King of England Is Money Master in Northern Rock's Wake
As Britain’s first coalition government since World War II wrangled over proposals to cut spending, the session between King and Osborne set in motion an overhaul of U.K. financial regulation that would give the Bank of England more power than it has ever had in its 316-year history, Bloomberg Markets magazine reports in its September 2010 issue.
Osborne told King that the government was pushing ahead with plans to let the central bank both set interest rates and police the country’s banks, insurers and investment firms, according to people with knowledge of the meeting.
The new responsibilities would make King, 62, the point man as Britain struggles to tame inflation and regulate and revive the institutions that created the credit crisis while the Conservative-led government enacts the deepest spending cuts in more than 60 years.
Two years into his second five-year term as head of the Bank of England, King is about to gain more combined power over domestic financial regulation and monetary policy than any other central banker.
European Central Bank President Jean-Claude Trichet’s attempts to navigate the 16-nation euro zone out of a sovereign- debt crisis are constrained by the need to defer to domestic regulators on bank oversight. While U.S. Federal Reserve Chairman Ben S. Bernanke gets increased power over non-bank financial firms under the Dodd-Frank law, he will have to coordinate with other agencies that regulate securities firms and the insurance industry.
“It’s a massive expansion of the bank’s responsibilities,” King says. Unlike the Fed or the ECB, the Bank of England will wield power over both interest rates and regulation across the financial industry.
The Financial Services Authority, announced in 1997 to oversee the financial industry, will split in two. Most of its regulatory powers will move to the bank under Hector Sants, the FSA’s current chief executive officer. He’ll become one of King’s deputies and chief executive of a new Prudential Regulatory Authority, which will regulate all deposit-taking institutions, insurers, investment banks and clearing houses. The PRA will operate under a board chaired by King.
A separate Consumer Protection and Markets Authority will be created to look after customers, regulate exchanges and take over the FSA’s authority to impose penalties for market abuse. The bank’s new powers won’t be official until Parliament passes a law on regulation, which the government says will be before 2012.
“He will be the most powerful central banker in the world,” says John Gieve, who was King’s deputy for financial stability from 2006 to 2009.
Some politicians question whether strengthening the Bank of England’s authority is the way to return the country’s financial system to health. “I worry that simply shunting the FSA into the bank doesn’t fix anything,” says Alistair Darling, who was chancellor from 2007 until May in the previous Labour government. “It’s a lot to ask of one institution.”
The central bank’s handling of the financial crisis under King, a former economics professor, has been criticized.
‘Absence of Contrition’
“Little was done to deal with the bubble, despite public concerns about excessive risk taking, while the response to the crisis was slow,” Sushil Wadhwani, who served on the bank’s interest-rate-setting Monetary Policy Committee from 1999 to 2002, wrote in a collection of essays called The Future of Finance, which was published in July by the London School of Economics. “Yet the absence of contrition from the BOE has been surprising.”
Lawmakers are already considering measures to rein in King. The government plan will also create a new Financial Policy Committee with King as chairman that would address risks to market stability. Bank of England executives will make up the majority of the committee, with other members coming from other regulatory bodies and the markets.
That authority should have limits, says Andrew Tyrie, a Conservative lawmaker and chairman of the Treasury Committee in Parliament.
“In my view, in a crisis, the chancellor should consider assuming chairmanship of the committee,” Tyrie says. The blueprint calls for the chancellor to have final say on any use of public funds, including through emergency lending.
Only Mistakes Remembered
Regulators are often remembered only for their mistakes rather than their successes, says David Green, who spent 30 years at the Bank of England and several years at the FSA. “Supervision only goes wrong,” he says.
Some say King was slow to recognize the scale of the crisis when credit markets seized up. King himself says he believed that merely pumping cash into the markets wouldn’t be sufficient.
“This wasn’t a crisis of liquidity,” King says. “It was a solvency crisis, and the answer in the end has to depend on improvements in the quality of the balance sheets of banks. To do that, they need more capital.”
When the crisis hit the U.K. in August 2007, King initially refused to boost liquidity in the interbank market. In early September, he sent written testimony to Parliament decrying “moral hazard” -- the fear that bailing out a troubled institution encourages risky behavior.
He turned down a request from Lloyds TSB Group Plc for 30 billion pounds ($47 billion) of stopgap funds to help finance a takeover of a troubled Newcastle-based mortgage lender called Northern Rock Plc. By Sept. 14, news of the bank’s woes triggered the first run on a British bank in more than 140 years.
At the time, the U.K. had no legal framework for resolving bank failures. Darling stepped in and guaranteed all Northern Rock deposits, and the bank became an emblem of the wider financial crisis that swept through the U.K.
“Moral hazard in the normal course of things is a perfectly good thing to be concerned about,” Darling says. “But when the banking system is crashing all around you, it’s all pretty academic.”
