Back from the Brink

1000 Days at Number 11

Alistair Darling

• Publisher: Atlantic Books
• Year: 2011
• ISBN:
  9780857892829
• Topic: Politica e relazioni internazionali
• Subtopic: Biografie in ambito politico

1 The Wreck of Northern Rock

The prelude to that chilling call from Sir Tom McKillop had been played out thirteen months before when we were caught out with a run on a small British bank, Northern Rock. That day, 14 September 2007, is seared in my memory. I had been Chancellor of the Exchequer for seventy-nine days. The echoing venue, then, was a grand Moorish hall in the Palacio da Bolso in Porto where European finance ministers and central bank governors had gathered for a meeting of the European Union’s economic and financial affairs council, Ecofin. The palatial surroundings made rather less of an impression on me than the scene displayed on a giant TV screen in the hall. What it showed was long, snaking queues of people waiting to make the first run on a British bank in more than a century.

As we gazed at this horrifying spectacle playing out in the Friday sunshine half a continent away, my companion leant over: ‘They’re behaving perfectly rationally, you know.’ It was not what I wanted to hear, even if it was Mervyn King, the Governor of the Bank of England, who was telling me. I watched an elderly lady emerge from a branch of Northern Rock with her savings. She was, she said, off to deposit them down the road at the Halifax. Not such a good idea, I thought.

A banking calamity that had begun with losses on risky loans to US home buyers now threatened catastrophe in Britain. The talks that day in Portugal were intended to find ways to improve crisis management and to guarantee financial stability within the European Union. A management consultant was trying to explain to the assembled ministers and governors how to work more efficiently – useful advice perhaps, but the irony was not lost on me. I left them to it and set off back to London.

What I had witnessed on television that day was potentially disastrous for Northern Rock, for other banks, and for the economy. As the pictures flashed around the world, the damage to our reputation would be immense. Politically, it was potentially fatal. People may have been panicking in a very British way – there was no shouting or hammering on windows – but they wanted their money out. No matter how much the bank staff tried to reassure them that there was no problem, that they could get every last penny, they wanted their savings and they wanted them now. It was going to take a Herculean effort to turn things around.

Safe as the Bank of England? We were all brought up to believe it. Yet, far from reassuring people, the announcement that the Bank was effectively standing behind every last penny simply caused a stampede to the doors of Northern Rock. I had flown out to Porto that morning, despite the fact that the run had started. I knew full well that if I did not turn up for the meeting it would simply reinforce the sense of crisis. But now I had to get home. We had chartered a small jet to allow us to make a fast escape. Jammed together in the back seats, Mervyn King and I had time to get to know each other better. There was ample time, too, for me to reflect on how we had got to where we were.

I had known Mervyn King for some years. We met first when I was a Treasury minister in the early days of the Labour government. He was one of the first people I spoke to after becoming Chancellor. Softly spoken, bookish and an academic economist, I liked his quietly considered, slightly impish style. He could also be incredibly stubborn. There are times when this is an ideal quality for a Governor of the Bank of England, but equally it could be exasperating. He and I were to work closely together over the coming three years. We had our disagreements, but, at the height of the crisis a year later, when it was clear that drastic action was needed to recapitalize the banks, he did what was needed.

In the back of the plane, the Governor and I talked about the unfolding crisis, interspersed with his explanation of how he had come to be an avid Aston Villa supporter when he was growing up in the West Midlands. As we descended through the clouds, the thought came to me: I was damned if our reputation was going to be destroyed over the failure of a small, reckless bank. We had to stop this run and regain control of events, no matter what it took.

When I arrived at the Treasury as Chancellor in June 2007, I was reminded of a perfectly calm sea on a summer morning – not a cloud in the sky, hardly a ripple on the water. On days like that, on my small boat in the Outer Hebrides, you look out for subtle changes in wind and wave: they are the harbingers. They were there in the Treasury too, not too far below the surface. Beneath the calm there was concern about what was happening in the US housing market, although it was thought to be containable. It had barely touched the public or political consciousness. Cheap mortgages had been sold to people on low incomes for properties that would be difficult, if not impossible, to sell when the economic waters turned choppy. Worse, these loans had been parcelled up by banks and sold on to other banks and financial institutions, in an attempt to spread the risks of people defaulting on loans they could not afford. They were certified by the credit-rating agencies as being top-quality, but they came to be known, notoriously, as ‘sub-prime’ loans.

