The collapse of Northern Rock and RBS, and the rapid sale of Alliance and Leicester and Bradford and Bingley were worrying and unusual events.  Pictures of people in queues trying to withdraw their money from Northern Rock have become the iconic pictures of the most severe financial crisis to hit the UK since the 1930s or even longer.

            The typical explanation is that these banks went down thanks to the greed of their senior executives and the “City”. The Regulators had only a bit part, it is argued,  as they had been rendered ineffective by “light touch” regulation. Testosterone fuelled lending was reacklessly pursued in the interests of earning more bonus, paid on profits taken long before the full outturn of the lending was known. It was a rotten City model. The answer is ban or tax bonuses, put in much stronger regulation, and buttress banks with large increases in capital in case they do it all over again.

               Recalcitrant facts get in the way of this comfortable explanation for the politicians and regulators who presided over this mess. Surely the main aim of all the regulation in place should be to stop just such a crisis happening? If the regulators thought they lacked the powers they should have asked the government to do something. If the government thought the regulations were too light they should have taken action. In  the UK, after all, the whole system of banking regulation was revised and new under the incoming Labour government.

                   The truth is the regulators had the powers to demand more cash and capital under the law as it stood. It was their call. They decided that they could allow the ballooning of balance sheets. They resisted anyone who argued for less debt in the economy, buying into the thesis that banks could now manage risk much better.

                 It is also true that in the UK the Labour government was keen for understandable reasons to promote large banks from parts of the country that had not traditionally flourished in the financial service area. The two largest ones that got into difficulties were from the North and from Scotland. Their rapid growth had full government support. The Bank of England allowed it to happen,no doubt understanding the political pressure for it to happen.

              The FSA has apologised for its part in all this. It had the prime responsibility for individual banks. The Bank of England, however, should not excape all blame. It was a central part of the tripartite arrangements for regulation. It had a duty to keep the system safe. The problems at troubled banks soon upset the system in a major way. It had the ability to monitor and the duty to understand the consequences of expanding bank balance sheets on money and inflation. It is difficult to say it did well in these areas. When RBS got into trouble, its balance sheet was larger than the entire annual GDP of the UK. Surely the Bank had to take an intelligent interest in its solvency and liquidity, as it was so crucial to the whole system.

I have argued for some time that the UK has gone above the tax saturation level. A country which does this finds that increased taxes become very unpopular, and may collect less not more revenue.

Mr Osborne wisely cut oil company taxes in his latest budget, realising that the tax increases of 2011 on this sector had depressed exploration and development.

He has now wisely changed the pasty and caravan taxes, and offered some compensation to churches for the VAT on historic building repairs.

The changes to Income Tax and National Insurance made by the outgoing government were wrecking amendments which are reducing the revenues. Mr Osborne has promised some changes in 2013 but will lose output and tax revenue in the meantime.

Some of you have rightly argued that it was not just or mainly the Bank of England to blame for the crash  of 2008-9. Under the tripartite Labour scheme of regulation the main blame rested with the government as the convenor of the tripartite system and the most powerful of the three parts. The government was removed from office by the voters, mainly for their economic and banking failings.

The FSA was also to blame. It has been the subject of review and agreed it made important mistakes in the way it regulated banks. The purpose of these blogs is to do the same for the Bank which so far has escaped review.

          The most serious issue that the  Enquiry into the Bank should raise is its role in the collapses of Northern Rock and RBS. We have seen that it failed to influence the tripartite regulators into controlling the surge in bank balance sheets in the years of expansion. In the two years of collapse it failed to make enough liquidity available in time to avoid a run on one bank and a near cessation of trading at another.

            One of the prime tasks of a Central Bank is to be the lender of last resort to banks in its system. All banks are meant to be solvent. The banking regulator supervises them and certifies they are. The Central Bank has to ensure they are also liquid. A strong bank may have a lot of its money invested in high grade loans. If too many depositors want their deposits out at the same time it may not have the cash to pay them. Given time it can sell its loans on to someone else and free the cash. The Central Bank is meant to step in and lend to bridge the gap.

                In the torrid banking summer of 2007 some of us were urging the Bank of England to make the banking markets more liquid by injecting cash into the system. The Bank refused. The inter bank markets dried up as banks lost confidence in each other. Northern Rock depended on a lot of inter bank borrowing to support its large mortgage business. It was obviously at risk. The Bank of England argued that it would induce moral hazard if it lent more to Northern Rock or other banks short of liquidity. The result became well advertised when Northern Rock ran out of cash.

                   After the collapse of the Rock the Bank of England did inject more liquidity into the system, showing it could do so. It repeated this performance on a larger scale with RBS a year later.

