Reckless lending prompts housingdeclineGuaranteeing a failing institution the funds to appease its investors may create more problems than it fixes and runs contrary to market discipline
BANKS and other mortgage lenders are by no means the only culprits in property booms and busts. Miscalculations by developers, investors, homebuyers, sellers, and government officials usually contribute to roller-coaster rides in housing markets. But lax lending by banks often plays a major role in property cycles.
By deciding on which projects to finance, banks determine what gets built and by whom. Decisions by banks about how much to lend to homebuyers and under what terms and conditions are important for determining the demand for housing.
Properly managed banks and sound banking practices are therefore essential for a well-functioning property market. Wild swings in prices and building activity can often be traced back to reckless lending behaviour by banks.
As events at Northern Rock graphically illustrate, banks are inherently unstable. This instability arises because banks' assets (mostly loans) are illiquid while their liabilities (deposits and short-term borrowings) are highly liquid. Banks borrow on short-term from depositors and other banks on the interbank market, then lend long-term in the form of mortgages and other loans.
In normal times, this mismatch in maturities doesn't create a problem -- because a bank can be pretty sure that not everybody is going to withdraw their deposits on the exact same day and funds will almost always be available for them to borrow on the interbank market.
But these are not normal times. Problems in sub-prime lending in the US have prompted a credit crunch. Banks have become increasingly nervous about lending to other banks. What we witnessed in the case of Northern Rock was a run on the bank -- first by other banks, and then last week by depositors.
The British authorities' response to the Northern Rock debacle has two corresponding dimensions. First, the Bank of England offered to lend to Northern Rock any amount of cash that it will need over coming weeks. These funds will substitute for the loans that Northern Rock is unable to roll over on the interbank market.
Second, the British government pledged to guarantee all deposits at Northern Rock. If the bank goes bankrupt, the UK taxpayer will ride to the rescue and reimburse depositors in full. Of course, the British government couldn't possibly extend such a guarantee to depositors in only one bank. So, effectively, all depositors in the UK now have 100 per cent deposit insurance.
This blanket guarantee on deposits appears to have worked in easing the panic. The queues outside Northern Rock branches have all but disappeared. This quelling of depositor panic is certainly to be welcomed.
But there is a downside to the measures taken by the British authorities and one that may come back to haunt the UK banking system when the current crisis subsidies.
You see, banks -- like any business in a market economy -- need to face the right incentives if they are to make proper decisions.
For reasons of financial stability, banks are generally subject to special regulation and prudential supervision. But regulation and supervision, though important, are no substitute for market discipline.
That discipline comes from three sources: shareholders, other banks on the interbank market, and depositors. If a bank behaves recklessly, worries about its future lead shareholders to dump the stock, other banks to stop lending to the bank, and depositors to withdraw their deposits. The threat of these actions and the prospect of going belly up help to keep banks to the straight and narrow.
By offering Northern Rock emergency Bank of England funding -- albeit at penalty interest rates -- and by guaranteeing all deposits, the authorities have blunted the market discipline on British banks. That could mean trouble ahead.
As Allan Meltzer, my old economics professor at Carnegie Mellon University in Pittsburgh used to like to say: "Capitalism without failure is like religion without sin -- it doesn't work."
The turmoil at Northern Rock also highlights the challenges posed to governments by the growth of cross-border banking. What we saw here was Tanaiste and Finance Minister Brian Cowen assuring and reassuring Northern Rock's customers in Ireland that the British government's pledge to guarantee all deposits included them.
The Tanaiste's involvement in this affair is understandable. But it does raise an interesting question. Northern Rock might yet go bankrupt if it cannot regain access to less expensive financing.
In that event, Chancellor of the Exchequer Alistair Darling might have second thoughts about sending €2.4bn across the water to reimburse depositors who, after all, don't vote in the UK. Those depositors would then surely point to the Tanaiste's assurances and look to him to make good their losses.
The result would be that Irish taxpayers would end up contributing to bailing out a woefully managed UK bank. That is a disturbing prospect.
Alan Ahearne is a former senior economist at the Federal Reserve Board in Washington DC. He lectures in economics at the Cairnes School of Business and Public Policy at NUIG
