Banks are still highly leveraged – they could come begging to the taxpayer once again

Ten years ago Northern Rock sought and received an injection of liquidity from the Bank of England. This was taken by its customers, correctly, as a sign of the bank’s structural failings.

A run on the bank had seen savers lining the streets of Northern English towns trying to get their money out of the institution after news broke earlier in the week of the bank’s struggle to raise money on the international markets.

I was 15 at the time and just starting my final year of GCSEs but the lessons in economics I learnt over the months that followed were more effective than much of my formal education after.

To put it simply, Northern Rock had overextended themselves and had attempted to cover long-term debts with short-term borrowing. When liquidity tightened they struggled to raise funds to cover the level of liabilities that grew and grew, and which they were obligated to pay.The approach of the Bank of England was a very visible sign that all was not right at the Newcastle-based bank and, as a lender of last resort, indicated a near total collapse of market power.

It was an interesting episode academically, with the run not causing a liquidity crisis (as has usually been the case in the past) but coming after it. Of course, for savers and businesses it was not academic. The effect was immediate and catastrophic. People and businesses scrambling to get their cash savings out of the bank was an awful sight to see played out in rolling news coverage.

Labour’s chancellor Alastair Darling ended the run by guaranteeing the full payment of all deposits at the bank by the British government and the Bank of England in the case that the bank collapsed. While action effectively ended the lines that had formed outside Northern Rock branches it didn’t stop the bank’s slow-burn collapse. But rather than letting the business go under the government nationalised Northern Rock in February 2008. Over the next few months losses at British banks exceeded half a trillion pounds but taxpayers ended up paying the price.

Now could this happen again? Have our banks done enough to ensure that they lend with prudence and are resilient to the point where they could survive another shock like we felt a decade ago? Has our central bank set the rules that ensure market players operate sensibly?

Worryingly, our latest report suggests not. While the Bank of England issues tests that pass all of our major banks we are not so sure. British banks are still highly leveraged. They can still operate 40 times the capital requirements. This is a lot, with leverage so high even a loss of 2.5 per cent could wipe out the banking system’s entire stock of capital (in fact, we think that the market value of banks suggests they’re even more leveraged than before the crisis). They can also game the figures used in the tests by, at least until recently, loading up with bonds from eurozone crisis countries like Greece and Italy – which were astonishingly weighted as low or even zero risk.

In fact, we’re worried that the Bank of England’s tests themselves as causing more problems for the British banking sector – forcing banks to all manage their risks the same away despite all of them having wildly different business models and risk profiles.

The Bank of England is independent of government, rightly so when it comes to managing monetary policy. But its regulatory actions have political consequences, especially if banks remain “too big to fail” or a crisis means they end up being bailed out by taxpayers. We should all be scrutinising their actions here in case they come asking us to cough up again.