                            The Review needs to ask why didn’t the Bank act as a lender of last resort to a greater extent earlier to ward off bank collapses?  Wouldn’t it have been better if the Bank had made cash available to prevent these collapses? Wouldn’t short term loans have been cheaper and better for taxpayers than forced purchase of shares? Wouldn’t such action have staved off the worst but forced the banks to cut costs and sell assets to repay the loans? Isn’t that the new system they say they now wish to operate in a future crisis?Why didn’t they do it when they had a live crisis? If living wills are good for a future crisis, why didn’t they use a controlled form of administration, where the authorities kept the main deposits and payment systems going?

            The Bank’s review of its conduct needs to ask could the bubble have been forseen in say 2005? If so what action could they have taken to rein it in before it became damagingly large?

              There were several commentators and the Opposition parties saying in the middle of the last decade that the government was allowing far too much debt to be extended. Meanwhile, the Bank of England cut interest rates sharply in 2001, cut them further in mid 2003, raised them modestly to mid 2006, only to   cut them  a little again. As we advanced in 2007  the Bank belatedly started to take the inflation threat more seriously, and hiked rates to 4.75%, finally reaching 5.75% in 2008, by which time the crunch was obvious to its critics.

                    It is a fair comment to say the Bank did too much too late on interest rates. It by general agreement did too little for much of the gathering boom.  It should have sent a stronger signal against credit and money expansion in the middle 2000s than it did with higher rates, when others were worried. It then raised rates too much and kept them too high in 2008, when the banks were already in serious trouble and the system was deflating.

                    The FSA for its part put forward more and more detailed rules affecting banks, but was lax over the amounts of cash and capital banks had to hold. In the 1980s and early 1990s when I was a financial regulator as a Minister, it was thought prudent to keep a commercial bank balance sheet to less than 20 times its core capital. By the time the Credit Crunch hit well over 30 times was thought normal and acceptable.

                           When I asked regulators in the  2000s why they thought banks could gear themselves so much more than before, I was told that thanks to a wide range of new fianncial products they could carry more risk with the means to offset it through futures, options and derivatives. It did not prove to be like that. Indeed, as some of us feared, the large positions in special instruments often increased the exposure to dangerous markets, and increased the geared impact of a fall in markets.

                        There was no new paradigm which allowed banks to magic more money into the system without extra risk.

                   The Banking regulator and the Competition Authority made the problem worse by allowing or even encouraging mega mergers so large banks emerged with hugely geared balance sheets. Some of us argued against allowing the RBS/ ABN Amro merger. Many more of us opposed the LLoyds/HBOS merger. The authorites allowed these through, ensuring that if  a bank did collapse it would be a very large one. They thought it cut banking risk. Some of us thought it concentrated banking risk, and meant strong banks would be pulled down by weak ones within the new enlarged groups.

It is a popular myth that the whole western crisis was brought on by an outbreak of light touch “Anglo-Saxon” regulation which allowed irresponsbile banks to lend too much. Ultimately the authorities had to act and managed to bring the whole system crashing down.

This convenient myth ignores some basic truths.

1. The European banking system is in a worse mess than the UK or US systems today. There is no evidence that the EU, Spaniards, Italians, Greeks and Germans suddenly fell in love with “light touch Anglos Saxon regulation” and made the same mistake, yet they ended up with more weak  banks.

2. The volume of regulations expanded substantialy during the build up of the boom. The EU came into the game and added many pages of new financial regulation at their level, on top of all the extra regulations the UK and US authorities were issuing.  The UK was governed by a left of centre administration which believed in the efficacy of more regulation. The FSA reviewed all past banking regulation and added to it.

3. The authorities themselves were enthusiastic proponents of the easier credit they allowed under their myriad of new detailed regulations. In the US a Democrat President promoted more mortgages to people on low incomes as a social policy, which led directly to the junk loans which jeopardised the system later. They called the crisis the “sub prime” crisis in honour of the loans advanced by mortgage banks and by a couple of state financing arms that were fully nationalised in the crisis. The UK government ran up big bills paid for by off balance sheet transactions called PFI and PPP in the spirit of the lend more age.

4. The UK administration was particularly keen on promoting the growth of Northern Rock, a North Eastern company, and RBS,a Scottish company, as they grew very quickly. They took pride in  the huge expansions of their balance sheets, and in the way they used off balance sheet vehicles to speed their growth. In the good days these were northern and Scottish companies showing London and the south how to  run modern banking and financial services.

The regulators managed to combine ever more detailed regulations and more enforcement of them with an inability to see the bigger picture. They missed the obvious. There was too much credit in circulation and being extended. The balance sheets of some leading banks were becoming too racy. We will look tomorrow at could all this be predicted? Did the authorities have the powers to rein it in?

