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Farmida Bi assesses the future of credit in the aftermath of the Northern Rock crisis

NOW that the queues outside Northern Rock branches have melted away, thanks to the Government agreeing to guarantee its deposits, a big question remains over the long-term effects of the drama, not least on the less well-off with small savings.

Amid speculation over a possible autumn general election, Chancellor Alistair Darling’s announcement of a Government guarantee for the first £35,000 of depositors cash in any institution was an attempt to show that the Government has moved quickly to address the issues raised by the Northern Rock crisis.

In a further attempt to reassure the markets, banks and, perhaps more importantly, investors, Darling will tell the House of Commons next week that he intends to put joint Treasury and Financial Services Authority proposals out to consultation within the next four to six weeks, with legislation next year. The reforms are said by the Treasury to cover measures to enable savers to get their money back more quickly if a bank or building society collapses.

But while the reactive prescription may provide temporary balm, it does little proactively to address the underlying fault lines in the system. And the fault lines could easily rupture again.

For a start, the credit crunch was never limited to Northern Rock and the Government guarantee has not been sufficient to restore normality to the markets. The fact that no banks participated in the Bank of England’s first auction of £10 billion of three-month money on September 26 does not meant hat banks are now able to borrow the money they need in the inter-bank market at sensible rates. The market view seems to be that most banks were worried about the damage to reputations that borrowing from the Bank could give rise to, since the rate offered was expensive (being 1 per cent. above the Bank’s base rate) and borrowing at that rate would signal desperation.

“Securitisation” techniques had allowed banks and others to sell their right to receive payments under mortgages, credit cards and anything else which produced a regular cash flow (including such exotic products as Madame Tussauds, champagne and even Gordon Brown’s International Finance Facility). These rights were sold to investors in the capital markets, such as pension funds or insurance companies. The cash the seller receives was then used to make further loans to more customers, thus expanding the amount of business they could do and the amount of credit available in the market.

So the original cash has been stretched. But the process has helped to reduce borrowing costs for individuals and companies, which has helped to power growth in the global economy, as well as give rise to the property bubble.

The concern is that, whereas in the past banks made loans and took care to ensure that the borrower could repay the loans back to them, “securitisation” has allowed the banks to become cavalier about who they lend their money to, since they will have sold their rights and obligations in respect of those loans long before the loans become payable.
Therefore, they do not need to worry about how much cash they hold in deposits compared to the loans they have made, since they can meet their immediate obligations by borrowing cheaply from other banks in the inter-bank market. This model has worked smoothly since the 1990s, to the point where banks increasingly make money from fees that can be generated from selling and the returns from holding securitisation assets, rather than from the products which were the traditional backbone of most high street banks.
It’s a case of money feeding on money to generate more money. If that is a difficult concept to comprehend, don’t worry. Last week, the Bank of England admitted that it doesn’t understand the markets. Amid accusations that it failed to act quickly enough to the Northern Rock crisis, the Bank’s chief economist, Charles Bean, said: “One important step in analysing monetary demand and supply shocks involves improving the Bank’s information about credit controls.”Investors are often not interested in the sophisticated details of the assets which generate the return on the asset-backed bonds they buy, since they look only to the credit rating given to the bonds by the rating agencies and pay a price accordingly. But they are the first to feel the impact, the hard way, when things go wrong. The rating agencies have unsurprisingly come under scrutiny as a result of the credit crunch, especially in the US by the ecurities and Exchange Commission.

Labour MP John McFall, chair of the Treasury Select Committee, exasperated by the responses given to the committee by the Bank’s staff, said: “The responses that people gave were unconvincing as a whole. I’m looking at the system and asking the question: ‘Is it working?’ And it’s not working.”

The fact that banks are having difficulty borrowing from each other and the securitisation markets have seized up is likely to have an impact on the economic performance of the economy as a whole, and the likely costs of borrowing for the poorest in the country will increase substantially. David Cameron and the Tories may talk of a credit bubble having been created under this Labour government, but it has allowed many more people to buy their own homes, cars and go on holidays, at historically low borrowing rates which have been easily manageable. That may well change now with one rating agency, Standard and Poor’s, warning that the poorest homeowners coming to the end of fixed rate mortgages and looking to refix may well face increases in their housing costs of up to 60 per cent. There is also a danger that businesses that are not able to finance their activities may start to make redundancies.

The dreaded word “recession” has already started to be mentioned by luminaries such Alan Greenspan, the Treasury advisor and former chair of the Federal Reserve in the United States, who is now saying that the risk of recession in the US has increased.

And a new iceberg has appeared as a tiny dot on the financial horizon which has a potential hazard for hundreds of thousands of ordinary workers – the huge, and high risk, transfer of control of some of Britain’s largest company pension funds in multi-billion foreign deals.

In advance of the launch of its new quarterly survey into credit conditions in this country, the Bank said that while it was “too early” to judge the effect of turbulence in the financial markets, it “could lead to a slowdown in bank lending and potentially lower spending”.

According to the Bank, “overlapping” legislation prevented swifter action on Northern Rock, suggesting legislative measures the Treasury has yet publicly to admit are necessary. The crisis also exposed gaps in the “tripartite” regulatory system involving the Bank, the FSA and the Treasury, holes which need to be plugged if the biggest financial crisis of Labour’s 10 years in power is not to run the risk of repetition under Brown as premier.

While Mervyn King, the Governor of the Bank of England, is right to talk about “moral hazard”and a correction occurring in the pricing of risk, we are all affected by the turmoil in the capital markets, with the poorest affected the most. The banks and their institutional investors may have been greedy and lazy, and talk of City bonuses being drastically reduced may be widely welcomed, yet the economic prospect now seems darker than at any other time since Labour came to power.

That’s something to concentrate the Prime Minister’s mind as he contemplates the date of the election.

Farmida Bi is a City solicitor and a member of Wimbledon CLP