Normally, if you make a loan to someone it makes sense to insure yourself against the risk of the borrower defaulting. But what happened in many cases was that one part of a bank sold off the loans and, unwittingly, another part of the same bank bought them back. In other words, the risk was simply wheeled down the corridor. Yet despite these indicators of turbulence, it was still thought on both sides of the Atlantic that this was little more than a temporary squeeze and, even at the beginning of August 2007, the Treasury believed there were no serious implications for UK banks. The view was that this was an American problem which could be contained. Many of the loans, however, had been insured by big companies like AIG – best known in the UK at the time as sponsors of Manchester United Football Club – and that British banks, RBS among them, were very exposed to these insurers. If the insurance companies collapsed, British banks would be badly hit.

There was an additional problem. The Treasury and the regulators tended to focus on the financial health of each individual bank, rather than on how much the banks depended on each other and the extent to which, if something were to go wrong with one of them, it would infect the others. The British authorities were not alone in that. To my mind, this was one of the biggest failures in the global financial system. Most banks borrow very large sums from each other over a short time period in order to fund risks that are very long-term. If they can’t roll over this funding, which they often need to do every ten or twenty days, then they are in real trouble. If banks cannot lend to each other, they cannot lend to other people. The banking system grinds to a halt. When, later in 2007, the banks finally woke up to the full horror of what was happening, they did stop lending to each other. Money seized up – giving rise to the so-called ‘credit crunch’ – and that precipitated the banking crisis.

But at the beginning of August 2007, two months into the new job, as I left the Treasury for a week’s holiday, there were few signs of the storm that was about to break. Our family flew out to Majorca, where, aside from the daily call to the private office, we relaxed with friends for a few days. On the morning of 8 August I walked down to the local supermarket to buy the morning rolls. Passing the newspaper kiosk I picked up a copy of the Financial Times – as you do when you are Chancellor. Sitting by the pool side, I noticed an item reporting that the French bank BNP Paribas had frozen withdrawals from two of its funds. It could no longer value their assets. The paper also reported problems with WestLB, Germany’s third-largest state lender. Lending between banks had begun to freeze, as banks began to fear that what they thought were good quality investments were rapidly losing their value. In response, the European Central Bank had pumped 95 million euros into the European banking system. In the US, it was reported, the Federal Reserve was putting $12 billion into the system.

I had read enough to know this looked bad. London was the world’s major banking centre. It was inconceivable that banks there were not also affected. I telephoned my private office at the Treasury to find out what had prompted the European Central Bank to take this action. This being August and the height of the holiday season, it took several hours to find someone with any idea of what was going on. It was infuriating. Why hadn’t I been phoned? It was one of those cases when the civil servants dealing with the matter were so close to the problem that they did not see it for the crisis it was about to become. Ministers are not always told everything that the department is concerned about, but the judgement as to when to impart information is a critical one, and I made sure that such a situation should never arise again.

I wanted to know which of our banks could be in trouble and how we were going to deal with it. I asked that the Bank of England and the FSA, which is responsible for the supervision of banks and building societies, work along with the Treasury to identify potential problems. A few days later, back home in Edinburgh, I was told the FSA was worried about Northern Rock. Northern Rock’s business model was heavily reliant on raising funds from financial institutions, mainly in the US, rather than from individual savers, and the cost of its borrowing was rising sharply. They feared it was going to find it extremely difficult to raise funds. If that happened, the outlook was grim.

