Northern Rock: A Real Bank Run

Bloomberg and the Financial Times both have reports on the fact that British customers have been queuing up to pull their funds out of Northern Rock, ironically as a result as the emergency cash infusion by the Bank of England announced yesterday.

There’s a potent message here; the information conveyed by regulatory action can counteract the intended effect of that action. And even if it’s only one stuffed-up bank that’s in trouble, the image of people lining up to pull out their cash is so strongly associated with the Great Depression that it isn’t good for the mass psyche.

From Bloomberg:

Hundreds of Northern Rock Plc customers crowded into branches in London today to pull out their savings after the mortgage-loan provider sought emergency funding from the Bank of England.

“It’s scary,” said Peter Pye, 60, a retired university lecturer standing in a line of about 30 people outside the Moorgate branch in the financial district. “I have my life’s savings in Northern Rock.” He said he would withdraw a “six- figure” sum and leave 5,000 pounds in the account.

The Financial Times has extensive coverage on the Norther Rock mess. From the lead story:

As regulators and politicians called for calm, Northern Rock – Britain’s fifth-biggest mortgage lender – scrambled to contain the fallout after it became the first British bank in decades to be bailed out by regulators. One person close to the situation said customers had withdrawn about $2bn Friday but Northern Rock declined to comment on the figure, which would amount to 4 per cent of its deposit base.

Tim Congdon in a comment earlier in the week, “Pursuit of profit has led to risky lack of liquidity,” pointed out how British banks have come over time to reduce their holding of cash and liquid assets, which puts them in a more precarious position in the event of unusual demands:

In the 1950s liquid assets were typically 30 per cent of clearing banks’ total assets (and hence of their liabilities). Liquidity was dominated by the Treasury bill, an instrument that was issued by the government and so was entirely free from default risk. Within the 30 per cent figure the banks also kept cash roughly equal to 8 per cent of liabilities. In these circumstances it was virtually inconceivable that a solvent and profitable clearing bank could run into liquidity trouble.

Although cash is an essential item on a bank balance sheet, it is also unprofitable because notes and coin in bank tills earn no interest. As liquid assets usually have a return only slightly above money market rates, banks try to minimise their holdings of these as well. So – in a sequence of steps agreed between the Bank of England and commercial banks – the commercial banks drastically lowered the ratio of both cash and liquid assets to total assets.

At June 2007 UK banks’ cash deposits at the Bank of England were £2.4bn ($4.9bn), while the notes and coin held in their tills were worth just under £8.8bn and their holdings of Treasury bills were under £8bn. By contrast, their total sterling liabilities were over £3,150bn. Cash is about ½ per cent and traditional liquidity about 1 per cent of total liabilities. The reduction in the ratios of these low-earning assets to total assets has of course been good for bank profits, but the contrast with the conservatism of the past is striking.

Sophisticates may say that the history is irrelevant, because nowadays the banks use government securities in repurchase operations. In their view, the technology of repo operations is so advanced that there is no need for another liquidity buffer. But the plain fact is that many banks have economised too much on assets suitable for sale to or repo with the Bank.

Charles Pretzlik, one of the FT’s bloggers, argues (invoking Willem Buiter) that Northern Rock wasn’t a fitting candidate for a rescue (it wasn’t too big to fail) and was riding for a fall:

If Northern Rock is not bust it is only because of the Bank of England and the government don’t want it to be. Call it what you like, but this bank ran out of money and can no longer fund all its liabilities, let alone finance its aggressive business model. It is not an innocent victim of events far away, as chief executive Adam Applegarth portrayed it on this morning’s call; it has had to be rescued because its strategy made it more vulnerable to those events than others’. One of our reporters listening to Applegarth on the analysts’ call this morning was struck by how laid-back and quick to blame others he was.

And John Gapper similarly disabuses the view that Northern Rock was a happless victim of subprime contagion:

Actually, there is something to worry about, even if those queuing outside Northern Rock branches to withdraw their money on Friday were (understandably) over-reacting. The Bank of England does not bail out banks every day. The last comparable wobble was the secondary banking crisis of 1973-74, in which the Bank of England launched a “lifeboat” for troubled small banks and National Westminster Bank nearly foundered.

Here is the blurb to Margaret Reid’s book on that crisis: “Abundant credit in a liberalised financial system led by a government hell-bent on growth provided a hot-house atmosphere for a breed of self-styled financial entrepreneurs…Their reign was brief, foundering in a mix of political chaos, currency crises, rebounding interest rates, over-investment in property and the inevitable and dramatic change in that most fickle of ingredients – confidence.”

