The financial crisis and the benefit of hindsight

13th June 2012

Northern Rock crisis? Regulator tells world he could have prevented it.

Anyone can be a genius – armed with hindsight. So just as Hector Sants prepares to leave the bridge at the end of this month as chief executive of the Financial Services Authority, he tells the BBC that the Northern Rock crisis in 2007 could have been avoided.

If only, he said, the other powers – the Bank of England and the Treasury – in the tripartite division of banking supervision had done what he had advocated, then the run on Northern Rock and the subsequent near-collapse of the UK banking scene could have been avoided.

Sants wanted the government to lend Lloyds TSB the money to hoover up the troubled Northern Rock. He told the BBC: "I think things would have been different if the government and Bank [of England] had taken my recommendation that they should provide liquidity support to Lloyds to purchase Northern Rock.

"I think that would have made a difference, it would have avoided the queues and it would have changed the general climate in relation to the old building society sector that had moved into the banking sector. So, at that early stage, if we had avoided the Northern Rock problem, which we could have done through that action, then I think the tone and people's view of the UK banking sector would have been different."

Sants recounted that Sir Mervyn King, governor of the Bank of England, had vetoed the idea of providing a guarantee to Lloyds TSB. Sants also favoured full nationalisation of RBS and LloydsTSB a year later.

Sants' new warning

Having complained of the Bank of England governor's actions in 2007, he now warns that the governor will have too much power under the new Prudential Regulation Authority which is due to take over banking control from the FSA next year.

But while Sants' admission is interesting, BBC reporter Robert Peston failed to ask the obvious question:

Why, if you had such a major disagreement with the Bank of England over such as fundamental problem did you not resign and alert investors and depositors at the time? 

One interpretation, perhaps generous, may be that he did not want to exacerbate an already difficult situation. In fact, his silence solved nothing. And why did he wait until now – about to leave the FSA and almost five years after Northern Rock's implosion started the process that wreaked banks and investor holdings?  He might have revealed this all earlier rather than saving it for valedictory memoirs.

Learning from past mistakes

However, sometimes organisations can admit past errors, at least by inference, and produce lessons to learn. 

As the Sants revelation shows, the Bank of England's ability to protect the banking system left much to be desired. Its predictive powers have also been weak – especially when it comes to inflation.

As prices started to rise steeply from 2009, the constant mantra was that each month of above target rising prices was a "blip", that there were special factors. But while it is nearly always possible to identify one-offs every month – a whole succession of one-offs make up a trend.

Andrew Haldane is the executive director for financial stability at the Bank of England and a member of the Financial Policy Committee. His paper Tails of the Unexpected was presented earlier this month at a University of Edinburgh event entitled "The Credit Crisis Five Years On: Unpacking the Crisis". It does not, on the surface, sound more than an analysis based on what has been – a piece of history packaged for academia.

But it is more. It is a critique of statistical methods commonly used – including the one that declares an event is a once in a hundred years occasion which then happens twice in four years (rather like extreme weather). The idea of randomness is also under Haldane's attack.

The Bell Curve is cracked

His first finding is that there is no such thing as "normal". There is an assumption in both finance and other fields (such as weather or forest fires) that life is a bell curve with extremes at both ends but with a comforting reversion to the middle – the fat part. We use this all the time – we say shares will revert to their long term norm or that there is such a thing as fair value. To do these, we need a concept of what is usual, what is expected.

Weather watchers refer to floods happening once in 20 or 100 years or some such formulation. But when a once in a 100 years event occurs twice in 10 years, does that mean it will not happen again for 190 years – the next 100 years plus the 90 years left over the other 100 year interval?

The same applies to financial crises. The once in 80 years event – say a massive depression or banking crisis – now seems to occur more often.

Chaos and yo-yo markets

Put simply, chaotic dynamics and tipping points are in play. The problem is that it is almost impossible to predict the tipping point – as financial markets show more and more often as they yo-yo from exuberance to crisis.

Here's an illustration of what economic thinkers are up against. Try piling up grains of sand one by one. After a time, the pile becomes unstable with small cascades. Continue adding grains and there will eventually be an avalanche. As with the camel's back and the last straw, it is impossible to know just when the sand will collapse although at least someone conducting this exercise knows the pile must eventually fall down – many in the investment world think the good times will roll forever.

Another example is traffic. Add one tiny extra event to a motorway and everything comes to a halt or slows down dramatically – remove one and drivers go off at full speed. Frequent drivers will note these events but rarely be able to understand what caused them.

Higher risks as investors demand more from less

In finance, there is a build-up to whatever investors are chasing – it could be yield or capital returns. For a time, everything will go well even though prices are rising and y
ields are falling. Financial firms will then go for higher risk to keep the show on the road.

Sooner or later, the search for better results spills over (like the grains of sand). The self-organised system becomes self-organised criticality with a single new element causing the whole edifice to collapse in an avalanche.

Before that happens, no one talks of any reversion to "fair value" – a phrase such as "new paradigm" comes to the fore. After the catastrophic event – maybe just one contract too many is traded – no one talks of a new paradigm while optimists believe that there will be a return to "normal".

The difficulty with "normal" is that it encourages regulators to set rules using that measure. If there is a lesson from Haldane's paper, it is that rule makers have to look for a new definition of "normal" – one that both allows for the focus to shift and that accepts that the classic bell curve concept is cracked beyond repair.

 

More on Mindful Money:

Banking connections – the more there are, the greater the risks

Can the financial system be fixed? The Philosopher vs the Trader

Wellbeing, happiness and sustainability: hallmarks of a new economic paradigm

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