Savers Will Be the Real Losers in Northern Rock Bank Run

Can you believe there’s a bank-run taking place in Britain? In the event of a bank run, it’s best to avoid the advice of the authorities and run, don’t walk. Or, if you’re British, stand politely in an orderly queue.

Patient UK pensioners and savers queued up outside the doors of U.K. mortgage lender Northern Rock Plc. and withdrew some US$4.3 billion last week. The lines were long, though, and more people will likely be back Monday, looking to take their cash somewhere else, if they can get it.

What has happened? Our former cubicle mate in London, Adrian Ash (now with Bullion Vault) explains that it’s not actual subprime debt that’s infected Northern Rock’s (LON:NRK) ₤100 billion portfolio. The problem is that the company’s source of financing for growth has dried up with the rise in short-term interest rates.

Ade says “the problem stems from how Northern Rock financed its runaway growth. ‘In the first 8 months of the year, Northern Rock’s total net lending was up 43% over the same period in 2006, with net residential lending up 55%,’ as the bank itself said in a statement. This stellar performance compared to its peers came thanks to what the Financial Times now calls ‘an alternative banking model’.

“‘Eschewing customer deposits kept down costs – the bank has just 76 branches – and facilitated a rapid expansion of the loan book,’ says the FT online. ‘Compared with the UK banking average of 7%, Northern Rock used wholesale market securitisation for 43% of its funding.’ All told, the UK banking sector held one-fifth of liabilities in securitised loans by April this year, according to the Bank of England.”

That loan book needs to be refinanced now. Trouble is, no one is in a lending mood in the global banking sector. Thus, for the first time in nearly 30 years, the Bank of England has stepped in to provide emergency funding for a distressed lender. Northern Rock has been lent money to keep it afloat (at punitive rates, we are assured). UK Chancellor of the Exchequer Alistair Darling went on SkyNews to assure the public the lender was solvent. Depositors ignored his reassurances and queued up for their cash anyway.

All in all, it’s quite an orderly bank run. Police with megaphones patrolled the queues outside the bank. No one threw rocks or trampled children in a rush to the door.

Who stands to lose the most when a bank fails like this? Well, Northern Rock shareholders can’t be too happy. The shares fell by 33% last week and will probably fall by more this week. Depositors still have some ₤10 billion in the bank. They will probably get their money out. But the real loser will be savers.

The more that central banks get involved in providing loans to tottering institutions and accepting risky collateral the market will not accept, the worse it’s going to be for the main product of central banks – fiat currency. Banks will print money to bail out the system, and any incremental increase in the money supply will lower the purchasing power of all the money already in circulation.

This is the trouble with the Fed and the Reserve Bank accepting mortgage-backed collateral for loans. It’s an attempt to launder bad loans. But the central banks can only hold those loans for awhile. They can’t do anything to improve the quality of the loans. Distressed lenders hope that the market value for those risky assets will rise while the central bank holds them and sprinkles magic central bank disinfectant pixie dust on them. Then, in a fairytale ending, the distressed lender can go back to the toxic collateral and sell it to some gullible, lobotomised investor.

But the credit market is in full freeze mode. Investors are not buying risky debt or even much short-term corporate debt.  Northern Rock cannot get funding for its operations for the market because no one wants to fund risky lending any more. This is not an American problem. This is not a British problem. This is a global problem. The stock market may not fully appreciate the gravity of the situation.

Dan Denning
Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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Adrian Ash

Quick update — Northern Rock itself says today that it’s been raising three-quarters of its funding from the wholesale credit markets. Try financing that every 3 months now that liquidity’s parched…

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