Northern Rock: No Need to Panic

In the Times of London today, Anatole Kaletsky worries about the magnitude of a potential mass liquidation of Northern Rock's liabilities:

Of course, the Bank and the Government would be deeply embarrassed if small depositors lost money. But what about depositors with £100,000, or £1 million, or financial institutions with 100 times that much? Darwinism supplies an easy answer: it is rational for all substantial depositors to withdraw their money – and to do so at once.
What if this happens? Northern Rock, when it last reported, had £34 billion of customer accounts and deposits from other banks. To repay this money, it would have to turn to the Bank of England for what would probably be the largest loan ever advanced by a Government to a private company anywhere in the world. What would be the political reaction to such a loan? Especially when it turned out that Northern Rock’s collateral included buy-to-let and unsecured lending in a housing market on the brink of a freefall?

I'm more sanguine. For one thing, players in the interbank market are not depositors. Yes, we have seen long queues outside Northern Rock branches from retail depositors wanting to withdraw their money. But big banks don't panic in that way and try to call their interbank loans without thinking long and hard about the systemic consequences of such an action.

And in this sense, Northern Rock's vulnerabilities are also its strengths. The reason that NR is in trouble is that it is a huge mortgage lender, but the mortgages it has written are much larger than its deposit base. So it has to fund its mortgages in the wholesale market, by borrowing money from other banks. As that market has dried up, it has had to turn for emergency funding to the Bank of England.

But the disconnect between Northern Rock's assets and its deposit base is also the reason why a run on the bank by its depositors will not have the drastic systemic consequences that a run on most high-street banks would: NR's deposit base simply isn't big enough for that. In turn, this means that there's little reason for NR's interbank counterparties to panic and start calling their loans, even if that's possible – not when the worst-case scenario for NR still leaves it with a positive equity value of 180p per share. Yes, that's a lot lower than where the shares are trading now. But so long as it's greater than zero, everything should be OK.