Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Deposit Insurance and Northern Rock

The flurry of comments and discussion that followed Mervyn King’s interview
to the BBC on November 6, 2007 have led me to the conclusion that the
true lessons from Northern Rock are largely about deposit insurance and not
about bank supervision.

Mervyn King’s interview about the handling of Northern Rock
prompted a series of comments last week in the Financial
by Philip Stevens, Willem Buiter and Martin Wolf. This
has prompted me to revisit Northern Rock which I blogged about last
month here
and here. I
am even more convinced than before that the Northern Rock episode does
not reveal fundamental flaws with the model of unified regulation and
separation of monetary policy from bank supervision. I also think that
King’s decision to provide liquidity only at penal rates and
against top class collateral was quite correct. Mervyn King said
in his interview:

If you look at what the European Central Bank lent to banks through
their auctions that they conducted, relative to the size of the
banking system they lent an average of 230 million pounds per bank
participating in their auctions. Northern Rock needed something closer
to 25 billion, 100 times larger than the average amount which the
European Central Bank was lending to banks through their auctions. The
scale of the funding that was needed was staggeringly large.

So could we have had an auction that was sufficiently large that
all the banks would have got 20 to 30 billion and Northern Rock
wouldn’t have been noticed in that process? Well, that would
have been an auction on a scale 50 odd times that which any other
Central Bank had engaged in. And I’m absolutely convinced that
the first question you would have asked on that day is: “What on
earth must have happened to the entire British banking system to have
merited an auction of that size?” We were doing this not to bail
out the British banking system, which didn’t need bailing out,
but actually to get money into one institution that needed it.

In my view, the lessons from Northern Rock are:

  • In the age of television, even a small bank with retail deposits
    is systemically important. When television starts relaying images of
    depositor panic, there is a risk that investors worldwide are going to
    think that there is a problem with the entire banking system of the
    country in question. This means that the only politically feasible
    solution is to regard almost all retail deposits as de
    insured. The only question is whether the deposit
    insurance is ex ante or ex post. The
    realistic solution is a ceiling for deposit insurance approximately
    equal to the level of financial wealth at which financial regulators
    stop worrying about investor protection and treat the individual
    investor on par with institutional investors. In most developed
    countries, this would imply that the ceiling would have to be in the
    range of 1 to 5 million US dollars. To be non distortionary, such a
    large deposit insurance would not only have to be risk based but would
    also have to be funded by a tax on all bank deposits. The point is
    that the negative externality of banking is so large that it needs to
    be addressed with a large tax.
  • There is a problem when a bank with some retail deposits has
    disproportionately large wholesale liabilities. Since wholesale
    lenders usually recognize a problem sooner than either retail lenders
    or regulators, uninsured wholesale liabilities are effectively senior
    to insured retail deposits. Thus wholesale lenders obtain the
    advantage of deposit insurance without paying for it. Therefore,
    regulators need to see liquidity management not as a problem for bank
    management, but as the primary mechanism by which uninsured wholesale
    lenders are prevented from free-riding on the deposit insurance
    provided to retail depositors. One way to make this happen is to make
    deposit insurance prohibitively expensive when wholesale liabilities
    become disproportionately large. This would have shut down Northern
    Rock long ago or forced it to become a pure wholesale
    operation. Either way, the problem would have been avoided.


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