'Nothing automatic' about aid for banks says Eddie George: Bank Governor issues stern warning to shareholders

THE BANK of England would severely penalise shareholders of any bank that it is forced to support as lender of last resort, no matter how big it is, Eddie George, the Bank Governor, said last night.

In his first definitive public statement of the principles the Bank uses when it decides on a rescue of a bank in trouble, Mr George made clear that no bank should expect to be bailed out as a matter of course. Rescues were not designed to give special protection to shareholders, employees, managers or depositors, he said.

Referring to the belief that some banks - the big clearers - are too big to fail, Mr George conceded size was an important factor in deciding on a rescue to safeguard the banking system. But he added: 'Even so, I have to say there is nothing automatic about our acting as lender of last resort, and even if we did decide on support, no bank should assume that it would be immune from penalty.'

The terms of a rescue would be 'as penal as we can make them without precipitating the collapse we are trying to avoid,' he added.

Mr George set out five principles for coming to the assistance of banks in trouble, drawn up as a result of the Bank's experience in 1991 and 1992, when runs on a vulnerable group of 40 small banks caused a 25 per cent shrinkage in their deposits.

Because of the effects of the recession, falling property prices, a withdrawal of foreign banks from London and the collapse of BCCI, the Bank was forced to rescue a small number of them to prevent the runs getting out of hand. In its last accounts it said the rescues cost pounds 115m.

Mr George said that although the Bank is using public money, on its own balance sheet it will normally make decisions without seeking formal Treasury agreement - unless it proves necessary to provide support on a scale that would strain its balance sheet. In that case it would be a matter for the Treasury.

In a lecture at the London School of Economics Mr George said the overriding principle was that support was to safeguard the financial system not the troubled bank itself.

Beyond that the Bank of England applies five rules:

Every option for a commercial solution would be explored before the Bank committed its own funds. These include asking shareholders for support, selling the bank at a knock-down price, or asking creditors to help. Even if these options are not available the Bank may decide against support, as it did in the case of British and Commonwealth Merchant Bank.

There would be no public subsidy to private shareholders, and if support was provided 'we will try to structure it so that any losses fall first on the shareholders and any benefits come first to us'.

The Bank will not normally provide liquidity to a bank it knows at the time to be insolvent, because its own capital is not to be used as risk capital. However, a bank helped with funds could easily become insolvent later, which was why the Bank of England had had to make provisions against some of the troubled institutions it helped two years ago.

The Bank of England looks for a clear exit. The company may be required to run down or restructure to the point at which it can do without official support. Mr George said: 'Making the terms of our support as unattractive as possible has the great advantage of encouraging this process.' Alternatively, the company may be wound down under Bank management, as happened with Johnson Matthey Bankers and Slater Walker.

The fact that support is provided is usually kept secret at the time.

If it were known the Bank was supporting the financial system, there could be a wider loss of confidence and it could rapidly find itself underwriting the whole banking system.

Hamish McRae, page 33