Northern Rock: what did really happen? Did account holders really risked their money?

I think nearly everybody heard about Northern Rock, the fifth English bank as size. Customers, when they heard about a possible liquidity shortage for the bank, run to to the bank counters to withdraw their money.

Did really account holders risked their money? In fact, as usual panic can be more damaging than the real problem. But since Northern Rock is specialized in mortgages, and lately “mortgage” is a scary word, we witnessed a phenomenon that was mostly emotionally-based.

A liquidity shortage isn’t, in general, a dramatic problem: it just means that a too big part of the assets is immobilized. This requires the bank to borrow money (or better, more money than usual), and therefore the bank will have to pay more (and often higher) interests on these loans. This will surely influence bank profits (or losses), and therefore will impact on shareholders. But it’s quite unlike that this will involve account holders. For them, the worst-case (realistic) scenario is that the bank is bought from another bank, that would also take over any business relation with customers.

But if all account holders start a run on the bank to withdraw their money, the situation may become dangerous. This is because any bank can’t give back immediately all money to all customers, since (simplifying) that money is lent in loans and mortgages (I’m sure you know that the money you borrow from the bank isn’t some clerk’s or manager’s money…). And even if many contract include a clause that provide that the bank can ask the borrower to immediately give back the money at bank’s request, it’s quite difficult that borrowers will be able to do it that fastly. Therefore, the bank collapses. It’s worth noticing that bank runs can do more damage than most kind of crisis: many economists agree that much of the Great Depression’s economic damage was caused directly by bank runs, more than from stock market crash.

For a outside observer, what happens is a quite interesting phenomenon: self-fulfilling expectations. I.e. people fear that the bank may become insolvent, so they start a bank run and they get the bank to become insolvent. And in the end they probably will say something like: “Have you seen? They said that there was no danger, but the bank failed! Luckily I withdrew all my money…

Original Italian version of this post: Northern Rock: cos’è successo veramente? Davvero ci sono stati rischi per i correntisti?

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