Rocking the market

The crisis at Northern Rock highlights both how people's lives depend on financial institutions and how irresponsibly these institutions are managed. Christopher Hird dissects the crisis, arguing that the left has the chance to press for new kinds of socially responsible financial institutions - and for new standards of personal (and political) financial literacy
January 2008

Just after the government's rescue of Northern Rock, I was at a dinner at the Institute of Economic Affairs. The IEA is generally described, especially on the left, as a 'right-wing' think tank - a soubriquet it resists, preferring something like 'free market'.

During the 1970s, in particular, its stream of pamphlets attacking state intervention and espousing market solutions for almost all areas of public policy made it a powerhouse of ideas for the Thatcher-led Conservative party and government. Today, with no substantial ideological divide between the main parties on the role of the market, the IEA does not have the political potency it once had. But one might still have expected there to be criticism of the government's meddling in the market by stepping into to save Northern Rock.

Around the table at the IEA were leading economists, former bankers, businesspeople, academics, newspaper columnists and so on. But none of them (with the exception of a young IEA staffer) thought that the government had made a mistake in rescuing Northern Rock. There may have been some argument about how it had been done, what the long-term consequences would be, but everyone realised that in our society, no government could allow hundreds of thousands of ordinary savers to be impoverished.

This pragmatism was in sharp contrast to the approach of the government, whose handling of the Northern Rock affair showed that it has still not got a handle on how to deal with the power of the financial markets. But it also raises important questions for anyone on the left who wants to have practical policies that tackle the role of financial institutions in our society, on which most of us to some extent rely.

Profit makers to profit takers
Once upon a time, Northern Rock was a modest but successful building society, which operated mainly in the north of England. Building societies were mutual organisations, dedicated to providing mortgages and owned by the people who saved with and borrowed from them. They needed to make profits to stay in business, but, in words they often used, they were 'profit makers, not profit takers'.

One should not be too dewy eyed about building societies. Over the years they had become large managerial organisations in which much of the original democratic impulse of their founders and constitutions had been lost. Their lending policies were excessively conservative, discriminating against the unmarried and the working class. Indeed, these were among the reasons why there was no great outcry to save the building societies when, in the 1980s, the managers of many of them decided to turn them into banks.

The arguments in favour of this process of 'demutualisation' were various but in reality the process was driven by the ambition of the managers, who saw the prospect of running big banks, not boring building societies. It was eagerly lapped up by building society members, who received windfall profits as their mutual organisations became shareholder-owned companies. One of the building society chiefs attracted by this was Adam Appleyard of Northern Rock, who successfully demutualised the society in 1997.



Although mutual organisations are far from perfect, they do offer the opportunity of a different form of business model - one for which profit is not the driving force and that could develop different types of accountability and participation. However, partly because far too many people on the left were stuck in traditions of socialism that focused only on the role of the state and of labour, there was no substantial attempt to save them. We are paying the price of that narrow vision today.

Freed from the constraints of being a building society, Appleyard set about trying to achieve his ambition of turning Northern Rock into one of the largest mortgage lenders in the UK. To do this he needed literally billions of pounds of people's savings and without a large network of branches across the country this was quite a task. He achieved it by a big campaign to attract online savings deposits - often at relatively high rates of interest - and also by relying on borrowing money from the money markets. The latter strategy was to be his and Northern Rock's undoing.

Money market deposits come from the vast sums of cash sloshing around in banks, international companies and other financial institutions. With the growth of globalisation, these funds are international and their key feature is their volatility - the money moves where there is the highest return and it can quickly move on if professional investors get nervous.

That is exactly what happened last year when, bothered by losses in the US mortgage market, the supply of short-term credit, which was so important to Northern Rock, started to dry up. Northern Rock had made the fatal error of lending its money long term - on mortgages - but had funded these disproportionately with short-term funds. So, when it found it hard to lay its hands on more short term funds, it had to go to the Bank of England to see if it could help out.

Foresight failure
Could all of this have been foreseen? The answer is, unequivocally: yes. Indeed, many people in the banking industry had been commenting on Northern Rock's vulnerability, but while the plan seemed to work, with Northern Rock's profits and share price rising, not many people listened to these warning sounds.