Some replies to the new that real public spending grew by 1.6% contributing positively to economic growth said they did not think government could produce positive output. I have used official figures, based on normal GDP accounting conventions.

Presumably all agree that if someone sets up a fee paying school or a private healthcare business the income for those ventures add to GDP. Similarly if the state provides education and health care paid for by tax and borrowing that too adds to GDP. One of the main reasons for the positive increase in state output was more students educated and more patients treated by the state.

I have also been criticised for failure to understand causality. I did not comment on causes in the short piece I wrote. Some of the increased state spending resulted from its high borrowing and from the state of the economic cycle. Some came from positive decisions to increase spending as with overseas aid and EU programmes. Some came from increased numbers  needing services, and some from chosen service improvements.

The interesting thing is that high levels of borrowing-fiscal stimulus- and of spending have not prevented a downturn. The situation shows that action is needed to bring about the private sector led ecovery the government seeks.

           One of the myths that needs to be cast aside in any review of the role of the Bank of England in recent years is the myth that the Bank is and can be independent. In a democracy voters take great interest in economic progress as it affects their jobs, their incomes and their living standards. They hold the two senior elected officials, Prime Minister and Chancellor, to account for economic progress, along with the government generally. A government may choose to entrust part of its economic management to the Bank, but will be blamed for its failure and claim credit for its success.

           Far from making the Bank independent, the last Labour government demonstrated  just how much of a creature of the government it is. At the beginnning of their tenure they stripped the Bank of its powers to monitor and control the day to day workings of the commercial banks. They passed this important work over to a new body, the FSA.

           They claimed to give the Bank more independence to fix interest rates. However, all the MPC members were government  appointments directly or indirectly. They never explained why some were renewed and others were not. They changed the requirements from RPI to CPI at a crucial point, in a way which moved the Bank to an easier money policy as the bubble was growing. They rightly overrode the Bank , cutting interest rates in international Finance Minister crisis meetings. They  asked the Bank on one crucial occasion to endorse such action in a special meeting of the MPC, which they duly did.

               The Coalition  has changed the Bank’s powers and remit again on taking over government. They say this is to create a stronger independent Central Bank. However, the government itself still signs off decisions to print more money, and often expresses views on bank regulation and credit easing.

                In  reviewing the Bank’s conduct in recent years it is important to be fair and to understand that there were high levels of political intervention at crucial times. When it came to cutting interest rates in the middle of the crisis the politicians were wiser than the Bank and correct to force their hand. When it came to choosing MPC members, to changing targets and removing powers to control banks, the politicians made the Bank’s task more difficult. Governors traditionally work closely with the government of the day to avoid public conflicts of view.

             The famously “independent” German Central Bank of the post war period was instructed how to handle ostmark/DM union when it gave wise independent advice the politicians did not like. It was also told to surrender the DM altogether, the very currency its ” independence”  was meant to protect!

         The revised GDP figures have attracted headlines because the downturn was slightly worse than the first calculation. There has been far less reporting of the fact that government spending added a positive  1.6% to the figures, an annualised 1.8%, reinforcing the view set out here that real public spending in total has been growing. Indeed, the rate of growth accelerated in Quarter One.  This, of course, did not prevent an overall downturn, as the private sector is still struggling with a shortage of money, tightly regulated banks and the tax rises.

              Reluctantly and later than the other main participants the Bank of England has agreed to a review of its conduct during the recent banking crisis, Credit Crunch and recession. There is plenty of material for it to sift through, and plenty of issues for it to handle.

                I will be setting out some of the questions, and looking at some of the answers over the next few days. I see the Boom-bust cycle of the last few years as primarily a crisis in Central Banking. It was a crisis brought on by regulators who allowed excess credit and money in the system up to 2007. It was a crisis made far worse by the sudden lurch to very restrictive money and credit policies in 2007-8. It is a recession that has taken a long time to reverse thanks to tough pro cyclical banking policies after the  crash.

                The official enquiry will want to know why the Bank’s Monetary Policy Committee proved so bad at forecasting inflation, let alone at controlling it. It will want to know to what extent the Bank thinks it has some wider role in maintaining output and activity, and why it was unable to do this in 2008.  I hope it will examine the popular view that the whole crash was the fault of the commercial banks, aided by “light touch” regulation.  It should go on to ask why the economy is not now performing well given that presumably we now have “heavy touch” regulation. It will need to review the impact of taking away powers to regulate banks from the Bank of England in 1997, and how the tripartite system of Chancellor, FSA and Bank tried to work together during the crisis.

                The UK was not alone in putting its economy through a boom/bust cycle of unusual  violence. The US and the Euro areas authorities also did something similar, though there were important differences in how they responded to the worst of the crisis, and how they handled the problem of banking weakness in their jurisidictions.