Panic on the streets of Britain: Northern rocked, City shocked

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The Independent Online

Yesterday something happened that I have not seen in my lifetime, a run on a major British bank. There were queues outside Northern Rock branches as depositors tried to get their money out.

This is the sort of event that happened in America after the Great Crash of 1929. For Northern Rock, this is catastrophe. For the rest of us it marks the end of an era of easy money.

This cheap money, which fuelled the housing and takeover of recent years, was gradually drawing to a close as the Bank of England increased interest rates. But for those who were prepared to pay the going rate, getting a loan has remained easy enough. Now, with the bail-out of Northern Rock by the Bank of England, it is going to be rather more difficult.

Northern Rock, which has been doing one-fifth of the new home loans in Britain, had to go to the Bank of England for emergency funding. There is, we are assured by the Financial Services Authority, no problem with the solvency of Northern Rock.

The Bank of England says that this is simply part of its job to supply liquidity to financial institutions that are having temporary problems. The Chancellor has approved the bail out. If all these assurances are sound then there is no danger that depositors will lose any money. But the fact remains Northern Rock's reputation is shot. The company will presumably be taken over by a larger and more secure rival.

This is not just a story about a run on one medium-sized British bank. It is about the complexity and the possible fragility of the international banking system. And it is a story about the excessive credit that has been washing around the world, with banks throwing money at borrowers without paying proper heed to the risks. Let's hope it does not become a story of a more general economic slowdown.

Northern Rock's troubles did not start here; they started in the US, with the so-called "sub-prime" mortgage market. "Sub-prime" is a euphemism. These are mortgages to people who are poor credit risks. Banks made these loans then sold them on to other financial institutions, which for whatever reasons did not understand the risks involved.

US house prices started to fall, borrowers defaulted and the price of these loans collapsed. Some of the buyers were European banks and a couple of regional German banks have already had to be rescued by takeovers.

Northern Rock did not have these loans but the climate of fear generated in the banking community by the collapse of this market led to banks hoarding their cash. Better keep the money handy in case something else went wrong. That was Northern Rock's downfall. It has relatively few High Street branches and has expanded very fast. It has relied on borrowing money from other banks to balance its books. When that market started to dry up it was in trouble. The only place it could be assured of funds was the Bank of England.

Why did Northern Rock not see this coming? Two reasons. One is that we have not had a run on a bank in Britain since the fringe bank crisis of the 1970s – Barings went bust but that was rogue trading losses – and few bankers are old enough to remember that far back.

And the other is that the links between different banks and what they owe to each other have become so complicated that no one knows quite where a problem on one side of the world will end up.

The second part of the story is the global lending spree. Interest rates have been very low, in some countries below the rate of inflation, for several years. So it made sense to borrow money that was, in effect, free and stick it into property, hedge funds, private equity, whatever. In addition huge savings have been building in China and the Middle East and these too have been washing round the world hunting for a home.

Here in Britain this has had two consequences. One is that asset prices, particularly of prime property, have shot up; the other, that lending terms, again particularly for property, became very lax. The two fed off each other: if asset prices went up people did not mind borrowing and banks were happy to lend against the security of the assets. We have seen that in the credit cards pushed through people's doors and mortgages for six times' salary, but that has been just the tip of the iceberg, British examples of a global phenomenon.

One result has, in both Britain and to an even greater extent the US, been a spending boom. In both countries retail sales have grown much more swiftly than incomes, with people borrowing to cover the gap. We still save a bit; American households do not, in aggregate, save at all.

Slowly that is changing as saving comes back into fashion. Personal consumption accounts for about 70 per cent of US demand, a bit less here, and about 60 per cent on the Continent.

The question that follows is whether cutting back on spending will lead to such a sharp cut back in overall demand that our economies go into recession.

That is the final part of the story and we cannot know the outcome to it yet. There are serious fears of recession in the US and there are hopes that the US Federal Reserve will cut interest rates shortly in an effort to boost the economy and avert it.

In Britain and the Continent those fears are more muted. Much will depend on what happens in the various housing markets. In the US prices are falling but in the UK, France and Spain (all of which have had housing booms) the evidence is not at all clear. As to the future, the experts as always are divided. Yesterday the financial markets were in panic mode, marking down the prices of home lenders, building companies, estate agents – anything connected with property. Sterling did badly, too.

But we know enough about markets to appreciate that once they have digested the information they may well take a more sanguine view. Let's not kid ourselves, though. A run on a bank in a developed country is big stuff.

The longer these financial upheavals run, the greater the danger that financial ructions will feed through into economic damage. On the positive side the main "emerging" economies, China, India, Russia and Brazil, are all growing strongly. If the US, or indeed the UK and Continental economies falter, then there will be scope for trimming interest rates. But there can be little doubt that the developed world in general is moving into a more sober period.

It will be harder to get credit and more important to save – and not, many will think, before time.

The bank that liked to say yes

By Martin Hickman

Northern Rock is a building society-turned-bank with big ambitions, an aggressive regional player which rose from its base in Newcastle to become a national force. Just 10 years after it floated on the stock exchange, the bank is the fifth-biggest lender in Britain's £334bn mortgage market and regularly heads best buy charts by offering initially low interest. At the heart of Northern Rock's problems – and the secret of its previously rapid growth – is a business model which relies less on local branches and more on international money markets to raise money to lend to customers.

Under the leadership of its go-ahead chief executive Adam Applegarth, Northern Rock wished to escape the plodding path of many a regional building society or bank, carefully nurturing a branch network and growing slowly. Instead, he wanted Northern Rock to be a thoroughbred charging across the country, boldly borrowing money and winning mortgage business.

Although some money for these deals would come from its 1.5 million savers at its 70 branches, 75 per cent would come from short-term borrowing in the markets. The approach seemed to be paying off. The internet drew customers lured by cheap deals. Profits raced ahead early in 2007, when half-year results leaping by 16 per cent. Mr Applegarth was still confident yesterday, despite the emergency help from the Bank of England, when heinsisted Northern Rock was one of the safest places for the public's money.

Many, though, will question whether the bank continues to be a 'rock'.

Until a few years ago, it was solid and respectable but recent events have wiped out much of its stock market gains and its reputation has taken a hit.

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