The people who should have been saying something were Northern Rock's shareholders, particularly the big institutional investors, who manage the savings and pensions of us all. Why did they do nothing? Largely because in the UK we still have a very strong tradition of the non-active institutional investor.

This failing of the UK financial sector was exposed and discussed last year in the rather unpromisingly titled book, The New Capitalists, one of whose authors is David Pitt-Watson, once finance director of the Labour Party and now a fund manager in the City. The book argues that the big investment funds should recognise that they are interested in the capacity of the companies in which they invest to generate sustainable profits in the long term - often the very long term. Therefore, investors should actively pressurise the boards of companies to change their policies if they do not make long-term sense. If the investors in Northern Rock had had their wits about them, they would have gone to Appleyard and pointed out the long-term danger of him building profits growth in the way he was. If they had done that, the crisis may never have happened.

But the obsession with profits growth often militates against taking the more sophisticated long-term view. The crisis in the US that provoked the problems at Northern Rock was the result of a combination of the professional ambition of people running banks over there and the demands from their shareholders for profits growth year after year. These pressures encouraged the banks to take greater and greater risks as they increased their lending - the best known example of which has been the much reported 'sub-prime' mortgage business in which money was lent to people with no incomes, often already heavily in debt and often on houses that were not even inspected.

Personal responsibility
Of course, we should always remember that no-one forced those Americans to borrow money they could ill afford - just as no one forces us to have credit cards and (unlike the pre-war and immediate post-war generations) we freely choose to buy things on credit, rather than save for them. So, although Northern Rock does make us ask questions about the forces that drive businesses, it should also make us ask some questions about our own behaviour as consumers and citizens. And whereas once many of the left would think that the regulation of financial markets and the interests of consumers was not an appropriate area of interest, that is certainly not now the case.

One of the many consequences of the economic and political changes of the past 20 years has been a withdrawal of the state and employers from providing things such as pensions and the increase in the individual having to take responsibility for them. The blunt fact is that many people are disturbingly ill-informed about the risks they face. Recent work by the Financial Services Authority showed a widespread ignorance among the holders of ISAs (which are widely held by people of modest means) about the risks they faced. People queued up to withdraw their money from Northern Rock because they thought they would lose it, even though Alistair Darling's initial statement made this extremely unlikely.

Of course, Darling did botch the whole job. He should have given an unequivocal guarantee that all deposits would be safe - which in the end he was forced to do. He hung back from doing this in the first instance because he was advised that this would amount to a carte blanche to the whole of the financial sector that the government stood behind all its deposits. This would create what bankers refer to as 'moral hazard' - encouraging banks to take risks without regard to the consequences. But the reality is that whatever the textbooks may say, there are a complex series of forces that would stop banks going mad just because one rather rogue company had been saved. The people at the IEA dinner understood this, even if Darling didn't.

What next?
So what happens now? In the short term, the chances of Northern Rock being taken over by the government, or by a government-backed rescue, are very high. Already the bank is largely financed by the special loans from the Bank of England. If this happens, then the government just has to make sure that this takes place on good terms for the taxpayer and that it acts imaginatively with regard to Northern Rock's future. This would be a chance for the government to increase the diversity of financial institutions by doing something other than re-selling it to the highest bidder. It would be a chance to create a major institution, which, while profitable, is not driven simply by the need to maximise profits. An example of social entrepreneurship.

In the medium term, the government will almost certainly increase the formal protection for savers, but the Northern Rock affair has highlighted something more important: there is a need to make us as financially literate as we are politically literate. We know that large companies are increasing centres of power, but we also know that they respond to public and political pressure.

This is a good thing - the more that large economic organisations can be forced into a social relationship with the society around them, the greater the chance of turning these organisations to a social purpose. But we cannot embark on such a political strategy if we don't know what we are talking about.

Improved regulation is important but, as with many things, it would be better still if the government helped us do it ourselves. So, for the left, one response to Northern Rock would be to demand the government promotes the socially active financial citizen as much as it promotes, for example, faith schools or academies.






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