It was a Thursday afternoon in late 2006. Mervyn King, the Governor of the Bank of England, Callum McCarthy, the head of the Financial Services Authority, and I were being presented with a dangerous and fast-changing financial war-game scenario, designed by our officials at my request to test out our mechanisms for dealing with a future financial crisis should one arrive.
In that war game, a northern building society was on the verge of going bankrupt, having borrowed far too much. One of the largest British clearing banks was heavily exposed to that building society and now risked running out of money overnight. Unless we did something immediately to guarantee its deposits and provide emergency resources, there was a real danger the bank would have to cease trading. Its cash machines would empty, the doors of its branches would close. At best, public confidence in the banking system would be lost. At worst, there would be widespread panic.
We debated what to do. Mervyn was clear that bailing out the clearing bank risked what the economists call “moral hazard”, the idea that banks and their shareholders will be more emboldened to make risky investments if they think they are immune from the consequences.
Callum and I took a very different view, namely that a large bank going bust would hugely damage confidence in the UK economy, and in our war game I was clear that we had to make a public statement before the 6pm news to calm the public’s worries and reassure them that we would not let the financial system collapse. Little did any of us know that just eight months later a crisis with eerie parallels would unfold in real life.
I left the Treasury in June 2007 to move into the Cabinet as Children’s Secretary, and just a few weeks later in August, the credit crunch began.
In August, on holiday in the south of France, Yvette, the kids and I visited Sue Nye and her husband, the economist Gavyn Davies, at their holiday home. While the children played in the pool, Gavyn and I discussed what was happening. We agreed that the financial markets looked as shaky as we’d known them, and it would be very important for Mervyn King to send a clear signal that the Bank of England would step in to provide support if needed.
As it turned out, and contradicting the conclusions reached during our war game, Mervyn did the opposite, informing the Treasury Committee just a few weeks later in early September that he did not think it was the Bank of England’s job to bail out ailing financial institutions.
Two weeks on, with queues of savers waiting to get their money outside branches of the deeply troubled Northern Rock, the crisis became a reality for the public.
After Northern Rock’s bankruptcy fears were exposed by Robert Peston on the 10pm news, I was astonished to wake up the following morning to find there was still no government line on the 7am BBC bulletin explaining that things were under control and that people’s deposits were safe.
It was one of the very rare times that I called the Downing Street switchboard and asked to speak to the Prime Minister urgently. Something needed to be said to reassure the public that the government was in control. Alarm bells must also have been ringing next door at 11 Downing Street and an hour later Alistair Darling was on the Today programme explaining that a plan was in place: the deposit insurance scheme was to be expanded, thereby protecting all savings.
It is an uncomfortable truth that less than a year before this Northern Rock debacle, we acted out that “war game” at the Treasury anticipating almost exactly this scenario, and rehearsing how the British financial authorities would respond. And yet, despite that effort, we were still taken totally by surprise and unprepared when the real crisis struck.
For all the talk now of Labour’s championing of the City and supine reliance upon the banks to bring in tax revenues, the explicit task I was given when I became City minister in 2006 was to try to repair what had become very antagonistic relations between the banking industry, the City of London and the government.
Gordon Brown had never been a great fan of banks. On assuming the Chancellorship in 1997, he commissioned Don Cruickshank, the former Telecoms regulator, to conduct a review into competition in the banking industry, something the banks definitely saw as an unfriendly act.
Cruickshank wasn’t the only reason why the Treasury’s relationship with the banks was rocky. The decision — alongside Bank of England independence — to move responsibility for banking regulation away from the Bank to a new statutory regulator, the Financial Services Authority, was seen as an attempt to get tougher on the banks, following the fiasco of Barings Bank’s “rogue trader” Nick Leeson.
In fact, both senior Treasury officials and the new Deputy Governor of the Bank, Mervyn King, wanted to go further and have a complete separation of the Bank of England from any oversight of the commercial banking system.
But both I and the Governor, Eddie George, were determined that the Bank of England should continue with an oversight role for the wider stability of the financial system, which obviously included the health of the banks. Mervyn would regularly complain to me that the financial stability wing of the Bank of England was much too overstaffed compared to monetary analysis. He was determined to rebalance the Bank’s priorities when he took over as Governor.
Senior figures from the stability wing have subsequently told me that they felt unable to ask the FSA for the details of the capital health of individual banks. They felt that was the FSA’s job, not the Bank of England’s, and in retrospect, I understand how those kinds of turf wars can occur between institutions.
If anyone had ever come to me, as a Treasury adviser and then as a minister, to complain they weren’t getting access to information, I would have immediately done something about it. But no one ever did, and I’m afraid neither the Bank of England nor the FSA were spotting what was going on, and post-hoc attempts to say “We’d have spotted it if . . .” are rather too wise after the fact.
Worse was to come when the issue arose as to whether RBS would be allowed to take over the Dutch Bank ABN AMRO, which it was competing to do against Barclays. I asked senior Treasury officials to give me their views and to get advice from the Bank of England and the FSA.
And the word back from all quarters was that the takeover was fine to proceed. The only word of caution was the Bank insisting that the merged entity had to be regulated out of London rather than the Netherlands because we didn’t trust the Dutch regulator. At no stage did anyone raise even the slightest concerns about the state of ABN AMRO’s balance sheet, or whether RBS/NatWest’s balance sheet was strong enough to cope with the added stress. If we’d looked into those in anything like the detail required, we’d have seen that both of them were potentially in huge trouble.
But if you want a sign of how much that was off our radar, look back at our war game in late 2006, when the fictional UK clearing bank was in difficulties and the FSA suggested an international bank as a possible buyer. Who did they suggest? ABN AMRO. In hindsight, it’s tragic.
Talking to Mervyn a few years later, I asked him whether he worried that, only a few months before the financial crisis, none of us spotted the warning signals that the financial system was becoming too overextended. He replied that, in fact, the financial stability wing of the Bank of England had done some work in their annual report, led by the then Deputy Governor, John Gieve, which highlighted some of the risks.
But as I said to him then, the fact that we used to meet every month while I was the City minister to discuss the financial system, and not once did the Governor raise any of those concerns with me, indicates that they were clearly not at the forefront of his or anyone else’s mind at the time, except perhaps John Gieve’s.