British banks are better-capitalised now and the UK faces nothing like the same economic (or governmental) problems. But there are some echoes of the past. Property prices have been rising at an unsustainable rate, until the financial bump in August, and economic growth has been lopsidedly dependent on the City’s expansion and housing.

Northern Rock, the allegedly innocent victim of US speculators, has been an active orchestrator of this phenomenon. It offered loans of more than 100 per cent of the value of properties to first-time buyers and grabbed a chunk of the increasingly speculative buy-to-let market; it disclosed on Friday that its net residential lending had risen by 55 per cent in the first eight months of the year as it accelerated into this summer’s liquidity crunch.

Even worse, in terms of its financial health, Northern Rock has been the most aggressive of the former building societies in moving from funding its loans with retail deposits and going instead to wholesale markets for cash. As any banker knows, retail deposits are often more expensive to obtain than wholesale ones but they are more stable and dependable in times of financial instability or illiquidity.

So far, Northern Rock’s mortgage loan book is not in bad shape – its bad debt ratio is below the industry average. But it was not picked on at random by other banks and wholesale lenders. They knew that it could well have liquidity problems (a concern that unfortunately tends to be circular) and that it would probably suffer heavily if the UK housing market went the way of the US, with slumping sales and prices.

The notion that Northern Rock was prudently minding its own business when it caught a bout of American financial flu is ridiculous. In fact, it had made itself very vulnerable to a financial and property market upset, no matter where it emerged. The fact that the inciting incident happened to originate in the US mortgage credit market does not absolve it…..

Until the August financial shock, the world was enjoying an era of enormous financial liquidity, driven by low interest rates and high commodity and property prices. A lot of it flowed into the UK, in the form of both corporate investment and Middle Eastern and Russian billionaires buying big houses. Everyone from Northern Rock to investment banks, ministers and regulators enjoyed the knock-on effects while they lasted.

It is therefore a bit rich for the British, who have been basking in the heat of hot money, to turn around and blame foreigners when things suddenly get chilly. That was what some Asian governments did after the 1997 financial crisis and it was equally unattractive and unjustified.

Together with sterling and house prices, British self-regard has become unnaturally inflated. It is due for a correction

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  1. Shutter

    There are two tests of solvency ;

    1. Inability to pay debts as they become due.
    2. Insufficient assets to cover liabilities.

    Northern Rock borrows money wholesale and lends it to people to buy houses. Due to the interbank rate now exceeding Base Rate by over 1 % their sums don’t add up. Loans are due for repayment and cannot be replaced. They are insolvent.

    In UK law, the people who decide that a company is solvent / insolvent are the Directors. When they judge themselves insolvent they are obliged by Company Law, to undertake certain legally prescribed steps, which effectively places control of the company out of their hands – into those of receivers, administrators.

    The Money jugglers of the City have shrewdly put (switched) the onus for judging insolvency upon the FSA – who are hopelessly ill -equipped to make such judgements – and of course rely totally upon the information the Directors provide them with.

    If the BOE hadn’t stumped up, the Directors would have had to file for Administrators to be called in. Period.

    If the BOE hadn’t stumped up, the Directors could not continue in business as they had lost their ability (and confidence of lenders) to raise capital to continue to fund their loans. Period.

    That is the simple, clear, transparent unvarnished TRUTH.

    ADministration would have also yielded a better return for shareholders.

  2. Yves Smith

    That’s a very important point, and I completely forgot about it. For readers who aren’t familiar with UK/Commonwealth law, if a company is ‘trading insolvent” the directors are PERSONALLY liable. This puts considerable pressure on companies that are under water to liquidate.

  3. Anonymous

    Dear Shareholders

    Our temporary inability to fund certain obligations at the right price means that we will have to draw on earnings to finance a refunding excercise over the next few quarters and maintain a lower than planned volume of lending in our markets.

    Some of this and the following two quarters earnings will need to be assigned to losses arising from refunding costs and we plan to suspend dividend payments over this period.

    While Merv and the little Darling have been kind enough to offer us a cheap slug we feel that, should we accept, the short and long term effects on our business reputation and our business discipline would more than offset the temporary advantages that such a course would entail.

    A reduced business volume will permit reductions in variable and overhead costs. Management salaries and bonuses will be cut and some staff reductions will be made in the funding part of our business. We plan to restore these as soon as possible.

    Fortunately, we believe that these economies coincide with a tightness in conditions in our markets and that cost reductions will not impair our ability to resume market-paced growth once funding is in place.

    I and the present senior management accept responsibility for the failures resulting from over-optimistic business growth and innapropriate funding choices and have agreed it is appropriate to suspend all our own remuneration until new funding has been sourced. Once we have seen the company through this uncomfortable period we have agreed with the board that we should step down.


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