There were also concerns about two more banks. The first was Alliance & Leicester, a medium-sized former building society. Alliance & Leicester had not got into trouble itself, but the FSA feared that once it became known that Northern Rock was in difficulties then Alliance & Leicester would be seen as the next in line. In the course of the crisis every building society that had given up mutual ownership to become a public company during the 1980s either failed or was taken over. The second bank singled out for concern by the FSA was HBOS, formed by the merger of the Halifax Building Society and Bank of Scotland. HBOS was medium-sized in world terms but was one of the bigger British banks, in a different league from Northern Rock. Its headquarters were in Edinburgh, where I was an MP. There was a growing sense that the party that had been enjoyed by the banks for so long was about to come to an abrupt end. To make matters worse, I wasn’t sure than anyone knew how deep these problems were, or what was their exact nature.

It was Northern Rock we had to tackle first, and straight away. A former well-run, small building society based in Newcastle, it was popular locally and had converted from mutual ownership to become a bank. Despite its size, it quickly became one of the major UK mortgage lenders, lending more money to some of its borrowers than their properties were worth, relying on ever-increasing house prices to make up the difference. In fact, a couple of years before the crisis, my wife Margaret had been looking for a mortgage so that we could buy a flat for me to stay in while Parliament was sitting. It had become cheaper to pay off a home loan than to rent. They asked for no evidence that we could pay; everything was done online, by the click of a mouse. Millions of people had been happy to take advantage of this easy credit, and buy-to-let mortgages had made landlords out of savers across the country, confident of good returns on their investments in the property market. It was a far cry from the 1970s, when, as a young lawyer, I advised clients that they would have to save with a building society for at least two years before they would be able to get a mortgage, and even then there might be a waiting list of as much as six months.

What was really worrying, though, was Northern Rock’s increasing dependence on the wholesale market – that is to say, borrowing money from other banks – to provide funds for mortgages. In fact, this was the case with mortgage lenders across the board. In the past, as many as 90 per cent of mortgages provided by banks and buildings societies would be funded from deposits lodged by their savers; by 2007 less than a third of mortgages were funded in that way. The upside was that more mortgages were being made available to the public, and more cheaply. The downside was that the whole interlinked system was entirely dependent on the banks’ ability to borrow from each other.

My worries about Northern Rock were compounded when it became apparent that the company itself seemed strangely detached from the looming disaster. The management appeared to resent the growing list of questions surrounding their business. In fact, they, as well as the FSA, had been aware of the risk they were exposed to since February 2007. More should have been done to deal with the problems then. They were too dependent on being able to raise money, mainly in the US, to keep their business going. If confidence in them dried up, it would be the end of the road. That is precisely what happened to them six months later, in September 2007.

At the same time, I was increasingly concerned about the relationship between the FSA and the Bank of England. Before 1997, the Bank had regulated most of the business conducted by banks. But some of the banks’ activities, such as the sale of insurance, were overseen by a series of independent self-regulating bodies. There was a great deal of confusion as to who was responsible for what. It used to be said that when the Governor of the Bank of England raised his eyebrows the banks would take notice. That was fine when you were dealing with perhaps half a dozen banks, run by the old-boy network typical of the English establishment. By the mid-1990s, however, there was hardly a bank in the world that did not have some presence in London. The system needed to be modernized. So, in 1998, we brought all the regulation of financial services under the control of the FSA.

The responsibility for the architecture was largely mine. When we were in opposition in the early 1990s, Gordon had asked me to take responsibility for the City. I realized quickly that getting the right supervision and regulatory regime was essential and set about planning for the change in regulatory control which we implemented once we were in power. However, the system depended on a strong working relationship between the FSA and the Bank of England. Now, in 2007, it was clear to me that the relationship between the Bank and the FSA was not good. They had not worked as closely as they should have done over the previous decade, each blaming the other for this state of affairs. The FSA was chaired by Callum McCarthy, who had served in a number of City posts after starting his career as a civil servant in the Department of Trade and Industry. A quietly spoken, thoughtful man, he had an incisive mind and I respected his judgement. After we first met when I became Chancellor, both of us assumed we would encounter one another only occasionally. As it turned out, I spoke to him almost every other day until he retired in September 2008.

