Friday, September 14, 2007

So, What Does a Bank Run Look Like?

Despite backing by the Bank of England, customers of Northern Rock PLC are flocking to withdraw their funds:

Northern Rock has 76 bank branches, according to Hunter. By 11 a.m., dozens of people formed queues on the sidewalk outside the Moorgate office, the Maddox Street branch in the West End shopping district, and the Kingston Upon Thames outlet in southwest London.

The Bank of England is stepping up to the plate, what's the issue here?

The issue is that financial markets are doing exactly what they are supposed to do. Savings is low, demand for funds is high, so the interest rate rises both encouraging savings and lowering demand. It should be a great time for the average wage-earner to toss his extra quid in a savings account and let his money work for him.

But, Northern Rock was fully loaned out. Not content to quit making more loans until their customer deposits increased, the bank went to the Bank of England and complained about the "liquidity crunch." They wanted a lower discount rate (the rate at which the Bank of England loans money to commercial banks). The problem is, a lower interest rate is a signal to consumers to save less and entrepreneurs to borrow more, thus exacerbating the "liquidity crunch."

So, Northern Rock's customers did what depositors do when their bank starts making noises about needing funds; they rushed to pull out their deposits.

"It's scary,'' said Peter Pye, 60, a retired university lecturer standing in a line of about 30 people outside the Moorgate branch in the financial district. "I have my life's savings in Northern Rock.'' He said he would withdraw a "six- figure'' sum and leave 5,000 pounds in the account.
...
"Why leave your money in a bank that obviously has some major problems?'' said Michael Ribotham, 74. "I'm not young and don't have a chance to make it back again.'' Ribotham was waiting at Moorgate for about 40 minutes.

What does "backed" by the Bank of England really mean? Well, at the end of the day, Northern Rock compares the total amount of funds they have loaned out and the total reserves they have deposited with the Bank of England. If their reserves are below the required reserve ratio, they write an IOU to the Bank of England, and the Bank of England increases their reserve account in the computer.

However, the Bank of England doesn't have a pile of money sitting there to make the loan. It increases Northern Rock's reserve account without making a corresponding decrease in another account. So, in other words, the money it loans to Northern Rock is created out of thin air.

Now, if you happen to have a few pounds in your wallet or bank account, those funds are now competing with the newly-created funds for the goods on the grocery store shelf. Through the magic of central banking, the Bank of England stole a bit of your purchasing power right out of your wallet and handed it to Northern Rock.

Keep in mind, there is no law that says Northern Rock has to be fully loaned out. There is also no law that says the Bank of England has to create new money to bail them out. But, there are things called legal tender laws which say that if someone presents you with this fiat money (which is now worth less than it was this morning) to pay a debt, you have to take it.

Meanwhile, the Bank of England is richer to the tune of the interest they charge for the loan to Northern Rock.

Is anyone concerned about the failure of this Ponzi scheme?

"There is no risk,'' said James Hamilton, an analyst at Numis Securities in London. "The Bank of England said Northern Rock is solvent.'' Hamilton said that "as credit turmoil will return to normal, Northern Rock's business will.'' The British Bankers' Association said there's "no reason for either mortgage customers or savers to worry.'' The group provides London interbank offered rates, or Libor, a benchmark for money- market rates in the dollar, the euro and 11 other currencies.

Guess not.

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