Under a law passed in 2009, the Bank of England can take control of a bank facing insolvency through a bridge bank if its failure could undermine financial stability. “If we had had a resolution authority during Northern Rock, it would have been resolved over a weekend,” King says.
King’s views of whether the Bank of England needs more power have evolved since 1997, when the Labour government moved bank supervision to the newly created FSA, those who know him say.
“He was happy when bank supervision left the Bank of England, and now he’s very likely happy that it is returning to the bank,” says Stanley Fischer, governor of the Bank of Israel, who’s known King for almost 40 years.
“We all now understand the lender of last resort function much better after the crisis,” says Fischer, 66, who was born in what is now Zambia, a part of the Commonwealth, and who studied in the 1960s at the LSE, where King later taught.
Fischer, who advised Bernanke on his graduate economics thesis while teaching at Massachusetts Institute of Technology, praises King’s skill at steering the Bank of England.
‘An Intellectual Powerhouse’
“Mervyn’s clarity of mind about mission, about approach, about theory has meant that the Bank of England is an example to many about how to run the central bank,” Fischer says. “It’s an intellectual powerhouse in the central banking world.”
The benefits of centralizing authority over banking outweigh the risk that too much power will be held by one man, former Fed Chairman Paul Volcker says.
“I am a believer in central banks having a strong hand in banking regulation and supervision,” says Volcker, 82, a senior economic adviser to President Barack Obama and one of the architects of the new U.S. financial legislation. “When we had the crisis, it showed that the central bank wasn’t quite on top of things.”
King says expanding the bank’s authority is crucial for it to succeed in its traditional role of controlling inflation. “Monetary stability and financial stability are two sides of the same coin,” he said in a June 16 speech in London’s financial district. “During the crisis, the former was threatened by the failure to secure the latter.”
Tennis With Geitner
The central bank governor peppers his speech with metaphors. “Macroeconomic stability,” he wrote in a 2004 paper, “is a bit like healthy living: You need to find a sustainable way of doing it. There is no point alternating between a crash diet and bingeing.”
King plays tennis with his policy-making colleagues. He’s volleyed with U.S. Treasury Secretary Timothy F. Geithner and Lawrence Summers, director of the White House’s National Economic Council. King, who attends Wimbledon every year, lost to former Fed Chairman Alan Greenspan and former Treasury Secretary John Snow in a doubles match in 2004. He keeps a cricket ball and a soccer ball from his favorite team, Aston Villa, on an antique side table in his office overlooking a leafy courtyard.
King’s path to power began in postwar Wolverhampton, an industrial and mining city 130 miles (210 kilometers) northwest of London, where he was the son of a schoolmaster. Like other clever boys of modest means, King passed a test for 11-year-olds to enter a state-funded grammar school that picked students based on academic ability.
Boys in Spectacles
“It was an all-boys school, the sort of little boys who wore spectacles,” says Stephen Lewis, a former Wolverhampton Grammar School mate who’s now chief economist at Monument Securities Ltd. in London. “Even by the standards of the school, he was very intellectually oriented. He was very good at mathematics.”
In 1966, King entered King’s College at Cambridge University to study economics. At the time, Cambridge was a bastion of Keynesianism, the theories advanced by 20th-century economist John Maynard Keynes, who advocated stepped-up government spending to prevent or reduce suffering during depressions. King was treasurer of the Liberal Club and studied under prominent Keynesian economists, such as Mario Nuti.
“If you studied at Cambridge in the ‘60s, Keynesian economics was economics,’’ says Peter Kellner, who was King’s classmate at Cambridge and is president of London-based polling company YouGov Plc. He says King’s political views were progressive and eclectic. ‘‘He was center-left in his general outlook,” Kellner says.
In 1971, King won a John F. Kennedy Scholarship to Harvard University, where he was a post-graduate student researching tax policies at the same time as Martin Feldstein, an economics professor who would later become chief economic adviser to President Ronald Reagan.
“His primary work was about corporation tax and how it affected the cost of capital,” says Feldstein, who didn’t supervise King though they researched similar topics.
King spent the next two decades in academia, teaching economics and researching tax policy and public finance. In 1983 and 1984, he returned to the U.S. as a visiting professor at MIT, where he had adjoining offices with Bernanke, who was also a visiting professor at the time. King said last year that the friendship he forged at MIT led to a close working relationship with Bernanke during the financial crisis.
Studied Market Volatility
After MIT, King joined the LSE, where he initially focused on microeconomics, examining the relationship between tax policies and investment. He moved toward macroeconomics as a founder of the LSE’s Financial Markets Group, where he co- authored a paper in 1989 with Wadhwani, the former MPC member, titled “Transmission of Volatility Between Stock Markets.”
The work concluded that the 1987 market crash was caused by investors in different markets overlooking diverse local economic conditions and examined the connection between volatility and contagion.
