Practice vs precept

In an extraordinary measure, the British government last week guaranteed all the deposits of banks in the UK, a step prompted by the fear that the run on Northern Rock, a mortgage lender with a defective business model, would spread to the rest of the banking system as a result of that dreaded financial phenomenon, contagion. What this means is that all bank deposits in Britain have now become, potentially, government debt. While this is extreme in and of itself, what raises eyebrows even further is that no action is sought to be taken to secure bank assets against the debt that the government has taken on its shoulders (by taking over the banks whose deposits are the problem). The assets stay in private hands, and have not even been put into more competent hands as would be the case if a forced merger with a healthy bank were to be arranged (as the Reserve Bank has done in India).

Several questions arise. First, the kind of initial bail-out given to Northern Rock had been opposed by the Bank of England's governor, the reputed Mervyn King, just two days before he did an about-turn that left many analysts bemused. The reason for Dr King's opposition was that such a measure would sow the seeds of a future financial crisis "" which is exactly what has now transpired. So, should he have stuck to his principles and allowed the mortgage lender to fail, and for the public to bear the pain of a major financial institution's failure? Perhaps, but that is where the political acceptability of such a course comes into the decision-making frame.

As a consequence, the second question concerns the much-touted independence of the Bank of England, held out as a model to many. The initial recommendation to give liquidity accommodation to Northern Rock (admittedly at a penal rate) came from the Financial Services Authority, and was finally a decision taken by the treasury (i.e. the British government). The guarantee of bank deposits has also been given by the government. In short, it seems easier to preach virtue than practise it when the times get tough (Britain's previous bank failure was 141 years ago, so the precept has not been tested since). This is something that the central bank governors of countries like India might bear in mind the next time they get advice on the central bank's independence vis-à-vis the government. That is not to argue that the ministry of finance should run the Reserve Bank, but to make the more nuanced point that cut and dried solutions to complex management problems usually do not work.

Meanwhile, if all bank deposits are to be given a government guarantee, is it the problem that the guarantee on bank deposits was inadequate in Britain (covering, as it did, a little over 90 per cent of deposits up to £35,000), and should it be made more comprehensive as in the United States? If so, it is a lesson to be drawn in India too "" where deposits with banks are protected only up to Rs 1 lakh, which is a small sum in today's context.