Northern Rock should have been allowed to fail

Willem Buiter is quite right to criticise the Bank of England’s bailout of Northern Rock. The message to bank directors and shareholders is quite clear: “take big risks, and if they go wrong the taxpayer will pay for your mistakes, if they work, you can keep the profit”.

The impact on borrowers and depositors would have been fairly limited. Assets could have been sold, so borrowers would simply have ended up owing money to a different bank. The money raise should have sufficed to repay depositors and other creditors most of their money. Even if this was not the case the vast majority of depositors would have fallen within the limits of the Financial Services Compensation Scheme and would not have risked losing a penny.

Given that Northern Rock does not have many depositors, and most would have been within the Compensation Scheme limits, very few would have lost any money. If banks that have lent to Northern Rock lost money, that would have taught them too to be more cautious in future.

It was perfectly foreseeable that Northern Rock’s strategy of relying on borrowing in the wholesale markets (from other banks) rather than from depositors, could unravel disastrously if the money market became less liquid, or lenders demanded greater spreads.

The directors and shareholders should suffer the consequences. If Northern Rock had failed, the directors would have have lost their jobs, giving the directors of other banks a salutary lesson in reasonable caution.

The loss made by the shareholders would have also made investors less willing to fund risky lending for many years to come, further reducing the risk of another crisis like the current one.

If Northern Rock is “too big to fail”, how much more of a old do the major banks, which do pose a serious systemic risk, have on the Bank of England? What incentive do they have to lend with reasonable prudence when they know that neither directors or shareholders will suffer the consequences of risk taking?

2 thoughts on “Northern Rock should have been allowed to fail

  1. Is Northern Rock merely facing a liquidity issue? if so, perhaps the “bailout” is probably not bad.

    Another question: The Fed and the ECB injected liquidity into the banking system sometime ago. What are your views on that? particularly, the Fed’s decision to reduce the interest rate at its discount window.

  2. If it is just a liquidity issue, why can they not borrow in the market? They would have to borrow at a high rate, but that seems to be a fair penalty for the risks they have taken.

    If no-one was willing to lend to them at all…..

    I do not think we yet have the information to answer your second question. Even when we do, people like Buiter are better placed to answer it than I am.

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