NORTHERN ROCK AND THE EUROPEAN UNION
by Tim Congdon
Contents
page 2 Executive Summary
page 3 The Bank of England’s past success
page 4 Northern Rock’s funding problem
page 7 The Bank of England and the
uncertainties of European Law
page 9 The Treasury and the EU’s rules on
state aid
page 12 European law and Northern Rock
after nationalisation
page 14 Conclusion
Northern Rock and the European Union:
How far was the EU to blame for the Northern Rock fiasco?
Tim Congdon
June 2008
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This pamphlet shows that the effectiveness of
the three official UK institutions most
involved in the Northern Rock rescue – the
Treasury, the Bank of England and the
Financial Services Authority – was
undermined by commitments made by the
British state to the European Union. It
highlights:
1. the Bank of England’s reluctance in
August and September 2007 to act as
an ‘honest broker’ to Northern Rock
because of worries about breaking
the Takeover Code (which became
statutory only in 2006 as a by-product
of EU legislation),
2. the Bank of England’s and the FSA’s
uncertainties in mid-September 2007
about the meaning of the EU’s
Market Abuse Directive,
3. the contrasts (from the start of the
crisis until now) between the Bank of
Spain’s attitude to its banks’ liquidity
problems and the attitude of the UK
authorities towards such problems at
British banks, implying the lack of a
‘level playing field’ in lender-of-lastresort
arrangements across the EU’s
supposedly ‘common market’,
4. the Treasury’s concern (from mid-
September 2007 onwards) to comply
with the EU’s rules on state aid, which
led to the inappropriate imposition of
a deadline for a private sector rescue
and the repayment of the Bank of
England’s loan,
5. the acceptance by the Treasury and
Northern Rock’s management (from
February 2008) of EU rules on the
conduct of business by state-owned
banks, and
6. the heavy redundancies at Northern
Rock (from March 2008), imposed by
the European Commission in applying
the EU’s state aid rules, even though –
in fact – Northern Rock’s cost of funds
from mid-September 2007 was well
above market rates and arguably
the bank had not received any aid
at all.
The common theme here is that agencies of
the British state have less freedom and ability
to act, and so are less powerful, because of the
UK’s membership of the European Union. A
further feature is that the transfer of powers
to EU institutions, while very real, has taken
place by stealth. Many details have been left
unclear. As a result, the Treasury, the Bank and
the FSA are uncertain about the extent of the
powers and responsibilities that they retain.
The conclusions are twofold:
1. if the British people and government
want key agencies of their state to
function freely and effectively, as they
did in the past, the UK must
repatriate powers from the EU, and
2. if the uncertainties created by the
encroachment of European law on
the law of England are to be
eliminated, Parliament must replace
ambiguous EU directives and
regulations with clearly-expressed
English law.
The repatriation of powers and the
replacement of European law by English law
will, inescapably, necessitate a renegotiation
of the UK’s relationship with the European
Union.
Executive summary
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Are the Bank of England and the Treasury able
to regulate the British financial system, and to
support banking institutions if they run into
difficulties? 40 years ago the answer would
have been ‘yes, of course’. The answer
nowadays is ‘no, not really, because the Bank
and Treasury no longer have the same powers
and freedom to act’. The argument here is that
the UK’s membership of the European Union
has reduced the scope of key agencies of the
British state to respond to financial crises, as
well as increasing uncertainties about the
extent of the responsibilities they retain. By
common consent the Northern Rock affair was
badly handled. The claim to be made in this
paper is that officialdom’s blunders and
misunderstandings can be largely blamed on
commitments arising from the UK’s
membership of the EU.
The Bank of England’s past success
When the UK decided in the late 1990s to
reject the single European currency and
instead to keep the pound, the Bank of
England became in one respect the most
important national central bank in Europe.
Whereas the national central banks in the
single currency area handed over the levers of
monetary policy-making to the European
Central Bank, the Bank of England was given
extra powers by being granted operational
independence to set interest rates in 1997.
Over the following decade it did a magnificent
job in delivering on-target inflation and steady
economic growth or, in a phrase, preserving
‘monetary stability’. However, such was its
success in this task that many people forgot
that it had another vitally important objective,
that of maintaining ‘financial stability’. This
objective can be defined, roughly speaking, as
ensuring the convertibility of bank deposits
into notes at 100p. in the £ and preventing
runs on banks.
The amnesia on financial stability was a
contributory influence on the Northern Rock
crisis in autumn 2007. But an argument can be
made that wider developments in the
European policy context were more
significant. Although the UK has kept the
pound, it has handed power over to the
European Union in numerous other areas of
state action. Moreover, the concept of ‘the law
of England’ has been heavily diluted because
of the accretion of ‘laws’, designated as
‘directives’ and ‘regulations’, which emanate
from the EU’s Council of Ministers and, at a
further remove, from the European
Commission. The erosion of sovereignty and
dilution of national law have occurred because
so-called ‘competences’ have passed from the
member states to EU authorities of various
kinds. Unfortunately, the transfer of
competences has been done with insufficient
care and precision, leading to uncertainties
about the demarcation of functions and
responsibilities of the agencies (central banks,
financial ministries and so on) which remain
at the member state level.
