The Northern Rock saga continues. The House of Commons Treasury Select Committee completed its examination of the circumstances surrounding the crisis at Northern Rock and produced Volume 1 of its report on ‘The Run on the Rock’ (HC 56-1) on 26th January 2008. The Committee had already been considering financial stability issues since early 2007 and extended the scope of its examination to include Northern Rock and the operation of the financial stability framework maintained in the UK, in particular, under the revised Memorandum of Understanding entered into between HM Treasury, the Bank of England and the FSA on 22nd March 2006. George Walker picks up story in this article.
The Treasury Committee Report contains a significant amount of valuable factual information especially on Northern Rock’s business model, the earlier supervision and regulation of the bank, the events in August and September 2007 and subsequent action until January 2008. Interesting observations are made on the importance of banks and need to ensure that appropriate procedures are available in dealing with failing banks, depositor protection, regulatory and political lessons and possible reforms. The Report is particularly critical of the management of Northern Rock but equally of the supervision conducted by the FSA. The Committee refers to the FSA’s systematic failure in identifying and responding to the clear warning signals that arose and of the inadequacy of the stress testing conducted. Overlapping the appointment of chairman and chief executive of the bank is referred to and the lack of banking specific qualifications of either is questioned. The banking industry has strongly questioned any call for review of CEO and senior manager’s qualifications within banks.
The Bank of England’s hesitation in supporting the money markets is referred to and the supposed failure of the Tripartite arrangements set up under the MOU. The Report is highly critical in places. The more detailed discussion is nevertheless balanced and informed and appears to appreciate the information and timing difficulties with which authorities had to deal. This still makes a useful and valuable contribution to the Northern Rock debate and is to be welcomed in these terms. Other issues will be considered in further detail in the follow-up volume II Report.
The Chancellor of the Exchequer launched the Government’s formal consultation process with a joint paper on Financial Stability and Depositor Protection: Strengthening the Framework which was issued jointly with the Financial Services Authority (FSA) and the Bank of England on 30 January 2008. This provides an introduction and overview of modern financial markets and the framework for financial regulation in the UK. Measures to reduce the likelihood of a bank failing are considered with possible corresponding action to reduce the impact of such crises. Consumer confidence and compensation arrangements are examined with proposals made for the strengthening the role of the regulations. Further recommendations are produced on effective coordination with a separate impact assessment being provided. The January consultation paper follows the earlier discussion paper on Banking Reform: Protecting Depositors produced in October 2007 and issued soon after the events at Northern Rock.
The proposals contained in the January 2008 consultation paper are stated to build on best practice from around the world and to represent an opportunity to modernise the UK regulatory regime in response to the challenges presented by rapidly changing financial markets. The Government, FSA and the Bank of England are to consult on the proposals put forward. This work is to be based on five key objectives referred to in terms of strengthening the financial system, reducing the likelihood of banks failing, limiting the impact of collapse, developing effective compensation arrangements and strengthening the Bank of England and securing improved coordination between the authorities. Formal response measures will follow before the summer of this year.
The Tripartite authorities issued a separate statement on a revised financing structure for Northern Rock on 21st January 2008. This was stated only to be made available in respect of proposals that would protect taxpayers’ interests as well as meet the authorities stated objectives of financial stability and consumer protection. The Government confirmed that if a private sector solution was not possible, it would bring forward legislation to facilitate the temporary nationalisation and public ownership of the bank. The refinancing anticipated that Northern Rock would raise funds from investors in the financial markets backed by a mixed pool of assets. The initial Bank of England loan would then be repaid by bonds backed by a securitisation pool with securitisation and structured finance having led to the original credit tightening that caused Northern Rock’s funding difficulties. The proposal will be submitted to the European Commission for approval as a state aid before 17th March 2007. If the bank is to be nationalised, the Treasury has confirmed that the company would be managed at arm’s length and on a commercial basis for a temporary period.
