The current debacle over Northern Rock is going to lead to a complete rethink on markets and the way they are governed.

The sight of bank depositors queuing to remove their funds from UK mortgage provider Northern Rock sent shockwaves around the world. It broke through the celebrity fog of US primetime TV and was also an item as far away as Ulaanbaatar, the capital of Mongolia.

It was the first run on a British bank since the collapse of Overend in Guernsey in 1866 and thoroughly shook the complacent belief that somehow markets employing the vogue regulatory model – a unified regulator and an independent central bank – were immune from the subprime crisis.

For months bank chiefs and government officials have been posturing that the subprime crisis was a localised event – in the US – without contagion risk and that market wobbles would soon be replaced by business-as-usual shrinking yields. In a way it is their job to say that so who can blame them.

Analysts have argued that the logical outcome of a credit boom is a credit crunch and the only debate to be had is about its timing, form and severity. It must now be clear that this is no passing rain shower and that the crisis still has a long way to go with further surprises expected along the way.

While all financial markets crises are the result of excess, this one is decidedly ‘new era’ in that the nature of globalised markets and the diversification of risk means it could pop up almost anywhere. But at the same time, the fact that so far everything has come back to rest with the banks gives one a feeling of déjà vu.

Regulators, meanwhile, have been fighting last year’s battles – capital adequacy when it appears that liquidity issues arising from the freezing up of wholesale markets is now the key issue – and worrying about the demise of a hedge fund when from a reputational perspective banks are still shouldering responsibility for off-balance-sheet structures and funds that were supposed to be out of their hair.

Government rethink

In the true nature of crises, the current debacle is going to lead to a complete rethink about markets and the way they are governed. The Bank of England initially tried to play hardball and waved the moral hazard card but was forced to retreat the moment things got too choppy.

Governor Mervyn King pleaded that this reversal – his decision to bale out Northern Rock after saying that those in trouble should suffer their fate – was not due to political pressure. But this piece of action, together with the US Federal Reserve’s hefty 50 basis point rate cut, raises the questions (which many thought had long been answered) as to how independent central banks really are and what exactly their role is. The British approach of going public when a bank gets into trouble also needs review, as it merely hastened Northern Rock’s troubles.

At a more technical level there are issues around whether assets are really off balance sheet or not; the robustness of online banking (Northern Rock’s website crashed almost immediately); the appropriateness of bank risk management systems and whether in responding to the various regulatory initiatives they are now cumbersome and unwieldy; and, as usual, the role of credit rating agencies and whether they should be looking at liquidity and market value as well as credit risks.

Investors must also take their share of the reproach for investing in structures they did not fully understand and for failing to read the reams of documentation they were provided with. It is a long to-do list and may become even longer before the current crisis is abated. Let us hope most survive the rest of the journey in reasonable shape.

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