The classic signal that a financial crisis is maturing is when a large financial institution has to be bailed out by the authorities. Fortunately this does not happen very often. Here in the UK we have not had such a situation since the fringe bank crisis of the 1970s, when lots of smaller banks had to be rescued by the Bank of England's so-called "lifeboat".
Elsewhere the experience is more recent. In the US, the Federal Reserve orchestrated a rescue for the Long-Term Capital Management fund in New York in 1998, and this summer the German authorities have stepped in to organise takeovers of a couple of regional banks that were caught up in the US sub-prime mortgage scare.
But central banks do not always ride to the rescue. The Bank of England might have saved Barings after it was struck by its "rogue trader" in 1995 but it chose not to – rightly as it turned out – on the grounds that letting one small player go would not lead to a general run on the banking system. Last week – rightly again, I think – it judged that the risks were too great. And so Northern Rock, and any UK bank that needed it, was promised an unlimited credit line at the Bank.
We don't yet know how bad the situation is at Northern Rock. The Financial Services Authority says it is solvent and we have to accept that. Given the nature of its core business, it would be astounding if it were not: anyone lending against the security of UK residential property must be all right, even if some of the terms on which the most recent loans have been made are rather hairy.
What we do know with total certainty is that if people found they could not get their money out, there might be a run on other banks too. Even the remote possibility of that happening is a risk no central bank dare take.
What has happened will be a cathartic experience in British banking. Viewed globally, I don't think we are out of the woods at all yet; I still think there will be serious losses in other financial institutions. But as far as the UK is concerned, there will be a number of consequences. Here are the key ones.
First, there is no doubt that mortgage lenders will tighten the terms on which they are prepared to lend. That was already happening but now it will take place more rigorously. I would be surprised if Northern Rock survives as an independent entity – I would think it will be taken over – but there can be no doubt that one of the most aggressive lenders is now going to be very cautious about new business. That will change the whole dynamic of the market and not before time.
Second, commercial borrowers will find debt slightly more expensive than it was before. A typical large company borrows for a range of maturities but the three-month rate is a crucial one. The problem Northern Rock ran into was that it relied too much on deposits bought on the money markets rather than deposits collected over its branch counters. So when the markets gummed up, with banks hoarding their cash in case it would be needed in the future, the bank suffered unduly. That paralysis in the markets also affects companies. They will have borrowing facilities tied to money market rates. They can get the money but the cost will be higher than it would have been had the markets been functioning properly.
Third, at the margin this will weaken sterling. That is largely because it changes interest rate expectations but maybe slightly because there will be a general bias internationally against sterling-based financial institutions and sterling instruments.
Fourth, further rises in sterling interest rates are off the agenda for the immediate future. That is not because the inflationary pressures have diminished, for these remain as great as ever. It is because credit will tend to be rationed by availability as much as price. Six months ago, the only thing that checked lending was the rate on the loan. Now all new lending, individual and corporate but most notably mortgages, will be scrutinised more carefully. So we won't need such high rates as we otherwise would to check inflationary pressures.
Fifth, there will be some influence on the housing market and more broadly on domestic demand. There is a clear link between property prices and retail sales going back to 1996. As house price expectations fall, so too – after a time lag – do retail sales. This does not mean that if prices go negative, as they did in the early 1990s, sales at the tills will actually fall. It just means there will be a more subdued climate on the high street, as indeed there already seems to be.
If sales go down, after a time lag house prices get weaker. That too points to a more subdued housing market.
To be clear: none of this means there is an economic meltdown round the corner here or anywhere else. Maybe there will be slightly slower UK growth next year than there otherwise would have been – let's say 2 per cent instead of something nearer 3 per cent. But I would be astounded were there to be a recession in the UK and surprised if there were one in the US or the main European economies.
But at the same time, I think we have to recognise that financial markets will be very edgy for some weeks, maybe months. The Northern Rock problem is actually a very old one: a liquidity squeeze on an otherwise sound bank. The management should have seen this coming and put in place lines of credit with the other banks, so that it could withstand the squeeze. That would have been expensive but so is most insurance.
The problems in the financial markets go deeper as they are associated with all the new credit instruments developed over the past five years – ones that not even the bankers themselves fully understand.
I expect other rescues in the months to come, not necessarily in the UK.Reuse content