Public Acquisition
The Government subsequently announced that it would take Northern Rock ‘into public ownership’ on Sunday 17th February 2008. The Government had considered the outstanding bids submitted with the assistance of Goldman Sachs and decided that it was in the public interest to assume control over the bank rather than proceed through a private market solution. The deadline for private offers had ended on 16th November 2007 with the preferred bid having made by the Virgin Group with two other bids from Olivant and a private management group. Olivant subsequently withdrew its offer at the beginning of February 2008.
Under the Virgin bid, £1.3bn of equity would have been injected into Northern Rock with £11bn of the Bank of England loan having been paid immediately and the balance cancelled by 2010. Additional shareholder funds would have been raised. The Chancellor accepted that the Virgin proposal would have brought in a new brand and management although taxpayers would not have received any share in Northern Rock’s recovery until its value had reached £2.7bn. This was disputed by Virgin which claimed that the Treasury would effectively have received a return when the share price reached 50p in light of the cash and private capital to be invested. Virgin was pressed to offer £100-200m for the use of the Government guarantee and a further £100-200m in equity warrants although it considered that it could only offer £300m in total and £500m in the event of Northern Rock’s recovery. The Virgin Group could then have received between £1-1.5bn with the Treasury receiving £0.5bn in the event of Northern Rock’s full rehabilitation.
The Government had set out how it would assess the bids following the deadline for offers in November 2007 and then again as part of the proposed refinancing in January 2008. This would, in particular, be considered having regard to the need to protect depositors’ money, protect taxpayers and maintain financial stability. The Government accepted the need to make available a continuing ‘backstop guarantee’ arrangement in light of the difficulty in obtaining exclusively private funds in the prevailing market conditions. The Government then concluded in February 2008 that the private bids would not balance the risks borne on each side and that public ownership would allow the Government to secure the entire proceeds from any future sale of the business.
While many commentators have supported the eventual decision to nationalise Northern Rock, it is highly questionable whether the decision should have been taken solely on the basis of the Treasury’s commercial share in the bank’s performance and business recovery especially following a period of possibly extended private sector management. The Treasury would have had to support the bank either directly (through the guarantee) or indirectly (through the Bank of England loan facility) in any case once the decision had been taken not to close Northern Rock. The Treasury was offered a reasonable return although it apparently wanted more possibly on the advice of Goldman Sachs.
The Treasury has confirmed that Northern Rock would be managed on an arm’s length basis with a newly appointed experienced and professional management team. While commentators have supported the initial decision to nationalise, many questioned whether the bank should be run with a view to continued business expansion and profit maximisation rather than on the basis of an orderly run-down only ensuring that assets and returns were used to repay the amounts outstanding to the Government. It has to be accepted the Government will face a number of difficulties in either case whichever policy is adopted. It will have to avoid being involved with management decisions especially involving redundancies and branch closure although it will still be held politically responsible for nay hardship created. It must avoid distorting competition within the UK deposit and mortgage market with Northern Rock already the markets knows that Northern Rock had already some of the most competitive terms available which could become even more attractive with tied Government support. The Government will also have to compensate shareholders in Northern Rock.
Northern Rock’s share price peaked at £12 in March 2007 although it subsequently fell to £8 by August of that year and closed at 90p on the day that its shares were suspended on Monday 18th February 2008. Whilst provision was made for the post-public acquisition valuation to be carried out with the Government support being excluded, it is inevitable that this will be challenged by the two major shareholders SRM Global and RAB Capital hedge funds as well as possibly by the Legal and General and the Northern Rock Small Shareholders’ Group. The acquisition will also be challenged under the European Convention on Human Rights and possibly as an illegal expropriation. There may be calls for separate judicial review and parliamentary enquiry. There may also be continued lobbying for action to be taken under European and UK competition law and the EU's State Aids rules. It can only be assumed that all of this was taken into account as part of the decision to reject the Virgin Group offer and to take the Northern Rock into pubic ownership for however long the period.
