Definitive proof that the Bank of England saw the financial crisis coming

Looking back in our archives this Christmas I came across a rather important article which I had half forgotten about. It dates from 2006, when the credit crisis was a mere apple in the financial system’s eye and the City was enjoying one of its biggest booms in history. The article, which can be found here, reveals that the Bank of England knew precisely what risk was posed by the dangerous build-up of debt which was brewing in the economy.

More strikingly, its Financial Stability Report from 2006 was as far as I can tell the first major institutional missive explicitly warning about the dangerous funding gap building up in the British banking system.

As we wrote in our City Comment that day: “One statistic in particular shows precisely how exposed the City is to the bursting of the household debt bubble. At the beginning of 2001, our banks were not lending customers any more than the total amount of deposits they held. By the end of 2005, banks were lending customers £500bn in cash which simply wasn’t in the vaults. Should customers default on their loans, these banks could be in trouble, having to resort to borrowing chunks of money at penal interbank rates.”

Not only did the Bank’s report, which can be found here (page 28 is the one on the funding gap – p30 on the pdf version), lay out the City’s increased reliance on wholesale funding – it also warned that this leaves banks extremely vulnerable in the event of a slowdown. Now, the Bank was not the first to diagnose the seeds of the crisis: there were one or two hedge funds which were already trading on the likelihood of a UK banking breakdown caused by this reliance on securitisation. There were plenty of commentators warning on the excessive build-up of debt. But as far as I can tell this was about the earliest warning on the problems inherent to the UK mortgage market.

The report completely debunks the notion that the financial crisis came as a surprise to the City, or indeed the Bank. The Government had been warned explicitly not by some crackpot economist but by its own employees in Threadneedle Street about precisely how the crisis could erupt. Not only this, but the report also revealed that its “war games” plotting out scenarios including a credit crunch revealed that a debt-fuelled crisis could cause a severe UK recession, a 25pc fall in house prices and a wiping out of a third of banks’ tier one capital – around £40bn at the time. It is difficult to think how it could have made more noise about the possible risks the debt build-up entailed.

Of course, the eventual crisis has been far greater than even this worst-case scenario, but remember that this was a warning delivered more than a year before the securitisation markets broke down in August 2007. Had it been heeded in Government, Northern Rock – not to mention the rest of the banking system – could very possibly have been saved from complete collapse. The UK could have been let off with a mild rather than severe recession. House prices could have been brought back under control, rather than booming again for another breakneck year of growth.

But this was not to be. As it was, 2006 was the year in which the credit bubble was blown well and truly out of proportion. Levels of money growth in the economy – until then under control – started to balloon, and the system started rolling along the road to destruction. The Bank could have done more to clamp down on this growth. The Financial Services Authority, which as part of the tripartite authorities was sent copies of this report and was even involved in the “war games”, should have done more to prevent Northern Rock and other lenders carrying out these policies and the Treasury, above all, ought to have wised up and taken the threat spelled out by the Bank seriously.

Last but not least, a good deal of the blame has to lie with the Bank’s Governor Mervyn King. Although one of the best monetary economists the country has to offer, he clearly failed to appreciate the scale of these risks. He was uniquely placed to take this warning from the obscure financial stability wing of the Bank, then sniffily regarded by many as something of a backwater, and actually do something with it.

But instead he succumbed to the received wisdom sprouted in the City that securitisation – the sale of mortgage debt onto other investors – had reduced the risk in the banking system. This was, of course, completely wrong, as the Financial Stability Report in 2006 (and for that matter 2007) indicated, and yet he believed it enough to say, in the August Inflation Report press conference, only days before Northern Rock had to turn to the Bank for support: “our banking system is much more resilient than in the past precisely because many of these risks are no longer on their balance sheets, but have been sold off to people willing and probably more able to bear it. Some have always had a preference for a banking system in which all the risk is concentrated there… [but] that’s a very risky system…We don’t have a system that is as fragile as that now. The growth of securitisation has reduced that fragility significantly.”

All of this might seem like ancient history now, two and a half years later. But it reveals some important lessons for policymakers. The first is that there was a more-than adequate early warning system in place here in the UK. The problem was that it was ignored. The Bank’s financial stability experts were sending out a clarion call to the rest of the financial system, but as loud as it screamed, no-one – not the Treasury, not fellow regulators, not even the Bank’s own Governor, paid it enough attention.

Posted By: Edmund Conway at Dec 30, 2008 at 12:37:00

Source: The Telegraph

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