King also began advising U.K. politicians on economic issues. In the 1980s, he consulted for the now-defunct Social Democrats on tax, poverty and pensions.
“He has a social conscience,” says Ros Altmann, a nonexecutive director at the LSE and a former student of King. She also advised the party, which merged with the Liberals in 1988 to form the Liberal Democrats, now part of Prime Minister David Cameron’s coalition.
King’s academic work got the attention of former Conservative Chancellor Norman Lamont, who says he tapped him for advice on simplification of the tax system. In 1991, while Lamont was chancellor, King joined the Bank of England as chief economist at the age of 42.
Bid to Prop Up Pound
He was thrust into a crisis a year later, when the pound came under severe pressure from investors led by hedge fund manager George Soros.
King tried to enlist German help in propping up the British currency, flying to meet Otmar Issing, his counterpart at the Bundesbank in Frankfurt.
“The meeting really took place under Wagnerian conditions, with thunder and lightning,” Issing says. The pound exited Europe’s exchange-rate mechanism two days later. “Mervyn King later called this the most unsuccessful mission ever,” Issing says. “Mr. King, like me, was well aware that the British pound was overvalued.”
When Tony Blair’s Labour Party swept to power in 1997, it made changes to the role of the central bank, then under the leadership of Eddie George. No longer would the bank oversee British lenders; Chancellor Gordon Brown handed that task to a newly created FSA.
He was reacting to criticism of the bank’s record that decade, when it had missed two global banking scandals: the collapse of Bank of Commerce & Credit International SA in 1991 and the near failure of Barings Plc after rogue trader Nick Leeson lost 862 million pounds on futures contracts, forcing the bank’s sale to ING Groep NV in 1995.
Brown also created the nine-member Monetary Policy Committee at the bank, allowing the institution to set interest rates independently of the government for the first time. A year later, King was named the bank’s deputy governor. When George retired in 2003, King became governor.
King and George were different in their approaches, Lamont says.
“Mervyn is more an academic economist, more conceptual, more theoretical,” he says. “Eddie George was more of a pragmatist, obviously more attuned to the banking system because he had been in the Bank of England for such a long time.”
Today, King sidesteps questions about his political views. He has thrown his full support behind Osborne’s “austerity to prosperity” economic plans. The aim is to reduce the country’s deficit of 11 percent of gross domestic product -- the biggest among the Group of Seven nations -- to 1.1 percent by the year ending on March 31, 2016.
The U.S. isn’t far behind: The White House projects the U.S. deficit will be about 10.6 percent of GDP this year.
“I am very pleased that there is a very clear and binding commitment to accelerate the reduction in the deficit over the lifetime of the Parliament,” King said at the bank’s quarterly press conference on inflation on May 12, adding that he was asked by the new government to comment publicly on the plan.
Osborne’s cuts take aim at welfare spending. He’s also announced a two-year public-employee pay freeze and an increase in the national sales tax to 20 percent from 17.5 percent, both starting in January.
King is now a key ally in Cameron’s austerity policies, which stand in contrast to those of Obama. The U.S. president has been reluctant to pull back stimulus programs despite concern about the budget deficit.
The U.S. has more room to maneuver as investors still snap up its debt: The yield on two-year U.S. Treasury notes touched 0.5516 percent on July 23, the lowest ever. On the same day, the equivalent U.K. bond yielded 0.85 percent. Obama says government spending is still necessary to keep the global economy from plunging back into recession. Such a divergence of opinions between the U.S. and the U.K., as well as other European nations that adopted austerity plans, was on display at June’s summit of Group of 20 nations in Toronto, which failed to reach a consensus on when to unwind stimulus programs.
King retains his social conscience: He says he regrets that the pain of the financial crisis will weigh most on the less well off.
“The thing I feel most strongly about is that the people who are going to bear the burden of this crisis are not the people who caused it,” King says. “We will have no excuse if we don’t learn the lessons of the crisis and reduce the probability of it happening again.”
The economy is recovering after six consecutive quarters of contraction. It surged 1.1 percent in the second quarter after growing 0.3 percent in the previous quarter. And inflation -- the central bank’s No. 1 priority -- has persisted above its 2 percent target. In May, prices rose at a 3.4 percent annual rate. In June, the gain was 3.2 percent -- well above the 1.1 percent rate in the U.S. and the 1.4 percent in the euro zone.
“The prime responsibility of the Bank of England is to meet the inflation target and to conduct monetary policy,” King says. “We forget that at our peril.”
Inflation Seen Falling
King says inflation should fall to its target in the first quarter of next year as the damage wrought by the recession tempers price pressures. Oil prices rose as much as 35 percent in the past 12 months while the pound weakened more than 13 percent against the euro -- the currency of the U.K.’s biggest trading partner -- and almost 16 percent against the dollar.
