A Deposit Protection Scheme was one of the provisions of the 1979 Banking Act. But it was not the only provision of that Act, and in many ways not the most important. In the words of the Bank of England (my emphasis):
Before the introduction of the first Banking Act in 1979 there was no statutory requirement that a bank or similar deposit-taking institution be authorised to accept deposits or undertake banking business in the UK. There were disclosure requirements (Protection of Depositors Act 1963) on those institutions that advertised for deposits, including the obligation to include in their accounts prescribed information, which were examined by the Board of Trade. However, banks and discount houses were exempt from these requirements.In other words, pretty much anyone could set themselves up as a deposit-taker and lender. Banking licences were granted by the Board of Trade without consideration of standing or conduct, and banks were not obliged to accept the Bank of England's supervision. Consequently there were a large number of effectively unregulated and unsupervised small banks, competing with each other for increasingly scarce deposits and lending mainly for property purchase.
The Secondary Banking Crisis of 1973-5 saw the near-failure of about 60 small lenders which had borrowed heavily on the wholesale money markets to fund mortgage lending. The Treasury, then responsible for monetary policy, had raised interest rates into double figures to fight inflation, and this caused a sudden crash in property prices and a spate of mortgage defaults. Concerned about systemic stability, the Bank of England opted to provide liquidity support for these banks to prevent their failure, a decision which cost it about £100m. No depositors lost any money, but there was widespread recognition that depositors' money had been at risk, and the excessive risks taken by these banks needed to be curbed. Following extensive consultation, the 1979 Banking Act was passed, which for the first time mandated the Bank of England to issue banking licences and supervise banks.
The Deposit Protection Scheme created by the 1979 Banking Act came into effect in 1982, and was almost immediately followed by a series of depositor compensation claims arising from the Bank of England closing down banks that didn't meet the criteria for either a full banking licence or a deposit-taker's licence (the 1979 Act distinguished between the two). But what happened later was much more interesting.
The report I found today examines 22 banks that failed and created potential claims on the Deposit Protection Scheme between 1984 and 1996. Most of these were small banks, but five were large enough to cause systemic disruption, and two - BCCI and Barings - are now household names. The fall of Barings remains one of the worst "rogue trader" events in history, and the extent of the BCCI fraud was exceeded only by Enron. Until recently, that is - the mortgage fraud in the US that underpinned the financial crisis looks set to be the worst corporate fraud in history, and the LIBOR rate-rigging scandal will run it a very close second. Or vice versa. Either way, BCCI and Enron now look like minor blips. But I digress.
The remaining three larger banks that failed were not known to me, so I looked them up. And what I found was fascinating and instructive. We simply do not learn from our past history: even though we put in place regulatory and supervisory measures to curb the excesses that lead to failures like National Mortgage Bank and Johnson Mathey Bank, over time we forget about them and we make the same mistakes again.....
National Mortgage Bank (NMB) was extraordinarily like Northern Rock. It borrowed on the wholesale markets to fund high-risk mortgage loans (yes, subprime existed in the 1980s!) which it then packaged up and sold on in an early form of securitisation. When BCCI failed, nervous money market lenders reduced wholesale lending, and NMB was forced to go to the Bank of England for emergency funding in February 1992. It all sounds horribly familiar, doesn't it? Except that Eddie George, then deputy Governor, kept the press at bay: the Bank of England resolved NMB swiftly and quietly, there was no panic and no run on the bank. What a contrast to the inept handling of the Northern Rock failure by an inexperienced Treasury team and emasculated Bank of England. The chairman of the restructured NMB, Ian Hay Davison, makes it very clear that in his view the separation of the Bank of England from bank supervision was the reason for the relatively poor handling of Northern Rock. But what I want to know is - given that the Secondary Banking Crisis was caused by high-risk property investments funded by volatile money market borrowing, and the failure of NMB was caused by high-risk property investments funded by volatile money market borrowing, why did the Northern Rock failure happen at all? Why didn't these failures teach regulators to monitor and control retail banks' propensity to over-borrow and over-lend when property prices are rising? Why are we STILL not making any attempts at all to moderate retail banks' risky behaviour?