The Banking (Special Provisions) Act
The Banking (Special Provisions) Bill was introduced to the House of Commons within two days of the acquisition announcement on 19th February 2008 and had received Royal Asset by 21st February 2008. The stated purpose was to enable the Treasury to make an order in certain circumstances relating to the transfer of securities issued by an authorised deposit-taking institution or a building society as well as of the property, rights and liabilities of such an institution. The Act was intended to be an interim measure to provide the Government with temporary powers to secure the continued stability of the UK financial system and to protect the public interest where financial assistance had been available to a UK deposit-taker.
The Act applies to ‘authorised deposit-takers’ which means any UK undertaking that holds permission to accept deposits under Part 4 of the FSMA 2000 (s.1(1)) which includes both banks and building societies. The Treasury is given power to transfer securities or property, rights and liabilities where this is considered desirable for one or two stated purposes (s.2(1)(a) and (b)). The relevant purposes are (a) to maintain the stability of UK financial system in circumstances where the Treasury considers that there would be a serious threat to its stability if the order was not made (s.2(2)(a)) and (b) to protect the public interest where financial assistance has already been provided by the Treasury to the institution for the purpose of maintaining the stability of the UK financial system (s.2(2)(b)). Financial assistance includes both funding provided by the Bank of England or guarantee arrangements by the Treasury either with or without the involvement of the Bank of England (s.2(3)(a) and (b)).
The Treasury has to have provided a ‘relevant notice’ of liability either by laying a Minute before the House of Commons or giving notice to the chairpersons of the House of Commons Committee of Public Accounts and the Treasury Committee (s.2(4)(a) and (b)). Treasury orders will only last for one year although the powers conferred may be re-exercised within the year (s.2(8) and (9)). Relevant orders are provided for under Schedules 1 and 2.
The Treasury may transfer securities under s.3 and property under s.6. Securities may be transferred to the Bank of England, a nominee of the Treasury, a company wholly owned by the Bank of England or the Treasury or any other body corporate (s.3(1)(a)-(d)). The Treasury may cancel any subscription rights in the institution or any of its subsidiary undertakings (s 4(2)). The Treasury is required to issue an order determining how compensation will be payable to shareholders and other persons holding subscription rights (s 5(1) and (2)). The compensation payable is to be valued exclusive of the financial assistance provided by the Bank of England or the Treasury (s 5(4)).
Parallel provisions apply with regard to the transfer of property, rights and liabilities with the Treasury being required to specify by order how compensation will be paid to the relevant deposit-taking institution (ss.6 and 7). The Treasury is also given power to make further transfers of securities either within the public sector or back to the private sector (s.8). This will allow the Treasury either to restructure the business within the public sector or transfer the business back to the private sector. The Act includes supplementary provisions with regard to the operation of the compensation procedures and allows the Treasury to issue regulations varying the tax implications of any transfer orders.
The Bank of England is to be given specific power to make relevant financial assistance available to building societies with the Treasury being given power to make modifications to current laws in this area (s.11). Somewhat surprisingly, building societies may be allowed to hold more than 50 per cent of their funding in the form of deposits with the Bank of England being given the power to take a floating charge from a building society in the event of financial assistance being provided. Consequential provisions are included with regard to supplementary, incidental or transitional matters that may be included in the Treasury orders with certain orders being given retrospective effects (under ss.12, 13 and 14). Retrospective operation applies specifically with regard to securities and property transfer orders, cancellation of subscription rights and consequential or supplementary provisions (ss.3, 4, 6 and 12). Lord Davies of Oldham has certified that the provisions of the Act are considered compatible with the European Human Rights Convention under s.19(1)(a) of the Human Rights Act 1998.
Comment
These are important events in the development of UK banking markets and banking regulation. The Treasury Committee had strongly criticised the supervision conducted of Northern Rock with a somewhat limited and only exploratory discussion paper being issued by the Tripartite authorities on revising UK depositor protection and financial stability mechanisms in response. The Treasury rejected the bids for a private market option to the Northern Rock crisis principally on the basis of commercial return having repeatedly stressed that it would prefer a private market solution. A new model nationalisation Bill has been introduced and received Royal Asset within three days. Whatever the merits of the Banking (Special Provisions) Act 2008 and its supposedly interim status, this may now form an important part of the new financial stability arsenal to be established with Governments of the day being able to threaten recalcitrant or obstructive shareholders with public ownership in similar cases in future.
