Lessons for the Middle East from the Northern Rock affair

28 September 2007
As a student of monetarism at the London School of Economics (LSE) in the mid-1970s, I was obliged to listen to stimulating but unpalatable lectures from Brian Griffiths, now a UK peer and adviser to Margaret Thatcher when she was prime minister. Most went in one ear and out the other. But three arguments stuck.

The first was that inflation is essentially a monetary phenomenon. The second was that fiscal expansions will produce no long-term benefit in an open economy. The third was that an independent central bank is a very good thing.

There was consequently a frisson of delight in May 1997 when Gordon Brown, then UK chancellor of the exchequer and now Prime Minister, announced that the Bank of England would be allowed to fix interest rates and manage monetary policy free from political influence. Banking regulation was transferred to the Financial Services Authority (FSA), which was given new powers in 2000.

This too was good. Giving independence to Middle East central banks is an idea whose time has not yet come, but separating out supervisory functions appealed.

In 1998, the Omani government created the Capital Market Authority (CMA) to regulate the stock exchange. This was almost immediately followed by a huge share market crash. No one then saw a direct connection between the two events.

There were also few doubts when Saudi Arabia followed Oman's lead and passed its Capital Markets Law in June 2003. This created the kingdom's own CMA and transferred regulation of the stock market, the largest in the Middle East, from the Saudi Arabian Monetary Agency (Sama), to the central bank.

The restructuring coincided with the Saudi Arabian stock market boom and subsequent bust. Between 25 February 2006 and the end of that year, the Tadawul All-Share Index fell by 63 per cent. More than $300,000 m was wiped from the Saudi share market capitalisation.

It was one of the biggest equity meltdowns of all time. It is amazing that the Saudi economy has weathered the storm so well.

The conclusion was that the Omani and Saudi stock market bubbles were mainly due to special Arabian circumstances. Irrational exuberance, easy credit and the deficiencies of an immature regulatory system were all blamed. Heads rolled. In Saudi Arabia, the CMA's first chairman was dismissed. But new light has now been shed on what went wrong and it has come from the market that inspired the new financial structures in the first place: Britain.

Northern Rock, a housing finance bank based in Newcastle, northern England, asked the Bank of England on 13 September for emergency funding due to its inability to raise money from the interbank market. Despite assurances from Alistair Darling, Chancellor of the Exchequer, confidence in the bank slumped. For the first time in living memory, queues formed in British provincial high streets as depositors demanded the immediate return of their savings.

The spectacle was a reminder that financial panics are not the preserve of emerging economies. The difference between the middle classes of Britain and the Gulf never looked smaller. The Northern Rock crisis was eventually resolved when the UK government announced it would guarantee all deposits in the bank. Bizarrely, the intervention, which has helped to prevent the failure of one of Britain's leading financial institutions at practically no cost to the taxpayer, has been excoriated.

Mervyn King, Governor of the Bank of England, has been savaged for reversing from his initial position that there would be no intervention to prop up banks affected by the US sub-prime crisis. He can comfort himself by thinking what the press would have said if he had not.

It is fun to blame individuals in London, Muscat and Riyadh when finance markets go wrong. But Britain and the world have been taught an important lesson this September.

The separation of a central bank's regulatory and monetary roles can make things worse rather than better when there is a shock. A new way of managing markets is needed to cope with the challenge of dealing with unimaginably huge and immediate financial movements. Significant changes are now expected to the system created in Britain in 1997 that will help to increase the co-ordination between the Bank of England, the FSA and the government.

This, in turn, will define a new template for the countries of the Middle East and provide further evidence that practically everything I learnt at university was worthless.

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