Date of Proceeding: 10.03.2008
Reference: 473 c52-4
Member: Lilley, Peter
Title: Northern Rock and Banking Reform
Description: I pay tribute to the hon. Member for West Bromwich, West (Mr. Bailey). He made a powerful point, to which the Government would do well to listen, about the dangers of producing a system of regulation that might have prevented the problem we have just experienced, but would create new problems for very different sorts of building societies. I also pay tribute to the Treasury Committee and its Chairman, the right hon. Member for West Dunbartonshire (John McFall), for the valuable report that provides the substance for today’s debate. It is slightly surprising, however, that it is the only substance for the debate.
Last time we debated Northern Rock we rushed through legislation, having been told that it was essential to set aside the normal process of parliamentary scrutiny so that steps could be taken rapidly by the new management at Northern Rock which would bring about a new situation. We expected those steps to be taken rapidly, and we expected some illumination to follow, although we were not given it at the time of the nationalisation debate. We expected to know more about the competition rules and regulations, and the approach that we would have to adopt. None of that has happened. We could have had proper parliamentary scrutiny at the time, but we were denied it, not because of the needs of the business but because of the desire of the Government to escape the embarrassment of prolonged debate.
I do not intend to pursue that point, however. Instead, I want to examine some of the factors underlying the problem of Northern Rock and the problems of the banking system, both nationally and internationally. Let me begin by mentioning a mistake which is so basic that no one in the Chamber has made or would make it, but which was commonly made by many commentators at the time when Northern Rock’s problems were exposed. They said “The problem is that Northern Rock has been borrowing short and lending long.” Well, of course it had: that is what banks do. If it had not borrowed short and lent long, it would not have been a bank.
It is intrinsic to the nature of fractional reserve banking that banks borrow short and lend long. Banks tell depositors that they can have their money back on demand or at very short notice, but in practice only a fraction of the people who deposit money at any one moment want it back, so the banks need keep only a fraction of the money liquid and in reserve. In normal circumstances, they will be able to invest long-term in less liquid assets. That is the nature of fractional reserve banking, but it is also why fractional reserve banking systems, although stable in normal circumstances, are potentially and intrinsically unstable.
If everybody decides they want to remove their money-as they have the right to do, and as the banks have promised them they can-they cannot do so because the banks only have a fraction of the money on reserve. We can draw an analogy with bridges: if people walk over a bridge in the usual random fashion it might carry 1,000 people, but if all those people march over it in step, it will collapse. The banking system can operate if some people are putting money in and others are taking money out, but if they all decide to take money out, it collapses, as we discovered when people formed queues outside Northern Rock branches.
It follows that there are only two possible approaches. One is the extreme but rigorous intellectual one proposed by people such as Murray Rothbard, which I do not think has many supporters in this House-apart, possibly, from the right hon. Member for Holborn and St. Pancras (Frank Dobson)-which asserts that fractional reserve banking is intrinsically fraudulent and that it should not be allowed or sustained. As a result, banks would find that they had to keep 100 per cent. of their assets in liquid reserves and would cease to be fractional reserve banks. I would not propose that view, but if we do not accept it, we must instead have a lender of last resort who is prepared to step in and prevent a bank from failing if there is the remotest chance of that bank failure spreading to other banks and causing people to want to withdraw their money simultaneously-to march in step rather than put money in and take it out in the usual random fashion-and that must be accompanied by deposit insurance. I think that the Bank of England might momentarily have forgotten that intrinsically it has to operate as a lender of last resort, and have thought instead that moral hazard overrode that position so it had to let Northern Rock go belly up. That cannot be allowed to happen; the lender of last resort is so important that it must at times override the concerns about moral hazard to protect depositors and to prevent the contagion of other banks-but not, of course, to protect the shareholders. There is no obligation on the Government or central bank to prop up the value of shares; people have put their equity at risk, and they know that they can lose it-and, as we are aware, there are, of course, equity risks in other areas.
Although we must accept this fundamental nature of the banking system, while we are looking afresh at our banking and mortgage finance systems, we might also look at the experience of other countries. The right hon. Member for Holborn and St. Pancras mentioned a point that I have previously made: the Spaniards have demonstrated that if banks are required to consolidate all their loans and operations, which we elsewhere have allowed them to take off balance sheet, they are less likely to go down the road that has led to the sub-prime crisis in most other countries. We might also look at what happens in Switzerland, Hungary and some other countries where mortgage loans are generally required to match more closely the term of deposits and bonds. That may result in slightly more expensive mortgages over their life, if short-term interest rates are on average a bit lower than long-term interest rates, but it produces a more stable system. There is a case for examining more closely what happens in countries that require that and which do not seem to have had these problems. They also do not seem to have had as much housing market inflation as our system has had.