The relationship between Callum McCarthy and Mervyn King was often strained, at times prickly. As we shall see, in those days I tended to side more often with Callum in his diagnosis of the escalating crisis. There is no doubt in my mind that their difficult relationship contributed to the fact that our response to the crisis was not as sharp and decisive as it might have been. But the real problem was this: for ten years there had been no financial crisis. The regulatory system had only ever operated in good times. The Bank had concentrated on its monetary policy duties, primarily the regulation of interest rates. Although it had had responsibility for financial stability since becoming independent in 1997, it did not have a sufficiently deep understanding of what was going on in the individual banks – or, indeed, of the critical relationships within the banking system. The FSA, in turn, had spent a great deal of time since its inception concentrating on consumer issues, rather than examining the systemic risks that were to bring the entire system to the brink of collapse twelve months later. And the Treasury had not seen financial regulation as a priority. That is not to say that there wasn’t a great deal of work being done. It had just not been seen as urgent.

In some ways all this was understandable, given the mood of the times. It was felt that judgements were for the markets. If a bank got it wrong, the shareholders would have to bear the consequences. The trouble was that when the crisis came the shareholders were hit – but so too was everyone else. The strains and stresses that had been there all along, but had not been evident, suddenly became very apparent. The whole system depended on the chairman of the FSA, the Governor of the Bank and the Chancellor seeing things in exactly the same way. The problem was that, in September 2007, we simply did not see things in the same way.

Fundamentally, the big issue on which we were divided time and again that autumn was whether to put money into the banking system as a whole, as the European Central Bank and the US Federal Reserve had done, or to concentrate our fire in the traditional way, helping each failing institution as the need arose. Callum McCarthy and I took the former view. The Governor took the latter. Unfortunately, that internal division of opinion became more and more apparent to the public as the weeks wore on.

At the beginning of September 2007, I returned to London and met with Mervyn King and Callum McCarthy in my office at the Treasury. It was to be the first of many meetings throughout the crisis. It was obvious that the banks were finding it difficult to borrow money, and the longer that problem went on the bigger would be the risk to Northern Rock. One way or another, its business model had failed. The only question was whether it should be wound down or sold – if anyone would buy it. We were agreed that in the meantime we would have to provide it with financial support. The longer that went on, the greater would be the risk that we would end up owning the bank, and that people would panic when they found out just how critical the position was. Banks are not like other companies, which can usually be allowed to fail. The risk with banks is that, rather like dominoes, if one fails it will take others with it. And it was proving very difficult to convince Northern Rock that the party was over.

At the time, we did not have the legal powers to step in and resolve the situation by forcing a sale or by simply taking over the bank. Had we had those powers, once it became clear that Northern Rock could not carry on, we could have resolved the situation over a weekend. That is precisely what we did a year later in the case of Bradford & Bingley, another small former building society that had overreached itself. But although the need for this legislation had been identified in a Treasury planning exercise twelve months earlier, it had not been worked up, which was a great pity. This lack of legal powers caused us huge problems in trying to deal with Northern Rock’s business over the next few months.

At the beginning of September, it seemed that the best solution from the government’s point of view would be to achieve a sale to another bank. That way, they could provide the capital and funding needed, as well as resolving the bank’s problems. Not surprisingly, there was limited interest from the private sector. Lloyds Bank approached Treasury officials and expressed an interest in buying Northern Rock on condition that the Bank of England would continue to support it for two years. There was never any direct discussion at a senior level. It was an informal approach about the potential acquisition. It seemed that Lloyds had a general interest in expanding their mortgage business and that Northern Rock was a possibility, no more than that. At no point did they ever put anything remotely resembling a proposal on the table. I felt they were merely sniffing around for a bargain, knowing Northern Rock was in trouble. And that trouble was growing.

The three of us held a telephone conference call on 9 September. Mervyn King was at a monthly meeting of bank governors in Basel. Callum McCarthy was in London. I was in Edinburgh. My concern that the situation was becoming more acute was mounting. Banks were asking for more money in the system. If we could sell Northern Rock, that would be desirable; but most urgent was the need to get money into the banking system to keep it afloat and to prevent further imminent collapse. I wanted general support as well as whatever was needed to deal with Northe...