The US subprime lending crisis has started to claim some big scalps. Stan O?Neal of Merrill has gone. Chuck Prince of Citigroup, too. But the biggest scalp of all, a somewhat unlikely victim of the subprime crisis, could be that of the Financial Services Authority?s (FSA?s) model of regulation. The fall of Northern Rock in the UK and the staggering guarantee that the UK Treasury had to issue to stem the run that it sparked off, has called into question the model of a financial regulator divorced from the monetary authority. One could argue that the FSA made a horrible mistake with its sloppy review of Northern Rock?s operations, and this has nothing to do with the system of regulation. Yet, one cannot ignore that Northern Rock?s business model was inherently risky. It funded its aggressive growth of mortgages primarily with wholesale market borrowing?basically by securitising its mortgage portfolio and not raising the more stable retail deposits on its own balance sheet. Thus, when liquidity dried up due to the subprime market convulsions, its ability to securitise its portfolio dried up too, leaving it with a big hole. It was given $26 billion of public money to stay afloat.

However, a careful review of what happened before the bank went under raises some important questions on the UK?s regulatory system. The FSA was created in 1997 in response to the orthodoxy that central banks suffer from a conflict of interest in managing inflation and preserving individual bank profitability. It was better to have institutions with distinct responsibilities so that there would be no dilution in their focus. The FSA was given the responsibility for oversight of individual institutions, while the Bank of England (BoE) had responsibility for the stability of the financial system and monetary policy. Increasingly, the BoE saw its job as inflation management and contributing to the financial system?s stability. For purposes of coordination, one of its deputy governors sat on the Board of the FSA, but the fact remained that only the BoE, with control of monetary policy, could act as the lender of last resort in a crisis. Dr Rakesh Mohan, the RBI?s Deputy Governor, in a speech on October 12, 2007, has raised questions about how central banks should discharge their responsibilities as lenders of last resort. Should they play this role for the system as a whole by injecting systemic liquidity, or should they also provide liquidity to individual financial institutions that are judged to be solvent but illiquid? If so, how do they arrive at such judgments if they do not have such information directly from the concerned institutions? Though central bankers will always empathise with other central bankers, the questions that Mohan has raised are good ones and pose a challenge to the orthodoxy on this issue.

To my mind, the political economy around such crises makes the division even more problematic. Let me explain. In times of crisis, speed is of the essence in public institutions. Bureaucrats are risk averse. It is important for public officials, therefore, not to believe that a looming crisis is somebody else?s problem. They run the risk of getting blamed for somebody else?s mistake, and worse, are unlikely to get any credit if a crisis is actually averted. In such situations, to expect a public servant to come quickly to help and solve what they believe is some other institution?s problem is like looking for Mahatma Gandhi?s in the wrong part of town. In this case, it did appear that the BoE saw this as an FSA problem for some time. The FSA model has created a system that splits such responsibility. Yet, only the BoE has the ability to act as the lender of last resort. Thus has the subprime crisis spurred a welcome new round of regulatory deliberation.

?Janmejaya K Sinha is managing director, Boston Consulting Group India. These are his personal views