Have banks benefited from Rock loans?

Bank of England loans to Northern Rock have been estimated at nearly £13 billion; but have other banks benefited from the Rock's woes too?

Simon Ward of fund manager New Star makes the point that other assets on the Bank of England's balance sheet rose by a further £2.3 billion in the week to Wednesday October 10th, bringing the total increase since the run on Northern Rock started to £12.9 billion. This is the best available estimate of the extent of the Bank's support to the troubled mortgage lender.

Northern Rock has used the funds advanced by the Bank at a penalty rate to repay its retail depositors and other creditors. (A small portion will also have been needed to fund mortgage commitments.)

Rather than stash cash under the mattress, these customers have mostly redeposited their savings with other banks and building societies, which have thereby enjoyed an infusion of liquidity without having to pay the Bank's penalty rate for emergency borrowing, says Ward.

This Northern Rock liquidity effect helps to explain why banks have spurned the Bank of England's offer to supply them with additional three-month funds based on looser collateral requirements but at an interest rate at least 1% above Bank rate.

Ward says that in effect, Northern Rock's shareholders have paid the penalty demanded by the Bank to supply the banking system as a whole with greater liquidity. More controversially, it could be argued that the current structure of incentives has created another form of moral hazard: by refusing to lend to Northern Rock, other banks have forced the Bank to supply additional liquidity, which they have been able to access at non-penalty rates.

Meanwhile, the Government has launched a discussion paper to consider reforms to the deposit compensation scheme and reforms to bank insolvency laws, following the Northern Rock debacle.

The existing compensation scheme and lack of transparency have commonly been cited by industry observers as the major reason why Northern Rock suffered from the first run on a British bank since the 1800s.

Chancellor Alistair Darling has previously said that the current guarantee - recently raised to £35,000 - could be extended up to £100,000.

Lobbying body, the ABI (Association of British Insurers) for one will be fighting any uplift to £100,000 however, arguing that the £35,000 limit already ensures that 98% of people will have their deposits fully protected.

Consultation on the reform is due in early 2008.

12 October 2007 © Moneyextra.com

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