When the cash and the trust ran out

 

The crisis at Northern Rock blew up because customers had lost faith in the system, writes Simon Carswell, Finance Correspondent.

Prior to last week's crisis at Northern Rock, the last time concerned depositors queued on a Dublin street to recover their money, the price of a pint of Guinness was £1.08, the average industrial weekly wage was £143 and Culture Club's Karma Chameleon was top of the pop charts.

In October 1983, the Irish economy was a basket case and customers of PMPS, the savings operation of the PMPA motor insurance group, were right to panic about their deposits. PMPS had just collapsed with the rest of the insurance group, leaving about 5,600 depositors nursing losses of £9.4 million.

The queues of people at PMPS branches were considerably longer - and angrier - than the line that formed outside the Dublin office of Britain's fifth-largest lender on Harcourt Street last week.PMPS depositors had to wait 22 years before they recouped their money as the scraps of PMPA were sold off and the proceeds distributed to customers. Northern Rock's customers, among them 24,500 Irish savers with €2.4 billion on deposit at the besieged bank, are in a much happier situation.

Last Monday, the British chancellor Alistair Darling was forced to intervene to stop the run on Northern Rock. He guaranteed that the British taxpayer would cover all deposits - not just at Northern Rock, including the Irish savings, but those at any other British lender affected by the current turmoil in the financial markets. (This prompted a headline in Wednesday's Financial Times: "Thanks, Darling".) The guarantee had a soothing effect - the queues started to shorten. However, many depositors still withdrew their money and the bank's share price continued to fall.

The chancellor's promise was unprecedented and remarkable - he was effectively guaranteeing that taxpayers' money would be used to safeguard the entire British banking system. The pledge was an explicit admission that, after several days of trying to persuade alarmed customers that their money was safe, Darling had failed to put depositors at ease. Customers stopped believing the chancellor, the bankers and the regulator, and Darling was forced to make an extraordinary commitment to win back their trust.

Most commentators believe the crisis at Northern Rock was exacerbated by miscommunication. The bank was initially unable to control news of its troubles. The BBC broke the story on the evening of Thursday, September 13th; the broadcaster reported that Northern Rock had to turn to the Bank of England as "the lender of last resort" for emergency funding after its supply of cash dried up in the international money markets due to the ripple effect from the US sub-prime mortgage crisis.

The following day, fear took hold, and depositors rushed to their Northern Rock branches. Images of queues outside Northern Rock's 70 branches in Britain and its Irish office began appearing and a crowd mentality took effect - the queues grew. By Sunday evening, roughly £2 billion (€2.87bn) - about 8 per cent of the bank's £24 billion (€34.48bn) deposits - had been withdrawn.

IRISH CUSTOMERS FRANTICALLYtried to withdraw their money. Northern Rock's business in Ireland is an internet and postal operation; it doesn't have a walk-in branch in the Republic, so the small number of staff in Harcourt Street were swamped with calls. When customers couldn't get through to the bank by telephone or withdraw their money online, the virtual queue of customers turned into an actual queue.

Most depositors had only ever dealt with the bank as online customers or by post, forcing some of the least technically literate people to sit for hours at computers trying to beat the heavy internet traffic and withdraw their nest-eggs online. They cursed the bank for failing to provide a human being they could speak to over the phone, an employee who could explain that their money was safe.

Northern Rock's Irish customers had chosen the bank because it offered deposit rates that were about 1 per cent higher than those of the mainstream Irish banks. Ironically, Northern Rock could only offer these deposit rates because it didn't have to maintain a costly branch network. Last week, customers were paying for the poor customer service at the bank with anxiety and stress. This did little for the bank's credibility and weakened the official assurances that the bank was safe.

The Latin root of the word "credit" is credo, meaning "I believe". Last week Northern Rock's customers lost belief in the banking system and the British politician who tried to defend it. The run on deposits was the first at a British bank since 1866. Nick Leeson, the rogue trader whose £750 million losses brought down British merchant bank Barings in 1995, says this was hugely damaging to the banking sector.

