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    September 17, 2007

     Northern Fudge

    The latest casualty of the global credit crisis is a middle-sized British mortgage bank, Northern Rock - which until last week had almost 20% of the new mortgage market in the UK. It financed its aggressive expansion by borrowing from the money markets and securitising its loans. The credit windows of other banks have suddenly shut in its face, though its loan book is sound according to the regulators. Northern Rock has had to go to the Bank of England as lender of last resort. The Bank's line of credit is at a penal rate, so Northern Rock will have to quit the market for new mortgages, its share price has collapsed and it's up for sale.

    It's more or less irrelevant to the failure, but Northern Rock has been the object of a classic run by retail depositors. Classic, but very unusual in recent times. The last retail bank failures in Britain were in 1973-74, and the secondary banks in question - such as Slater Walker - were niche players that were obviously riskier than the High Street ones. But Northern Rock is a High Street bank, and the run has meant highly visible queues of depositors trying to withdraw their money.

    Any lessons of general application?

    • The regulators - the Bank of England, the Financial Services Authority, the Chancellor of the Exchequer - all reassured depositors that their money was safe, but they were not believed. It's difficult to imagine a more solid establishment lineup, so the scepticism may reflect the wider decline of deference. Bank deposits aren't insured in Britain, on the moral hazard argument, so depositors didn't have a legal guarantee. Since the interest penalty for switching banks is insignificant, even the tiny risk of default was too much. This is worth remembering in discussions of reform of deposit insurance in the USA.
    • Like most British banks today, Northern Rock had a large number of online depositors. ( I do almost all my own banking on the Internet.) When the run started, the website jammed, making customers even more panicky. Online banking drops the transaction costs of switching deposits to near-zero and therefore quite possibly makes runs more likely; it will surely increase their speed and intensity. Regulators should think about this. Perhaps online banks should be required to be more conservative in lending. At least. they should be required to build in huge safety margins of capacity on their websites, like stock exchanges, and to set up transparent management of online queues.

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