Free Storm, The by Vincent Cable Page B

kind was directed at Mervyn King in London for not opening his cheque book sooner.
    In practice, in the early nineteenth century an approach to financial crises was developed pragmatically, by trial and error,
     and was later rationalized by Walter Bagehot. The resulting rule was that it is the job of central banks to advance liquidity
     to other banks when required, but only at a penalty rate, against sound collateral, and not to institutions that are insolvent.
     A procedure developed about two hundred years ago, and crystallized 130 years ago, has survived remarkably well the big changes
     that have subsequently taken place in banking. But there is much scope for misunderstanding over what the rule means in practice,
     since suitable collateral is a matter for judgement and the distinction between solvency and illiquidity can be less than
     clear.
    Financial commentators and financiers unfavourably contrasted the reluctance of the Bank of England to assist banks during
     the crisis of August 2008 with the greater willingness of the European Central Bank and the Federal Reserve. The Bank of England
     took a less accommodating approach to collateral; it was, understandably, reluctant to accept mortgages on taxpayers’ behalf
     in a falling housing market. But there was a more fundamental point. Mervyn King, in a comment that was to create a serious
     hostage to fortune, gave a classic statement of the case against indulging moral hazard a few days before the rescue of Northern
     Rock: ‘The provision of large liquidity facilities penalizes those financial institutions that sat out the dance, encourages
     herd behaviour and increases the intensity of future crises.’ Not only did the Governor then have to acquiesce in the rescue
     operation for Northern Rock, but several months later opened a special liquidity facility from which bankers could borrow,
     albeit witha penalty. The European Central Bank, by contrast, appeared to be willing to lend as and when required, without a penalty
     rate. And after Mr Cramer’s tantrum was taken to heart, the Federal Reserve was enthusiastically praised by Wall Street. Perhaps
     that was because it did what was asked of it, and in its later rescue of Bear Stearns, and then Freddie Mac and Fannie Mae,
     went beyond the traditional role of lender of last resort by rescuing companies from threatened insolvency.
    The three main central banks affected by the crisis have carried out their classic lender of last resort liquidity functions
     with varying enthusiasm and alacrity. There has been less common ground, and greater divergence, in the practical meaning
     of moral hazard in respect of rescue operations for failing institutions. As we noted above, when the Bear Stearns operation
     took place, the Federal Reserve acted speedily, through a guaranteed line of credit, to ensure that the bank was taken over,
     by J P Morgan Chase. The US authorities were less interested in the long-term risks of moral hazard than in the immediate
     consequences of bankruptcy triggering widespread default on the banks’ obligations in respect of derivatives. The state partially
     stabilized some of the risks of future losses. The shareholders were reprieved; instead of losing their shirts, they were
     allowed to retain roughly $1 billion in value. J P Morgan Chase, which took over the bank, had an opportunity to profit from
     any recovery, while benefiting from taxpayer guarantees, the full magnitude of which is not clear.
    Those who felt queasy about this use of the economic muscle of the state to support supposedly risk-taking, profit-seeking
     firms had even more reason to worry about the rescue of Fannie Mae and Freddie Mac. These privately owned bodies were given
     limitless state guarantees. No change was demanded in a management team whose business model, reinforced by personal incentives,
     had created excessive risk. And there were continued dividends for shareholders, who had already benefited