Global Agenda: Sterling dross

As recently as 10 days ago, most people outside of the UK had never heard of Northern Rock.

September 20, 2007 22:12
3 minute read.
Global Agenda: Sterling dross

northern rock 88. (photo credit: Courtesy)

Even by the standards set in the last three months, this has been an extraordinary week in the global financial markets. In many respects, what used to be considered the ordinary state of affairs has been lost, so that extra-ordinary is the new norm. But what we witnessed this week was once-in-a-generation, perhaps even once-in-a-century stuff. Most educated people will be acquainted with the concept of a "run on the bank" from reading nineteenth-century literature or the history of the inter-war years in the US, Germany and elsewhere. Yet the reality of a run on an existing bank, of flesh-and-blood people queuing in the street outside bank branches, determined to get their money out, has been virtually unknown in the developed world since the Second World War. In Britain it has been unknown since the nineteenth century, so that for professionals and laymen alike, the likelihood of actually seeing a run on a bank on their local high street was on a par with that of viewing public hangings at Tyburn (now Marble Arch). Unknown, that is, until last week. As recently as 10 days ago, most people outside of the UK had never heard of Northern Rock, then the fifth-largest mortgage bank (formerly "building society") in the UK. The British public knew the name, of course, but assumed that even in its new, corporate form and despite its aggressive marketing, Northern Rock remained a boring bank that took deposits from some households and made mortgage loans to others. In fact, however, the bank's management had adopted a strategy of rapid growth that required raising the funds it needed to expand its lending from "the wholesale market" - i.e. by selling the bank's own obligations to other institutions - instead of gathering deposits from retail customers. The nature of mortgage banks is that they make loans for long durations that are financed by deposits for much shorter periods. But most depositors don't need their money most of the time, so the deposit base is solid and reliable. Bonds sold in the market, however, reach maturity and need to be replaced - so that if lenders decide to withhold their funds and not buy the new bonds, a big hole appears. That is the essence of the liquidity crisis created by the paralysis the inter-bank lending markets in Europe and the US since July. Responding to crisis situations by providing the liquidity needed to "unfreeze" the markets is what central banks exist for - and the American, and even the European, central banks responded with alacrity by flooding the market with short-term funds. (This is not the same as cutting interest rates, as the Fed did this week, which is aimed at addressing much broader economic issues). But the "Old Lady of Threadneedle Street" - a.k.a. the Bank of England - refrained from acting in this way, claiming it was unnecessary - although the market rate of interest in the UK interbank market made it plain that a liquidity crunch was taking place. This shortage of liquidity posed an existential threat to entities reliant on short-term funding, and Northern Rock was now revealed as the most exposed such entity. But the tardy response of both the Bank of England and the British Treasury meant that the crumbling Rock was neither shored up, nor sold to a larger and more solid bank. This bumbling was exacerbated by contradictory and confusing statements - and these triggered the hitherto-inconceivable sight of panic-stricken British depositors besieging the bank's branches to get their money out. The crisis climaxed this Tuesday, when Finance Minister Alastair Darling proclaimed publicly that the government would guarantee all depositors for any amount. This, for all practical purposes, nationalized the bank - and by implication, the entire mortgage bank sector. Good news for the beleaguered depositors, and maybe even for the shareholders - if a serious buyer can now be found for the bank. But very bad news for the British taxpayer, who finds himself saddled with the biggest-ever bailout in British (and perhaps global) history). Unfortunately for the British public, their economy cannot bear this burden because they and their government are already mired in a level of debt that makes the Americans look like paragons of thriftiness. In the bigger scheme of things, Northern Rock is just a local landslide, but the twin pillars of the UK economy for the last decade - namely housing and financial services - are both beginning to show cracks. The rest of the world will surely not place any greater confidence in Her Majesty's Government than do her own subjects and can be expected to express their feelings in much the same way over the coming weeks and months - by withdrawing their holdings of sterling and moving to whatever they consider a safer home for their money.

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