Turning now to Johnson Mathey Bank. JMB was the banking services arm of a major precious metals company. Originally it was purely a bullion dealer and a member of the London Gold Fixing. But in the early 1980s, JMB expanded its activities into corporate lending, quickly building up a huge portfolio. The scale of its lending dwarfed its capital and it was heavily exposed to a small number of borrowers, some of whom turned out to be fraudulent. The decision to bail out JMB was made on the grounds of its importance in a very concentrated bullion business and worries about contagion causing panic in the wider banking industry. The Bank of England bought JMB for a nominal £1 and later sold it to Westpac. The concentration and riskiness of JMB's corporate lending portfolio led directly to the tightened reporting requirements for large exposures in the 1987 Banking Act. Yet if we fast-forward to 2008 - what caused the failure of HBOS? Yes, it was corporate lending: high-risk and fraudulent loans concentrated in particular sectors, dwarfing the bank's capital and funded by volatile wholesale borrowing. So given that the failure of JMB actually did lead to regulatory changes, how was HBOS allowed to happen? And since the cry at the moment is for banks to increase risky lending to risky businesses in order to "get the economy moving", what chance is there of anyone learning from this failure, either?
The third one was British & Commonwealth Holdings. Here is the first paragraph of the House of Lords judgement regarding Soden vs British & Commonwealth Holdings:
In 1988 British & Commonwealth Holdings P.L.C. ("B.& C.") purchased for some £434 million the whole of the share capital of Atlantic Computers P.L.C. ("Atlantic"). The acquisition proved to be disastrous. Atlantic went into Administration in 1990. The Administrators of Atlantic are the appellants in your Lordships' House. B. & C. is also in Administration. It has brought proceedings against, inter alia, Atlantic ("the main action") for damages for negligent misrepresentations said to have been made by Atlantic so as to induce B. & C. to acquire its shares. B. & C. has also brought proceedings against Barclays de Zoete Wedd Ltd. ("the B.Z.W. action") for damages for negligent advice given in relation to the acquisition of the Atlantic Shares. B.Z.W. has issued third party proceedings against Atlantic for contribution and damages.Yes, you're right. B&C was bankrupted by an unbelievably stupid acquisition of a company already riddled with debt and technically insolvent, without doing proper due diligence and with fraudulent misrepresentation of the share price. The House of Lords finally dismissed Atlantic's appeal in 1997 - but by that time B&C had been dead for 7 years. The B&C failure happened in 1990. In 2008, RBS failed due to an unbelievably stupid acquisition of a company already riddled with debt and technically insolvent, without doing proper due diligence and probably with fraudulent misrepresentation of the share price. Whatever was learned from the B&C failure had evidently been forgotten by the mid-2000s.
In fact all the lessons from the bank failures of 1982-96 had been forgotten by the mid-2000s. I am not hopeful that the lessons of the failures of Northern Rock, HBOS and RBS will be learned either. The Bank of England's report into the 22 bank failures identifies five main causes of bank failure. In order of importance, they are as follows:
- Bad management (18 of 22)
- Poor asset quality (16 of 22)
- Liquidity problems (9 of 22)
- Fraud (7 of 22)
- Dealing losses (2 of 22)
You will note that dealing losses comes last on the list. But which one are we paying the most attention to? Yes, dealing losses - hence that ridiculous ring fencing idea that gets far too much air time, and calls for structural separation that would achieve nothing but make everything more expensive. Why is no-one paying much attention to the top two - which are bad management and poor asset quality (i.e. highly risky lending)? These were by far the commonest cause of bank failure in the 1982-96 period. In fact they have ALWAYS been the top two causes of bank failure.
Those who wish to return to some kind of "golden age" when there were lots and lots of little banks might like to ponder on the findings of the 1996 report:
Another relevant factor, but one which is not highlighted, is size. All banks are affected by macroeconomic conditions. But smaller less-diversified banks do appear — not surprisingly — to be generally more vulnerable to changes in market conditions than large banks which are diversified across a number of sectors and income sources.So breaking banks up, restricting their size and limiting their range of activities DOESN'T make them safer. It makes them more likely to fail, not less. And the Secondary Banking Crisis shows us that when there are a lot of small banks all operating in the same sector, together they can create considerable systemic risk.
The message I am trying to give is this. Almost everyone seems to have an opinion about "how to fix banking". And some radical ideas are being considered. But no-one seems to be looking at what actually went wrong, either recently or in the past. If they did, they might come to different conclusions. For me, breaking banks up, separating retail & investment banking, full reserve backing for deposits - all of these miss the point. What is needed is consistent long-term regulation of the dull & boring activities of banks - deposit-taking and retail lending - and continual supervision of bank management. That's where the risks build up unnoticed. That's where the cause of most failures lies. Let's focus on controlling those, and stop worrying about the fruitcake stuff. It's really not important.