joanna gray

8/6/2019 Joanna GRAY

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FINANCIAL REGULATION BEFORE AND AFTER NORTHERN ROCK

Joanna Gray, Newcastle Uniersity

Just over three years ago queues of worried and panicking bank depositors began

to form in the streets outside the branches of the UKs tenth largest bank and fifth largest

mortgage lender in one of the largest and most sophisticated financial economies in the

world.1Narratives and analyses of causes and responsibility for what was the first run on

a maor UK bank since the late 1!th"entury can be found in subsequent official

reports

#

and the academic literature in law$ economics and public policy and these will

continue to be developed and debated in years to come. %owever one thing became

crystal clear in mid&'eptember #(() and that was that the institutions and processes put

in place for the maintenance of financial stability and the prevention of bank runs and

panics by the last maor reform in UK financial regulation had not worked. *hat reform

first conceived in 1!!) on the election of a +abour ,overnment transferred responsibility

for the prudential supervision of deposit&taking institutions from the -ank of ngland/to

the newly formed 0inancial 'ervices uthority established and empowered by the

0inancial 'ervices and 2arkets ct #(((.

s the crisis in the financial system has deepened and spread into the real

economy there has been much fundamental 3back to basics4 rethinking around some of

the assumptions made about the optimal structures$ institutions$ obectives and

substantive content of financial regulation both in the UK and indeed around the world

that cannot be effected without changes to the attendant legal institutions and codes of

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financial regulation. *his chapter uses that 'eptember #(() depositor run and subsequent

nationalisation in 0ebruary #((5 of Northern 6ock as the lens through which to give an

account of how legal and regulatory reform has unfolded insofar as it affects the

regulation of financial stability and minimisation of systemic risk. *he paper concludes

with some critical comment about the practicality of some of the current and recent

proposals ostensibly designed to make the financial system 3safer4 for the future.

THE REGULATION OF NORTHERN ROCK

Northern 6ock was a mutually owned building society based in the North ast

ngland which became a public company in 1!!) at a time when a number of large

mutually owned financial institutions assumed proprietary status so that their borrower

and depositor members became shareholders in a public listed company. 7ver the ten

years since it first became a public company N6 grew to become the UKs eight largest

bank and fifth largest UK mortgage lender. 8ts business was primarily financed by

wholesale money market finance rather than by retail deposits. *he sudden loss of

liquidity that afflicted the wholesale money markets by ugust #(() meant that N6

could not raise operating finance$ and although solvent in a balance sheet sense it could

not pay debts as they fell due so it alerted its regulator$ the 0inancial 'ervices uthority

90':$ to its difficulties on 1/ ugust #((). 8n the UK formal responsibility for financial

stability and vigilance against and curtailment of risk to the financial system was shared

between the 0'$ the -ank of ngland and %2 *reasury 9the UK ,overnment

department with overall responsibility for all aspects of financial policy in the UK:.

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*hese three bodies were collectively referred to as the *ripartite uthorities 9;*ripartite

hereafter: and the terms on which that responsibility was to be e


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announced the banks nationalisation heralding a period of 3temporary public ownership4

of N6.

*hat nationalisation was achieved by the passage into law on #1 0ebruary #((5 of

the -anking 9'pecial Crovisions: ct #((5$ which effectively provided the legal basis for

this and other subsequent bank nationalisations$ and the entire share capital in N6 was

acquired by the ,overnment on ## 0ebruary #((5 pursuant to that ct. *hat ct and

secondary legislation made under it established the principle that compensation be paid

to the N6 shareholders by a scheme of independent valuation of compensation to be

conducted on the basis of the twin assumptions that that all financial assistance provided

by the -ank of ngland or the *reasury had been withdrawn 9whether by repayment

being demanded or by other means:$ and that no financial assistance would in future be

provided by the -ank of ngland or the *reasury to the deposit&taker in question.Dny

compensation due N6 shareholders was further to be computed on the basis that at the

point of its nationalisation the company was unable to continue as a going concern and

was in administration.E*hese provisions have resulted in a somewhat unholy alliance of

two very large and active hedge funds that held significant stakes in N6 at the time of its

nationalisation and$ at the other end of the scale of shareholder siFe$ passivity and

investment horiFons$ a representative group of small$ individual$ shareholders in N6.

