Don't panic? Tell that to the public and the markets

'It's time to hold our nerve,' says one banker, but the ripples are spreading from Northern Rock, finds Andrew Murray-Watson
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The Independent Online

In scenes you wouldn't normally see outside a banana republic, the queues of worried savers and mortgage holders at Northern Rock branches on Friday told their own story. Don't panic, Adam Applegarth, the bank's chief executive, told them. Your savings are safe with us.

The queues were there because Northern Rock had just admitted that it had been forced to go cap in hand to the Bank of England for an emergency loan. The bank has struggled to raise money to finance its lending ever since markets seized up over the summer. To a greater extent than its rivals, Northern Rock relies heavily on loans from other financial institutions to fund its mortgage business. Banks are reluctant to lend to each other at the moment because of credit concerns that originated with the US sub-prime mortgage market.

The Chancellor, the Bank of England and other luminaries all chipped in to back up Mr Applegarth's assurances that his bank remained solvent, all was well and the problems were short term.

But the great British public, at least those with savings in Northern Rock, didn't seem to be listening.

Arthur Smith of Islington, north London, said: "I'm closing my accounts and my ISAs. It's my life savings, about £60,000."

That is £60,000 out of its retail deposits of £24bn. In total, the UK's eighth-largest bank has 1.4 million savings customers and 800,000 mortgage customers and looks after assets totalling £113bn.

Northern rock customers were also logging on to the internet to access their savings through the bank's website. Such was the traffic, the site seized up on Friday morning before steps were taken to meet the demand.

For Northern Rock, its inability to write as much new business as it would like, and the extra cost of borrowing from the Bank of England at a punitive rate of 6.75 per cent, means that the company will make around £150m less this year than analysts had predicted.

The Yorkshire-based bank has suffered a huge blow to its reputation, one from which it may never recover. Its share price closed down 31.4 per cent on Friday – to less than half its level at the start of 2007. On Friday, Mr Applegarth refused to comment directly on his chances of remaining in the job. Northern Rock looks distinctly vulnerable to a takeover by a bank whose reputation has yet to be tarnished by the current credit crisis.

So how did a medium-sized UK bank come to be so badly hit by a markets crisis that began with US institutions making foolhardy sub-prime loans?

The crisis has developed because banks across the world lend to each other in a complex web of agreements that has seen large numbers of institutions exposed to the US market for mortgage loans to people with poor credit histories. Often, riskier debt is packaged up with safer forms of loans. As banks try to work out how badly they are exposed to US sub-prime and what the debt on their books is actually worth, they stop lending to other institutions to limit their potential liability.

In the case of Northern Rock, the bank could not find other institutions willing to lend to it to cover the business it is writing.

So are others going to find themselves in a similar predicament? Well, the market is certainly worried. On Friday Barclays shares dropped by 3.1 per cent, while Alliance & Leicester, Bradford & Bingley and HBOS dipped by 6.9, 7.6 and 3.6 per cent respectively.

Alliance & Leicester and Bradford & Bingley made announcements to the stock market on Friday stressing that they were able to fund their lending activities despite the credit crunch, in an effort to quell speculation that they might be forced to follow Northern Rock in seeking emergency funding from the Bank of England.

The wider economy is likely to be hit by the credit crisis. David Brown, an analyst at Bear Stearns, says he is lowering his forecasts for UK GDP growth.

He explains: "We had previously pencilled in 2.4 per cent growth for 2008, but the risks are that the UK may be lucky to see anything above 2.0 per cent growth next year."

The last time a British bank was brought to the point of ruin was when Nick Leeson, the infamous rogue trader, destroyed the fortunes of Barings. On that occasion the Bank of England declined to bail out the bank, mainly on the grounds that there was no way of knowing the extent of Leeson's losses. But this time, with Northern Rock, the Bank can justify its decision to intervene on the grounds that if Northern Rock were allowed to become insolvent, the aftershocks would have far-reaching repercussions for the whole market.

One banker with links to Northern Rock says: "The damage to Northern Rock has been done. This is now about the wider confidence in the markets and in our regulators. If we panic now, predictions of some sort of apocalyptic meltdown in the financial system have more of a chance of coming true. It's time to hold our nerve."

Sub-prime time: how a mortgage crisis took hold in America and spread across the Atlantic

August 2005 to 2006

US consumers start to feel the pinch from higher borrowing costs as the property boom starts to unravel. Defaults on sub-prime mortgages start to increase.

8 February 2007

HSBC issues first profit warning as bad debt provision from UK mortgage lending spirals.

March 2007

Shares in New Century Financial, one of the biggest sub-prime lenders in the US, are suspended amid fears it may be heading for bankruptcy.

2 April

New Century Financial files for Chapter 11 bankruptcy protection after it is forced to repurchase billions of dollars' worth of bad loans.

24 May

Shares in Bear Stearns start to fall over speculation that it is heavily exposed to the US sub-prime market.

22 June

Bear Stearns says it will provide $3.2bn (£1.6bn) in loans to bail out one of its hedge funds.

25 June

Bear Stearns is forced to bail out a second hedge fund.

10 July

Independent market analyst Datamonitor says UK sub-prime mortgages are set to grow faster than mainstream loans, with the market for the products set to expand to £31.5bn by 2011.

20 July

Ben Bernanke, the US Federal Reserve chairman, warns that the crisis in US sub-prime lending could cost up to $100bn.

27 July

Concerns over the sub-prime crisis hammer global stock markets. The main US Dow Jones stock index loses 4.2 per cent in five days.

3 August

American stock markets fall heavily again while the FTSE 100 loses 1.2 per cent in a day to close at 6,224.

9 August

French bank BNP Paribas suspends three investment funds worth ¿2bn.

10 August

The FTSE suffers one of its worst days on record and closes 3.7 per cent down. European central Bank provides an extra ¿61bn of funds for banks.

17 August

Federal Reserve cuts the interest rate at which it lends to banks.

14 September

Northern Rock admits that it has had to seek emergency funding from the Bank of England.