Osborne’s plan to raise the sales tax in January may feed inflation in 2011 and prompt some companies to raise prices, policy makers said, according to the minutes of the July 8 interest-rate meeting.
King has few tools left to spur growth. Interest rates have stood at 0.5 percent since March 2009. His main strategy is so- called quantitative easing, known as QE, which involves the central bank flooding the economy with money by buying government bonds. Since early last year, the bank has bought 200 billion pounds of bonds.
If the economy weakens in the face of government-spending cuts, King says, he’s willing to roll the printing presses again. “It is an instrument in our armory and it will remain so,” King said at the May 12 press conference. “It certainly has not been ruled out.”
‘A Monumental Mistake’
The policy has its critics: It could send inflation out of control, according to Altmann, the LSE nonexecutive director and former student of King’s.
“It’s absolutely a monumental mistake,” says Altmann, who still talks to King. “We’ve had discussions about that. I’m much more concerned about the inflationary impact of what we’re doing.”
King’s support of low interest rates has stirred dissent at the bank itself, too. “We need to recognize that the weakness of the pound -- and its upward impact on inflation --may also have been affected by U.K. monetary policy and perceptions about its future stance,” MPC member Andrew Sentance said in a speech on July 13.
Sentance, at the MPC’s monthly meeting in June, became the first policy maker in almost two years to push for a rate increase. He was outvoted by the committee, of which King is chairman.
Adding supervision of financial firms to the central bank’s brief may leave it torn between setting interest rates at a level that’s right for banks and a level that’s right for the whole economy, says Gieve, King’s former deputy.
“If you give the central bank special responsibility for the financial sector, there’s a risk it will tailor its monetary policy too much to the financial sector’s interests and concerns,” he says. “Interest rates are the lowest they’ve ever been in history, so in that sense, the accelerator is still flat on the floor.”
The prior system, under which the Bank of England, the FSA and the U.K. Treasury were supposed to work together to ensure financial stability, failed. None of the three regulators was taking action to address overall risk as bank balance sheets exploded.
From 2001 to 2007, assets of U.K. banks tripled to 6 trillion pounds as lenders expanded by packing mortgages into securities and selling them. The central bank’s biannual financial stability reports highlighted the impending liquidity crisis yet lacked any sense of urgency.
“If it becomes impossible or expensive to find counterparties, financial institutions could be left holding unplanned credit risk exposures,” the bank wrote in April 2007.
That was only a few months after the bank had invited Nassim Taleb, who was about to publish his best-selling book The Black Swan (Random House, 2007), to give a talk called “The Impact of the Highly Improbable” to a group of central bank officials.
“I gave them a measure of robustness of banks to rare events, but they weren’t interested in taking the idea the extra mile,” Taleb says. “They were too scared of rocking the boat.”
If King was slow to recognize the magnitude of the crisis, he wasn’t alone. “It’s a fair criticism of all central banks, all regulators and all governments, that the issue of financial stability was put on the back burner for a lot of the last 10 years,” Darling says.
Even though he was steeped in Keynesian economics at Cambridge, King criticizes deficit spending while finding Keynes’s focus on uncertainty compelling.
“There are times when sentiment changes and people’s perceptions of the probabilities of events change,” King says. “They start to imagine events as being possible they didn’t even contemplate before. That’s the distinction between risk and uncertainty.”
After the run on Northern Rock in 2007, uncertainty had deepened. King eventually concluded the financial system was facing potential insolvency, not merely a crisis of liquidity.
Flooding the markets with cash was only a stopgap measure to deal with the underlying problem: capital shortages.
King had been urging the Treasury to recapitalize British banks by taking stakes. On Sept. 11, 2008, King declined to extend a special liquidity plan, announced the previous April, that let banks swap mortgage-backed bonds for U.K. Treasury bills.
Four days later, something happened that changed perceptions of what could happen in the markets: Lehman Brothers Holdings Inc. filed for bankruptcy. It was the black swan that Taleb had warned of. King then made a U-turn and extended the liquidity plan until the following January.
During the worst of the financial debacle in October 2008, King argued for a major capital injection into the country’s ailing banks, according to people familiar with the matter. On Tuesday, Oct. 7, King attended a meeting at 10 Downing Street to finalize the details of a bank bailout plan and pushed for a bigger capital injection than the FSA had proposed. King was worried that Royal Bank of Scotland Group Plc and HBOS Plc, two of the country’s biggest banks, wouldn’t be able to open their doors the next day.
The plan announced the next day was unprecedented. The Treasury offered to spend as much as 50 billion pounds buying stakes in Britain’s banks to prevent a panic. King had succeeded.
The bank’s new powers should enable King to shield the financial system from banks taking the kind of risks they did in the mortgage-security markets in the past. And as he knows only too well, Keynesian uncertainty can thwart even the world’s most powerful central banker.