Between a (Northern) Rock and a Hard Place

Every time I appear on Fox Business News on a day when the US markets are closed, there is some interesting story that emerges from overseas. Last month it was the massive sell-off in Europe on Martin Luther Kind Day, while this week, it was the big announcement from the UK that Prime Minister Gordon Brown’s government had taken control of Northern Rock Bank, PLC, the troubled mortgage lender.

The decision was reached on Sunday, after the government determined that two competing bids from a consortium led by Virgin Group’s Richard Branson and Northern Rock's own board did not add up to enough money. Instead, the government will "temporarily" nationalize the bank led by former Lloyd's insurance market Chief Executive Ron Sandler. The move follows the government’s emergency bailout package last summer of approximately £25 billion ($49 billion), which attempted to stave off the country’s first bank run in more than a century.

You may think that this sounds crazy—when has the government succeeded in doing a better job managing anything than the private sector? Well, you might be surprised to learn that in certain cases, specifically when it comes to failures in the banking sector, the government may actually be a better choice. In fact, in the US, we have a mechanism for doing this: it’s called the Federal Deposit Insurance Corporation (FDIC). The FDIC is an independent agency created by Congress that maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships.

When FDIC was not enough, the government established other organizations to handle the disposition of insolvent financial institutions: in 1989, Resolution Trust Company (RTC) disposed of failed Savings and Loans (S&Ls); in 1985, the Federal Asset Disposition Association (FADA) dealt with selling the assets of S&Ls; and in 1933, the Home Owners’ Loan Corporation (HOLC) refinanced mortgages, foreclosed on defaulted mortgages and sold foreclosed houses. In each case, the entities faced far more severe problems than an isolated bank problem.

I am not well-versed with the British system, but from what I understand, there is some form of insurance on accounts similar to the $100,000 offered by FDIC, but there is no formal entity that deals with bank failures, which is why this week’s government move seems necessary. The hope is that the government will maintain the business and then sell it or its parts later, when financial markets improve. Until that time, the government’s role will be to create stability and to assuage depositors who want to make sure that their money is safe within the bank. The success of the plan will be evident years from now, but at this point, it seems like a reasonable solution.