The summary proposals contained in the subsequent Tripartite consultation document on financial stability and depositor protection do contain a number of important and necessary reforms. These include formalising the Bank of England’s role in the area of financial stability, providing immunity from actions for damages, extending deposit protection entitlements, strengthening liquidity and capital reserve cover and removing other obstacles to successful crisis management. The creation of a special resolution regime for banks is also to be supported although many of the necessary powers are already available. The importation of any substantial new regulatory tools or devices from other jurisdictions should be avoided as this may create a whole series of unexpected secondary or consequential legal and regulatory effects which may cause more difficulties than the initial problems they were intended to correct. All of the necessary powers required in response to Northern Rock can be provided through more limited reform and corrections within the existing UK regulatory system.
The simplest and arguably most effective option remains the conversion of the FSA’s existing right to appoint an administrator (or intervene in administration proceedings) under ss.359 and 362 FSMA into a full special ‘financial or regulatory administration’ regime. This should have been considered at the beginning as soon as it became clear that Northern Rock would have difficulty paying its debts as they fell due without the Bank of England’s assistance. Financial or regulatory administration could be used (or revised with minimum statutory change to allow the expert management of a bank (or any other financial institution) for an agreed period subject to court oversight. Court involvement secures necessary validation and finality which other administrative options lack. This would also allow the financial or regulatory administrator to act without unnecessary, vexatious or obstructive interference by existing shareholders or external creditors. There should be no need for account closure during this period. This would allow full asset protection, continued provision of critical functions and the short or medium to long term resuscitation and rehabilitation of the institution’s business operation.
If the administration is successful, the business can be re-transferred to the private sector at any time. If it is not successful, the key parts of the business (including necessary critical functions) can be transferred separately and the rest of its operations run down and the entity eventually closed. While this may be of particular value in the banking area, it is also capable of common application across the financial sector and would form an important constituent component of the larger integrated regulatory control framework set up under FSMA. All necessary powers are either already available under FSMA, the Insolvency Act 1986 and the Companies Act 2006, or can be made available with minor amendment.
The structure and operation of the new regime could then be set out in a special ‘Financial Resolution’ manual or sourcebook within the FSA Handbook or included within a larger ‘Financial Stability’ sourcebook or manual to be managed in co-operation with the Bank of England and the Treasury in accordance with the revised terms of a strengthened MOU. All of this could be given effect through a short ‘Financial Stability Act’ or ‘Financial Services and Markets (Financial Stability Amendment) Act’ and supporting statutory instruments.
A number of important regulatory and political lessons have been learned from the events surrounding Northern Rock. This has prompted arguably overdue but necessary examination and discussion of various key areas of UK banking and financial market control. Care must nevertheless be taken not to over react, in particular, due to the unforeseen secondary legal or regulatory effects that may follow as well as to avoid creating the erroneous impression of substantial prior defect or failure within the UK regulatory system and the consequent reputational damage that would cause the City of London and the UK's financial markets. Many of the necessary tools and solutions are already available and appropriate corrections can be made with relative ease. Hopefully a balanced and informed, but still proportionate and coherent and integrated response, can still be produced.
Professor George Walker
Centre for Commercial Law Studies,
London
HM Treasury ‘Northern Rock’ Press Release 21st January 2008. This would have involved the sale of a pool of assets consisting of residual mortgages, unsecured commercial loans and certain investment grade securities to a special financing vehicle established for the purposes of the financing structure. This would fund the purchase of the asset pool through the issue of notes in the capital markets with payment being guaranteed by the Treasury. The note guarantee would be fully secured on a first priority interest in the asset pool with a fee being paid by Northern Rock for the note guarantee in addition to arrangement fees and expenses. Each class of notes would bear a market interest rate reflecting the Treasury note guarantee with maturity being determined on issue and based primarily having regard to assumed levels of repayment in the asset pool.
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