October 10, 2007 / 4:36 AM / 13 years ago

King backs reform after Northern Rock crisis

LONDON (Reuters) - Temporary measures put in place following the crisis over Northern Rock NRK.L last month must evolve into permanent reforms if a similar situation is to be avoided, Bank of England Governor Mervyn King said on Tuesday.

Governor of the Bank of England Mervyn King listens as U.S. Federal Reserve Board Chairman Alan Greenspan speaks at the Advancing Enterprise Conference & G7 Finance Ministers and Central Bank Governers' Meeting in central London, December 2, 2005. REUTERS/Toby Melville

Speaking on the same day authorities threw a fresh lifeline to the troubled mortgage lender, King defended his conduct during the crisis but said there were important lessons to be learned.

Most important, he said, was the need to introduce a mechanism for intervening pre-emptively at a troubled bank to separate the retail deposit book from the rest of the bank’s balance sheet.

Such a mechanism is already in place in the United States where it enables authorities to step in early to protect depositors.

“Legislation to create the powers to deal with a bank in this way seems to me the single most necessary reform,” King said.

Northern Rock, the country’s fifth-biggest mortgage lender, almost collapsed last month after a global credit squeeze forced it to seek emergency funds from the Bank of England. News of the credit line sparked the first run on a bank in more than a century.

RESTORING DISCRETION

King said central banks needed to be able to act as lenders of last resort without further destabilising the institution in distress.

“Reform of deposit insurance will go a long way to achieving this. But in an age of instant communications, where news of a facility for Northern Rock was leaked even before it was officially announced, it may be difficult to adopt the quiet methods used by central banks in the past,” he said.

King, who has already said he would have preferred a covert salvage operation for Northern Rock, said he would “explore ways to restore the use of discretion in central bank operations.”

Authorities on Tuesday offered to extend a guarantee on existing deposits at Northern Rock to new savers, giving the bank time to salvage something from its battered business.

King said regulators worldwide needed to pay more attention to the way commercial banks were funded rather than their loan book.

“Liquidity should be central to the regulation of banks,” he said. “Regulation worldwide has paid insufficient attention to liquidity.”

King defended his handling of the money market crisis, saying injecting liquidity sooner or on more generous terms would not have been appropriate.

“It is crucial that, in making their lending and borrowing decisions, banks face the right incentives,” he said. “That is why we did offer to lend in exchange for illiquid assets but only at a penalty rate of interest.”

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