Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Northern Rock and Unified Regulators

In my previous
post
today, I described what I had learnt about managing liquidity
risk from studying Northern Rock; in this post, I shall discuss the
implications for the regulatory architecture (separation of bank
supervision from the monetary authority).

Many observers appear to think that Northern Rock has revealed the
dangers of the UK system of separating bank supervision from the
central bank. In my view, it has on the contrary, revealed the
strengths of this system. It is clear from the evidence, that the
banking supervisor (Financial Services Authority) was keen to solve
the problem of Northern Rock by making changes in monetary policy
while the monetary authority (Bank of England) was unwilling to do
this. If the central bank were in charge of both monetary policy and
bank supervision, there is little doubt that monetary policy would
have been changed to save Northern Rock. The deficiences if any in
banking supervision would then have never come to light at all. This
is a form of regulatory moral hazard – regulators will tweak the
regulatory system to hide their failures. The UK system where the
central bank is not the bank supervisor is less vulnerable to this
kind of moral hazard.

That the UK had not had a bank run for 140 years prior to Northern
Rock is to me a troubling thing. Banks are highly fragile
institutions. If in 140 years including two world wars, a great
depression, the loss of a vast empire and over three decades of
chronic exchange rate difficulties, the UK did not have any bank runs,
then it tells us not that banks were well regulated but that they were
saved covertly. In these covert operations, doubtless the reputations
of bank regulators (and perhaps bank managers) were also protected at
the tax payers expense. That Northern Rock has dented many reputations
is not such a bad thing by comparison.

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