United in their view of what they saw as confiscatory and unfair terms of compensation

imposed by ,overnment as part of the N6 nationalisation these somewhat odd

bedfellows have combined forces to bring a most interesting legal challenge to this

legislation which$ although unsuccessful to date in the %igh "ourt and "ourt of ppeal$ )

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is being taken to the uropean "ourt of %uman 6ights now that the new 'upreme "ourt

had declined to hear the shareholder appeal.5*his litigation has resulted in the

development of udicial narratives on responsibility for systemic stability and who should

bear the losses and responsibility for value destruction that materialise as a result of

failures in a financial system that appear to have comple< and multi&factor causes that has

been the subect of comment elsewhere.! *his chapter e


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the defining feature of the UK 0inancial 'ervices uthoritys modus operandiand whole

philosophy of regulation I namely risk related regulation and supervision. @uring its

early stage development as a financial regulator$ shortly after it assumed from the -ank

of ngland direct responsibility for bank regulation and supervision$ 0' identified

;6isk$ specifically risk to its four legislative obectives1D$ as the organising concept

around which all future regulatory activity$ including supervision$ enforcement$

intervention and overall strategy and policy development would be built. *wo e


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environmental regulation15and the idea is that a standard should be e


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funding mechanisms, including the repo market. I have to say, I do not think any

reasonable professional would have anticipated that set of circumstances, but I

think as a regulator we should have engaged with that in an etreme stress

test...!#(

nd yet the "7 of N6 itself saw the risk of the sources of N6s wholesale

financing effectively all simultaneously closing for such a long period to be an

unforeseeable$ unprecedented and entirely unpredicted event and pointed out in his

evidence to the *reasury 'elect "ommittee that no maor authority had in fact foreseen

it.#1%ence$ viewed from the perspective of the individual organisation what happened

cannot properly be described as a ;risk and is more in the nature of genuine uncertainty.

%owever this was not the view of events e


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*he second of the key techniques through with 0's risk&related regulatory

philosophy hitherto found e


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*he run on and subsequent nationalisation of N6 and subsequent events have

revealed many other shortcomings within the practical processes and capabilities of UK

financial regulation as well as problems in the 667G supervisory framework and

perceived problems with 0's less intrusive style of 3principles based4 regulation.

*hese include the lack of a bespoke statutory insolvency regime for dealing with failing

banks$ the lack of public understanding and confidence in the UKs deposit protection

scheme for retail depositors$ the inability of the -ank of ngland and N6 to keep

confidential the fact that it had sought and received emergency financial support in

'eptember #(() 9both of these being factors that contributed to the bank run: and the lack

of a clear financial stability obective for the -ank of ngland. #=8n the meantime whilst

consultation relating to longer term legislation was ongoing the -anking 9'pecial

Crovisions: ct #((5$ provided the *reasury with emergency powers to facilitate an

orderly resolution to maintain financial stability or protect the public interest and this

temporary measure was used not only to nationalise N6$ but later in #((5 also -radford

L -ingley 9one of the largest mortgage lenders on residential property bought by way of

investment:#Dand to intervene in order to protect retail deposits held in the UK

subsidiaries of 8celandic banks. s the banking crisis deepened throughout #((5 the

subsequent UK ,overnment acquisitions of shareholdings in the 6oyal -ank of 'cotland

and in +loyds *'- 9following the liabilities it took on when it had earlier ;rescued

%-7' plc: to forestall funding crises in those much larger institutions all but dwarfs the

scale of the Northern 6ock nationalisation.#E*hat ct has now been replaced by the

-anking ct #((! which 91: reforms insolvency and administration procedures giving

0' new powers for use specifically with banks only$ a range of legal tools such as

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transfer to temporary public ownership$ or a private sector purchaser or a ;bridge bank

are all now options for dealing with banks in or likely to encounter distress. *hese powers

are to be e


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RETHINKING REGULATOR! TA#K# AND FOCU# IN THE UK

fter publishing its criticisms of the handling of Northern 6ock the *reasury

'elect "ommittee went on to make broader criticisms of the way in which all three of the

*ripartite bodies responsible for financial stability in the UK performed in the failure to

follow through the implications for the stability of UK financial institutions of the

growing threat to the supply of wholesale liquidity posed by the very mispricing of risk

about which 0' had long been warning in the credit markets and the emerging problems

in the U' housing market.

/#

s has been the case here too in the U'$ #((5 was largely

taken up with responding to a rapidly deepening crisis and preventing total catastrophe in

the financial system so that the 'eptember #(() run on Northern 6ock and its

nationalisation began to look relatively small scale compared to some of the action the

UK government was the forced to take in terms of supporting and rescuing much larger

and more systemically significant banks. Nonetheless the run on Northern 6ock still was$

in the words of the *reasury 'elect "ommittee$ 3a catalyst for change4 in regulatory

practice and marked the beginning of the re&thinking of the intellectual foundations of

regulation of financial markets that is still ongoing.//

8n 2arch #((!$ +ord *urner$ the current "hairman of the 0inancial 'ervices

uthority produced a ;root and branch questioning of some of the assumptions that have

governed how we should best regulate financial markets and discussed$ among many

other issues$ the shortcomings of risk measurement models employed within regulated

firms and embedded in standards and processes used in risk&based regulation./=%is main

