Why relief for Northern Rock savers could cost us all dear

Last night Alastair Darling, the UK Chancellor, guaranteed 100% of savings in Northern Rock – and indeed the Financial Services Authority has since gone further, stating this guarantee extends to other troubled financial institutions that might emerge in coming days.

Given the scenes we’ve witnessed since Thursday’s news that Northern Rock required a lifeline from the Bank of England, many will think it’s a good move. And sure, the decision will probably quieten the recent financial upheavals. It will certainly get the government off the hook for now (and to be clear, I don’t believe the government was responsible for the problems in the first place).

But it is without precedent in the UK, and has potentially serious consequences that sound academic but which in extreme cases have previously led to unpleasant upheavals of the blood and barricades variety. What’s worse, the guarantee has for now come without any balancing regulation to ensure the banks do not abuse the facility for their own ends.

At the very least then, a move designed to bring short term confidence to the UK banking system will prove embarrassing for years to come, with consequences for all of us in Britain who save, borrow and spend. Everyone, in other words.

Why? First, some scene setting. Yesterday I went to see the queues outside Northern Rock. Not to gloat in people’s misfortune, you understand. The opposite: I wanted a reminder forever of the consequences of financial panic. And I wanted to be able to tell my grandchildren I’d seen a run on a bank – naturally hoping that such a worrying turn of events will never be repeated in my lifetime.

It was a very orderly queue, almost jolly, with stools and chit chat amongst the Northern Rock customers. The branch I was able to visit was near Mayfair; I was witnessing the “I’d like to withdraw the full £100,000, please” crowd.

As I’ve written previously, I believe the customers were quite rational to want to take their money out, because, as I said then, why risk leaving it in?

In the same article though, I said I expected the government would eventually refund any and all depositors losses, even though the official FSA compensation scheme only protects the first £2,000 and 90% of the next £33,000.

If I expected full refunds in the event they were required, why am I surprised and dismayed that the Chancellor has now announced that he will do so in advance? Because he has now guaranteed that whatever bad decisions UK banks make in the foreseeable future, savers will be safe. An extreme view would be that he has (temporarily, we must hope) semi-nationalised the UK banking system.

With the Bank of England standing behind them to make good savers losses, yet exerting no control over their investments, what is to encourage banks to be prudent? Why shouldn’t they now go out and recklessly lend to whoever they fancy, however bad the credit risk?

In the absence of balancing regulation, the only justifiable answer is that the Bank of England’s emergency penal rate (which we’ve not yet been told) is so high that profits will be damaged and shareholders will suffer if it’s used – so even if savers face no risk, banks won’t want to be too cavalier with their investments for fear of calling on the bail out, making losses, and then being punished by the stock market.

It’s a reason, certainly, but I believe a convoluted one, especially since it’s currently near impossible for investors to judge the risks and rewards of owning a bank, given that we don’t know:

The penal rate the Bank of England is charging Northern Rock and others

How long it will extend these guarantees

What rules it might change tomorrow if politically expedient (at least until we get more clarification on the above two points)

Why you should care

Yawn yawn, you might now be thinking. Yet these rather esoteric-sounding events over the past 24 hours dramatically challenge the central tenants of our financial system.

Remember, there’s no gold in the vaults of the Bank of England to back up every £1 in circulation, and there hasn’t been for many decades. Rather, our system is based on us all agreeing to trust that a £20 note is, literally, worth £20 more than the paper it’s written on.

This has enormous benefits compared with lugging gold bars about the country – let alone having to barter for a coffee at Starbucks with half a dozen fresh eggs – but it only works if we all understand and follow the rules.

Collectively, we – individuals, institutions, companies and investors – have reached agreement about how corporate bonds, government bonds, equities and central bank interest rates work, the risks and rewards of each, and how they interact with each other.

For instance: We accept shares will go up and down over the short-term, because we believe there’s a good probability of long term gain. Another example: if we buy a fixed rate interest investment like a bond, we do so knowing that sometimes it will pay less than variable interest rate savings in a bank, and sometimes more. That’s the trade-off for the security of the fixed income.

I’m not saying this system is always entirely orderly. We generally accept that moments of irrationality or extreme events will upset the pricing of those assets, such as the ERM failure that threw the UK into recession in the early 1990s. But equally, we usually leave the markets to sort out the results, because the alternatives are worse.

So, before Darling’s announcement, if you wanted absolute guarantees about your capital, you bought gilts if you were, say, a pension fund, or put your money in a slightly lower interest paying National Savings if you were you or me.

Anyone who bought gilts or chose National Savings did so for that reason.

But by giving its full backing to Northern Rock and any other institution that looks vulnerable – not even the particularly good institutions, but rather, the specifically ‘gone bad’ ones! – the government has at a stroke done away with the distinction between buying low-paying gilts backed by the Treasury, and any high street bank following an unsustainable business model in order to win market share.

How can that be sensible?

For political ends, of course, but that’s at the heart of the concern. The history of governments directly intervening to change the fundamental running of capital markets for political reasons has a terrible history involving, in the very worst cases, revolutions, dictators, and hyperinflation.

To be clear, I’m not some frothing blogger who expects to be mounting the barricades of Threadneedle Street by next Tuesday. I’m simply pointing out why something that seems perfectly sensible – protecting savers – has potentially wide-reaching ramifications.

Monevator.com is about saving and investing, not overspending and living in debt, and naturally I have enormous sympathy for pensioners who were worried they were going to lose their savings at Northern Rock.

Indeed, given to where we’d got to, the government possibly had to do something – say extending the 90 per cent guarantee to cover savings above £35,000.

But however difficult it might have been over the weeks and months ahead, there must be some risk in a market economy. Otherwise the market cannot decide between asset A and asset B, pricing and risk/reward goes out of the window, and we’ll face the cost in years to come.

Confidence in a banking system means more than, “Will I get my money back?” We also need complete confidence that the system behind our money is more than smoke, mirrors and strings. A sudden decision to guarantee all UK savings – whatever the cost and however they were threatened – seriously undermines that credibility.

Things would have gotten worse before they’d gotten better if the market had been left to its own devices, make no mistake. But the government and the Bank of England should have toughed it out. If politicians wanted to get more involved in addressing the instabilities caused by a decade of debt then they should have been done cautiously, soberly, and long before the stuff hit the fan.

Update: It’s become clear(-ish) over the course of the day that the 100% compensation promised by Alistair Darling only applies to existing savings accounts. While this reduces the problem of devaluing government bonds (gilts) by giving new Northern Rock savings accounts the same AAA protection, it hardly obviates the wider impact of such meddling. Indeed, we now have a situation where if I open a savings account with a troubled institution tomorrow I’ll not receive 100% backing from the government, but if I opened one yesterday I will – despite it being exactly the same account!