UK Government over the Northern Rock debacle, but the true blame lies elsewhere.

It is true the Government has made mistakes in the way it has handled the Northern Rock saga, but the big mistakes have been made by other governments, not to mention major financial institutions, over and over again – for many years. On most occasions the criticisms levelled at those responsible for these bigger mistakes have been modest, and those very same people who are now slamming the Government over Northern Rock, seem to be precisely the same people who have failed to see the bigger picture in the past.

Take a look at the major economic shocks that have occurred over the last few decades, and more often than not you find bank short-termism as being the main cause.

We all know how over-enthusiastic bank lending, overseen by management teams on bonuses related to short-term goals, has been the real cause of the current global financial crisis. In fact, this weekend private equity bigwig, Guy Hands made precisely that point. The Telegraph quoted him as saying there is too much bonus-chasing in the financial industry, and that rewards should mirror the remuneration packages seen in the private equity industry which, says Hands, tend to be related to longer-term performance.

But the current crisis is no one-off. Ten years ago, the global economy was rocked over a succession of disasters that were created in banks and hedge funds. You may recall, the root cause of the East Asia crisis was banks jumping over each other to lend to the economies of that region – until finally it all ended in tears. Then in the wake of that crisis the Russian economy fell, like a domino. Then later, in 1998, we saw the collapse of Long Term Capital Management (LTCM) – the hedge fund equivalent of the Titanic. LTCM was based on a formula designed by three winners of the Nobel Memorial Prize in Economics, and employed algorithms which were so clever that it was said the fund could not possibly fail – until, that is, it collapsed and nearly dragged the entire banking system down with it.

Back then the solution was in part a range of bail outs – and in part the economies of East Asia and Russia were made to pay for the banks’ mistakes.

The Fed slashed interest rates – it orchestrated a bail out of LTCM, and the IMF did enough to ensure the economies of Asia and Russia were able to repay most of their debts – albeit at massive costs to the economies of those regions.

If you rewind the clock back further, you will see a similar pattern; savings and loans crises, Mexican debt, Third world debt – each of these crises has two common denominators: reckless banks which seemed to be run by a management team who looked no more than a few months ahead – and then a bail out by the authorities.

Banks have been saved in the past because no economy can afford to see major banks fail – a true banking crisis can have a catastrophic effect upon an economy. In fact, in the scheme of things, the Northern Rock crisis is actually small fry, in comparison to some other banking crises that have rocked various economies over the years. (see note at bottom of article)

At no stage during the course of the Northern Rock crisis could the Government afford the bank going bust – the consequences would have been simply horrendous.

And yet, there has been a danger that in bailing out the bank, Northern Rock was not being sufficiently punished for its past mistakes – and thereby increasing the chances of another bank making similar mistakes down the line.

One of the factors that has enabled the capitalist system to throw up so much prosperity has been failure. Capitalism is like the force of evolution – it leads to a form of natural selection – and without constant failure, this could not occur. It is what Joseph Shumpeter – the one rival to Keynes’ claim to have been the top economist of the last century – called gales of creative destruction.

So that’s the dilemma facing the Government. A way has to be found to ensure banks and their management teams pay the cost of reckless lending – but at the same time governments do not want to see an economic recession – even a depression, arise from the fallout of a banking crisis.

Now consider all this in the context of what some shareholders in Northern Rock are saying. The talk is that some will be taking legal action – they are up in arms because the Government has refused to extend the bail out to them.

You can have enormous sympathy with the smaller shareholders – there are around 180,000 of them, many based in the Northeast, and many acquired their shares when the company went from being a building society to a bank.

But it is the hedge funds who seem to be complaining the loudest – the hedge funds who ploughed in money sure in the knowledge the Government would never let a bank fail.

And at last, a blow has been struck for making banks pay the price of their mistakes – it is only a small blow – and it is easy to criticise the way the matter was handled – but in nationalising Northern Rock, the government has done three things: It has helped avoid a major economic crisis – it has helped increase the chances that we taxpayers will get our money back, and at the same time it has penalised the men and women who own and run banks. Just maybe, in the future, British banks at least will be a little more reluctant to jump on the next banking bandwagon on a one-way trip to economic folly.

Editor’s note

Sweden suffered a major banking crisis in 1991 – and the cost to the economy – 6 per cent of GDP; further back in 1987 it was Norway that was struck, and the cost – 8 per cent of GDP. But in 19977, it was Spain which felt the horror of a full-scale banking crisis – and the cost, 16 per cent of GDP. Examples of other major banking crises include France (1994), Germany (1977), Japan (1992), the US (1984), but top of the order comes the UK (1974, 1991 and 1995).