Central banks are very special institutions. The
state has given them the unique prerogative
of issuing legal-tender banknotes, with the
result that the definition of their role is
necessarily a matter for the government. On
the other hand, profit-seeking commercial
banks leave deposits with them and
sometimes borrow from them. They are
therefore banker both to the government and
to the banking system, and they straddle
rather awkwardly the public and private
Northern Rock and the
European Union
How far was the EU to blame for the Northern Rock fiasco?
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sectors. Given this ambivalence, it is
unsurprising that one recognised central bank
task – that of making so-called ‘lender of last
resort’ loans to banks when they are short of
cash – can become a subject of political
controversy.
Historically, the British record in this area of
public policy was magnificent. The Bank of
England, set up in 1694 to help William III in his
long military struggle to stop the French
dominating Europe, is one of Britain’s most
distinguished institutions. In the 19th century it
pioneered the modern conception of central
banking and in the 20th century its adroit
handling of financial crises contributed to the
high international regard for the City of
London. Whereas in the Great Depression of
the 1930s thousands of banks ‘closed their
doors’ in the United States of America, no one
lost money on a deposit with a bank in the
British Empire. But in the summer of 2007 the
Bank of England faced a new challenge. It had
to confront a financial crisis when its own
freedom of manoeuvre, like that of other
agencies in the British state, was constrained
by the UK’s membership of the European
Union. The next section discusses how it dealt
with – or rather failed to deal with – the
resulting problems.
Northern Rock’s funding problem
Banks can fund their lending in two ways,
either by taking retail deposits over the
counter or by borrowing from other banks
(and to some extent large companies and
financial institutions) in so-called ‘wholesale
markets’ around the world. In early 2007 this
second type of funding became increasingly
difficult as a by-product of unwise business
practices in the American mortgage industry.
On 9 August 2007 some French money market
funds, supposedly with an asset backing at
least as safe as that of bank deposits,
announced large losses on American
mortgage-backed securities. Financial markets
realised that these securities, many of which
had been granted triple-A status by the credit
rating agencies, could be risky and illiquid (i.e.,
difficult to sell). Tried-and-tested models for
valuing mortgage-backed securities and
related instruments became unreliable. In
2006 tens of billions of dollars of new
securities were being issued every week in the
international wholesale banking markets; by
mid-August 2007 these markets were
paralysed.
One category of British bank – three former
building societies (Northern Rock, Alliance &
Leicester, and Bradford & Bingley) specialising
in mortgage lending – were particularly
threatened by these developments. They had
never had the extensive branch networks that
had provided the large clearing banks with
their retail deposits, and so had financed their
expansion since the mid-1990s predominantly
by wholesale funding. Northern Rock had been
the most aggressive and successful of the
three specialist mortgage banks, and was
most dependent on continued wholesale
borrowing. When it realized in mid-August
2007 that it could not roll over a significant
proportion of its liabilities, amounting to over
£5b. out of a total balance sheet of more than
£100b., it informed its regulator, the Financial
Services Authority. The message was that
within a few weeks it would need a large loan
to prevent a fire-sale liquidation of its assets.
The need to approach to the FSA was itself a
Northern Rock and the European Union
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departure from precedent. The 1998 Bank of
England Act and the 2000 Financial Services
and Markets Act had taken the job of banking
supervision away from the Bank of England
and shared it out, in rather ill-defined
proportions, between the FSA, the Bank and
the Treasury (the so-called ‘Tripartite
Authorities’). Until 1998 a bank with funding
difficulties would have gone directly to the
Bank of England. Indeed, within the memory
of many people working in the City of London,
numerous banks had done exactly that in the
‘secondary banking crisis’ of the mid-1970s
and a smaller, less well-known crisis in the
early 1990s. The secondary banking crisis had
affected dozens of institutions and
endangered billions of pounds of bank
lending. It had arisen from an explosion of
credit after the removal of artificial official
restrictions on the banks in September 1971,
and a subsequent boom and bust in property
values. The Bank’s handling of the secondary
Northern Rock's growth as a mortgage bank
Chart shows earnings per share, on FRS3 basis
0
20
40
60
80
100
120
140
1998 1999 2000 2001 2002 2003 2004 2005 2006
p.
Northern Rock grew its earnings per share by a
compound 17% a year in the first eight years from its
demutualisation in 1998 and was widely regarded as
having a successful business model.
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banking crisis was expensive (in terms of the
losses the Bank itself took), but by common
consent its negotiations with a wide range of
financial system counter-parties were welljudged
and skilful. Throughout the crisis the
understanding in the world’s financial
markets remained that a British bank deposit
would always be repaid at par. Although
several institutions lost all the investment
made by their shareholders, there was no run
on a British bank.
The FSA in 2007 – unlike the Bank of England
in 1974 – had no capital, no balance sheet and
no ability to lend. So the FSA had to report
Northern Rock’s problem to the Bank and
together they had to coordinate a response.
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