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A government keen to boost consumer choice. A string of upstart operators with aggressive business practices. A sleepy regulator which failed to challenge those operators. And then a big market shock. We might be back in 2007, when Northern Rock — and a host of other macho banks — collapsed, ushering in a global financial crisis.
This, though, is 2021 and the tumult has shifted to the European energy market, with UK consumers once again at the sharp end of a crisis. Have we learnt nothing?
The answer is no. There are striking parallels between the UK banking market circa 2007 and today’s power market which has been jolted by an energy crisis with the potential to cause economic and political chaos. Yet no one had apparently realised another toxic time-bomb had been built from very similar ingredients in a very different sector.
First, a potted history. Northern Rock failed after a period of rapid growth, during which it supercharged what in banking sector jargon is called “maturity transformation”. All of banking rests on this ability to borrow short (traditionally through customer deposits) and lend long (typically through 25-year mortgages). But for many of those British lenders that crumbled in 2007/8 (also including HBOS, Bradford & Bingley, Alliance & Leicester) that mismatch had been taken to extremes.
Northern Rock had built up more than £100bn of lending, growing fivefold in a decade. When the bank was unable to replace its vast swath of short-term financing, collapse was inevitable. Banks across the world experienced similar pressures. The UK, though, had a particular concentration of aggressive midsized banks.
Compare that with the UK energy market in its recent incarnation. Dozens of small operators crowded into a highly competitive market. Many relied on exploiting a “maturity mismatch” between buying in the spot energy market and the long-term prices at which they locked in their customers. But when those spot prices spiked, suddenly they were racking up millions of pounds of losses every day.
Hedging that risk has been a rarity for many of the energy market challengers. That might be due to a desire to maximise the upside in good time. Or it could just be because it is not feasible for smaller operators to use one obvious hedging technique — buying in large volume at opportune moments.
This poses important questions about governance and risk controls. Weak bank boards, poor risk processes and insufficiently robust risk committees allowed the balance sheets of Northern Rock, HBOS et al to expand unsustainably. The UK’s energy upstarts seem to have had the similar shortcomings.
What about the role of regulation in all this? The UK energy market is commonly referred to as “highly regulated”. That is true in the sense that consumer pricing is supervised via a maximum price cap.
But Ofgem looks a lot like the UK’s old regulator the Financial Services Authority. It has not thought much about “prudential” risk: that is, the safety and soundness of individual companies or the system as a whole. If it had, it would not have allowed companies to operate with aggressive pricing and no hedging on supply costs. Strict regulation of banks’ liquidity and capital is now the norm in the banking industry; pre-2008 it wasn’t.
The regulatory administration of company failure exhibits parallels, too. So far, at least, the energy companies that have collapsed have been relatively small, and are being folded into bigger rivals with potential government support.
Back in 2007/8, policymakers employed a similar technique to deal with disaster, persuading ostensibly stronger banks to take over struggling rivals. That happened most dramatically when a teetering HBOS was rescued by Lloyds with government encouragement and an antitrust waiver granted on crisis grounds. This attempt to avoid a state bailout not only failed (the enlarged Lloyds itself had to be rescued within months) but it also created a behemoth bank with a quarter-share of the UK retail banking market. This made a nonsense of all previous and subsequent rhetoric about the importance of competition.
That same dynamic is playing out in UK energy now. Of the 70 companies operating earlier this year, experts now forecast fewer than 10 will survive, all with larger market shares. If more robust governance and regulation was merited before, it certainly will be now.
patrick.jenkins@ft.com