"All you need is a lack of credibility in the market to start a run on deposits," he says. "Banking is all about trust. If you cannot trust your bank, you are going to have a very trying existence in front of you."

The Financial Regulator's consumer line was inundated with queries - it clocked up 1,600 calls on Friday and Saturday (it normally receives 100 calls a day), rising to 2,500 by close of business on Monday. The customers contacting the line were generally pensioners who had only dealt with Northern Rock by post and who held deposits averaging between €80,000 and €100,000. Some had earmarked the money to pay for building work and large bills.

Northern Rock senior manager Brian Kavanagh went on a media offensive in Dublin, explaining to anyone who would listen that customers could withdraw their money if they wished, but that it was safe where it was.

The queues remained, surprising many banking experts. "I really failed at any stage to see why these people were queuing on the street," says Stuart Draper, head of research at Dolmen Stockbrokers. "There was no risk whatsoever to their money. This is not a solvency issue - it is a liquidity issue. It was just irrational behaviour of the highest order. It was quite shocking."

The bank was never in danger of going bust. It is, and always was, solvent. It had merely run out of cash, leaving it with no products (loans and mortgages) to sell and it had to turn to the Bank of England for emergency cash.

THE BELEAGUERED BRITISHbank was in the business of buying and selling money - it bought cash from other banks and sold it on to its customers. When it could no longer buy money in the inter-bank market - where banks buy and sell money from each other - it could no longer sell loans to customers. It would be like Tesco's suppliers failing to deliver, leaving the shop with no food for its shelves.

Northern Rock's difficulties have been sparked by the problems in the US sub-prime mortgage market, in which loans are given to borrowers with poor credit histories. This market has been decimated by the large numbers of high-risk borrowers who have been unable to repay their loans. This in turn has led to the so-called credit crunch that has reduced the flow of cash in money markets and driven up the cost of borrowing for banks.

Northern Rock was unable to sell its mortgage book in the international markets - one of the main ways it had raised cash in the past - because of the general fear among investors and institutions that complex financial products being traded by banks and investors could contain some exposure to the defaulting US sub-prime borrowers.

A Northern Rock-style scenario is unlikely to happen to any Irish banks because they obtain their money from a wider variety of sources in the financial markets and have access to a much larger pool of cash within the European Central Bank (ECB).

Nick Leeson believes that financial regulators and central bankers, the policemen of the banking sector, have failed to keep up with all innovative products in the financial money markets that have been developed to generate extra cash and profits.

"The people who are driving these financial markets are the whiz kids in the big banks in the City," says Leeson. "People in the control functions are never at the same speed as the people trading and controlling the market. They will always be catching up. That is not acceptable to the people who have their money in the banks.

Financial fallout: the Irish cases

The crisis at Northern Rock has raised the question of what would happen if a major Irish bank collapsed. However, the likelihood of this happening is very low, given the diverse range of funding on which financial institutions in this country survive.

If an Irish bank failed, under legislation, 90 per cent of a customer's deposit would be covered up to €20,000. This would be paid from a war chest of several hundred million euro raised by the Financial Regulator from the banks.

This fund has not been touched since it was established in 1994 because there have been no Irish banking failures in that time.

Only three Irish banks have collapsed in the last 30 years.

Irish Trust Bank, which was set up by Cockney businessman Ken Bates (later owner of Chelsea and Leeds United football clubs) failed in 1976. Depositors were later repaid by the government after a pre-election promise by Fianna Fáil TD George Colley in 1977.

Merchant Banking, the in-house bank of Patrick Gallagher's property business, crumbled with the rest of his empire in 1982. Depositors lost all their money.

Although a deposit-taking provident society, PMPS, part of the PMPA insurance group which failed in 1983, was regarded as "a back-door bank". Its depositors were not repaid in full until 2005.

"The customers at Northern Rock voted with their feet and queued to get their money back. They were not happy with the way the bank had risked their money."