The second fallacy that is frequently uttered in the public discussion of these issues is the suggestion that the credit crisis that we have experienced worldwide is caused by banks becoming more imprudent. If anything, the reverse is the case. The credit crisis has revealed the problem of imprudence at certain banks in certain cases, but it has not been caused by that. When the tide goes out we see who was swimming naked-we learn who forgot to put on their bathing trunks. The fact that they did not put on their bathing trunks did not cause the tide to go out. When the credit tide ebbed, we discovered which banks’ lending had been less prudent than others, but that less prudent lending did not necessarily cause the tide to ebb.
A third frequently made statement is that the problem was that banks chose to invest in risky assets when they should have put their money into safe assets. By and large, banks would have preferred to put their money into safe assets; they put their money into risky assets only because there were not enough safe assets with notable returns. Why were they being led in that direction? Why did they spontaneously and across the world start investing in more risky assets?
Mr. Mudie: Greed.
Mr. Lilley: No, it was not because of greed. It was because it was necessary that they be encouraged to do so. There is a systemic imbalance in the world economy. In China, above all, and in a number of other countries, the willingness to save and lend far exceeds the willingness to borrow and invest-it is extraordinary in such a poor country. That surplus of savings requires the rest of world, if there is not to be a deflation, to borrow more and save less than they would otherwise do in order to match that imbalance. That is what has happened: an outflow of savings from China has financed a huge deficit in the United States and other developed countries. That is the precise reverse of what one might expect to happen between rich and poor countries.
Ms Sally Keeble (Northampton, North) (Lab): I have listened carefully to the right hon. Gentleman’s interesting speech. Does he accept that a number of banks will say that they did not think they were investing in risky products because they were all given good ratings by the ratings agencies and that the products’ weaknesses emerged only afterwards, when it was, by and large, too late for the banks then to do anything about those products-or rather when the banks would say it was too late?
Mr. Lilley: The hon. Lady perceptively raises an issue that I am about to discuss. If she does not mind, I shall try to reach it by my own process, but as she realises, it is fundamental.
The imbalance of savings in China and elsewhere means that the rest of the world has to borrow and spend more, and it is encouraged to do so by decreasing interest rates. The reduction in interest rates means that people have to look around for things in which to invest all that cheap money, and there just are not enough high-yielding assets and opportunities in America, this country and other developed countries. Of course people look for the safest options and the best and most reliable yields, but they are being encouraged in this process.
If people had not spent and borrowed all that money, there would have been a deflationary tendency in the world economy, so let us not assume that there was an easy option-that they should just not have
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done it and they should have let the money pile up in their coffers. We would then have been complaining about the lack of spending, investment and borrowing to counteract the excessive piling up of savings in China and elsewhere.
Banks try to ensure that they have good collateral in circumstances in which yields are low; I come to the point that the hon. Lady was making. They think that bricks and mortar are safe, sound and robust. Bricks and mortar-buildings-may be solid, but the value of those assets is in itself a financial phenomenon, and it is partly driven by the weight of lending and borrowing that is taking place. People borrow money on the value of houses and that money then goes around the system, driving up the price of houses. When there is any check on that system, we suddenly find that the whole process is vulnerable, because the asset base used as collateral behind the loans that people have been encouraged to make starts to fall. That is what happened. The value of housing in the States fell, so the loans were not covered, and when people lost their jobs the mortgage institutions called in the loans and found that the value of the housing was not sufficient to cover them. That inherent instability means that when the whole party stops-when the spending stops driving up the value of the assets used as collateral to justify the loans-we find ourselves in a brittle situation.
I do not have a solution, but no one should pretend that the solution will be fiddling around with regulation. We will probably go through a difficult period; we may go through another cycle whereby the whole banking system is re-liquified by the central banks, and everyone thinks that that is jolly good and starts lending again. Unless and until the underlying problem of China’s saving too much and America’s running huge deficits is solved, we will be in an intrinsically unstable situation.
In the long run, we must move towards a situation where China uses its money to enrich its own people and America learns to balance its books and balance its own savings and investments rather than be the lucky recipient of poor countries’ money. Although the issues that I put before the House go far wider than the report, I hope that they will illuminate the further thought of hon. Members and the Committee on this subject and that the Government will take them into account when they think ahead, rather than imagine that a sophisticated system of regulation will solve the intrinsic problems of either the banking system or the world economy.