How did a few dodgy loans in the US housing market lead to a mini-crisis in Britain's banking system?by Michael Prest / October 27, 2007 / Leave a comment
A century of advancing regulation, bank consolidation and financial sophistication was thought to have put Dickensian bank “runs” behind us. Those queues outside Northern Rock branches said otherwise. And they spoke to a deeper fear: that what began as a complex financial crisis in America could degenerate into a slowdown or even recession here.
So what is the connection? How did some dodgy loans in the US mortgage market undermine the eighth largest British bank and apparently threaten several others? The link here is a financial mechanism which most of us never have to think about—the inter-bank market. At any one time, different banks have different requirements for short-term financing. The inter-bank market is the market between banks in which they can borrow from, or lend to, each other to meet their short-term needs. These transactions are secured against collateral such as government bonds. But the market has seized up because of uncertainty about the value of some of the collateral which institutions hold, such as instruments derived from US mortgages, whose value is now hard to determine. If Bank A is suspected of holding a lot of such debt, how can Bank B be sure that a loan to Bank A will be honoured?
Northern Rock fell victim because it depended more than most banks on the inter-bank market, rather than depositors, to fund its operations while also lending on highly attractive terms. In effect, the bank was borrowing short and lending long—the classic recipe for financial disaster. It raised funds by issuing short-term securities secured against its mortgages. This fuelled spectacular growth. But when the credit markets ground to a halt and interest rates rose, it could not raise the cash to fund its operations. Northern Rock’s problem was liquidity, not solvency. Unfortunately, depositors did not understand, or did not believe, that this was the case. The financial seizure exposed the shortcomings of Northern Rock’s business plan and sparked a textbook crisis of confidence.
For all the earlier tough talk about moral hazard, the Bank of England, the Financial Services Authority and the government had no alternative but to bail Northern Rock out. While Mervyn King, the governor of the Bank of England, could try to be resolute about the whole market, neither he nor the FSA and the government could countenance Northern Rock going bust.