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conclusion$ which echoes those now being drawn in other urisdictions and at

supranational level$ was that a ;lack of [a system"wide macro"prudential] perspective,

and the failure to specify and to use macro"prudential levers to offset system risks, were

of far more importance to the origins of the crisis than any specific failure in supervisory

process relating to individual firms/D%ow best to achieve this more forward looking and

holistic macro&prudential management of the financial system$ and indeed whether or not

it is truly a realistic and achievable aspiration$ is now perhaps thekey theme to debate on

financial regulation.

Unsurprisingly$ as 0' "hairman$ *urner saw no need to radically reorder the

institutional responsibilities for financial regulation in the UK and would retain the model

introduced over a decade ago of a single$ unitary financial regulator responsible with

prudential$ conduct of business and systemic risk responsibilities for the entire financial

sector. s for ;principles&based or ;lighter touch regulation$ the *urner 6eport

acknowledged that this less intrusive regulatory philosophy was based on 3the then

dominant philosophy of confidence in self correcting markets .and was not with

hindsight aggressive enough in demanding adustments to business models which even at

level of the individual institution were e


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increasingly clear before the election that ;light&touch and risk based financial regulation

was effectively dead. *he run on Northern 6ock marked the start of a progressive

abandonment by 0' of an approach to its 0'2 #((( responsibilities that respected the

autonomy of regulated firms in working out how best to minimise risk to regulatory

obectives through their interpretation and application of general phrased regulatory

principles. Just one e


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financial regulation is planned by the new ,overnment. Gith its emphasis on#udgment,

$ocus and %tability the language in the very title of the July #(1( consultation that

introduces these proposed reforms signals that change is to come$ not ust at the formal

and institutional level of financial regulation$ but at every layer and process of regulation$

in the inner meanings and psychology of regulation and regulatory actors$ as well as in

their e


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uthorityH Mes$ insofar as institution&specific regulation goes but certainly not insofar as

system&wide risk is concerned. 8nstead there is a new form of risk based regulation in

town I but the risk it seeks to signal for and act as a buffer to is a risk that cannot be

diversified away or reduced by the actions of any single institution$ sector or even

country I for it is the risk that is endogenous to the whole game itself and thus requires a

holistic and panoramic lens and a fle


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members of N6 on the one hand$ and the "7 of the 0' on the other hand$ as to

whether the closure of the sources of wholesale finance of #(() was foreseeable on the

part of anyone.==*he 0' took the view that they should have foreseen it but failed to do

so$ due to shortcomings in the application of the 667G model Ghether it is fair or

wise to have such e


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stumbles the ne


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17ne typical headline on 1D 'eptember #(() ran 3&olice called to break"up Northern Rock panic 'ueues as customers

withdraw millions4 in the @aily 2ail.

#Dth6eport from %ouse of "ommons *reasury 'elect "ommittee (he Run on the Rock %" DE&8 9January #((5:

/-ank of ngland ct 1!!5

=+astra$ 6. 9#((E:)egal $oundations of International *onetary %tability7


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1/$%A Internal Audit 2epartment In'uiry into supervision of NR9pril #((5 0':.

1=@alker Review of 5orporate overnance in B 0anks and other financial institutions9 "onsultation @ocument July

#((!? 0inal 6eport November #((! :

1D'ection # 0inancial 'ervices and 2arkets ct #((( defines these as market confidence? public awareness? protection of

consumers? and the reduction of financial crime.

1E-lack$ J. 9#((D: S*he mergence of 6isk -ased 6egulation and the New Cublic 2anagement in the UKS&ublic )awD1#&

D=!? ,ray$ J. and %amilton$ J. 9#((E:Implementing $inancial Regulation$ Giley 0inance$ "h #

1)&rinciples"based Regulation9 $ocusing on the 4utcomes that *atter90' pril #(():? -lack$ J.? %opper$ 2. and -and$

". 9#((): S2aking a 'uccess of Crinciples -ased 6egulationS 91:)aw and $inancial *arkets Review1!1(E? 0lueprint

for a *odernised $inancial Regulatory %tructure 9U' *reasury 2arch #((5: at 11D and at 1!1

157gus$ .$ 91!!=:Regulation9 )egal $orm and 7conomic (heory$ "larendon$ "h 5.

1!*he 0ifth report from *'" in #(()#((5

#(vidence given by %ector 'ants$ "7 of 0' to *reasury 'elect "ommittee$ ! 7ctober #(()

#1vidence given by the former "hairman and "hief


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