Voice from the City: Peston's Darling get's it wrong

Voice from the City asks if the end is nigh for the lender of last resort.

In his seasonal interview with the Financial Times on January 3rd, Alistair Darling appeared to propose the creation of an emergency response system to be triggered if banks seek to make use of the Bank of England’s lender of last resort function.  As the BBC business editor Robert Peston interprets him, “threatening tone…towards banks who might in the future follow the example of Northern Rock and request emergency funding”.  Indeed, Peston claims that one of the thoughts we should draw from the Chancellor’s interview is the following:

“Once any bank asked for emergency funds from the authorities, its board would no longer be in charge. The directors of the bank would lose their ability to direct the organisation as a condition of receiving help – and the rights of the bank’s shareholders would also be reduced in the process. That would prevent a recurrence of the extraordinary stand-off at the Rock, where the taxpayer is exposed to the tune of £57bn but where the power of the Treasury to direct the bank is highly circumscribed.”

There are many problems with Darling's proposals — not the least of which is that he only partially proposes to address flaws in tripartite system (though he has, belatedly, noted that not having a single ultimate decision-maker is a weakness, he is still not proposing to have the supplier of liquidity — the Bank of England — have supervision of solvency) and that he persists in believing that more extensive deposit insurance is an important and valuable part of the scheme.

However, I'€™ve noted these problems before, and the interesting new difficulty is that Darling’s proposals, at least as Peston interprets them, appear to represent the end of a proper lender of last resort function.

The old lender of last resort function was supposed to enable banks to get through short-term liquidity problems so that business could thereafter progress much as usual.  But under Darling's concept if a bank requests such emergency funding, its board loses control and the organization is thrust into ignominy under government control — broken up into pieces, with presumably all goodwill value in the company gone and with it all shareholder value.  Since shareholders stand to lose everything if they seek emergency funding under this scheme, that will mean that banks won't request emergency funding unless the shareholders have given up all hope of getting any money out of the institution. Indeed, in many situations it appears plausible that the shareholders might prefer to liquidate the institution rather than to seek emergency funding.  Alternatively they might be driven to attempt desperate gambles in order to obtain cash, thereby damaging their solvency. Is that really what Darling wants to achieve? I presume not.

Darling’s proposals are just kite-flying at this stage, and there is to be a consultation.  But it seems to me that (a) they don’t get to the heart of the issue, which is the lack of prudential supervision, liquidity provision, and takeover facilitation being concentrated in one institution; (b) they contain a number of misguided ideas such as deposit insurance, which will entail considerable additional regulation of UK banking; and (c) they won’t facilitate people in using lender-of-last-resort facilities in the future (and hence make liquidity-induced banking failure more likely, rather than less).  We should not tire of saying that anything other than an abandonment of Gordon Brown’s misguided tripartite system, for which he was so keen to take credit for so long, would not address the fundamental issue.  Does anyone really believe that it was a coincidence that, under the lender-of-last-resort system we have no bank run for well over a century, then once the system was introduced the first crisis led to a bank run?  Solution: You got it wrong, Mr Brown.  The only good way out is to reverse your previous error.  All these other ideas are just political face-saving at the expense of the UK financial sector.