Between a Rock and hard place

The only thing certain in the current turmoil in the global financial system is more uncertainty, says Jim Moody

Turmoil in the global financial system has virtually destroyed Northern Rock, Britain's fifth largest mortgage lender. It is fit for nothing now except a takeover. While the Bank of England has pumped in billions of pounds in order to stop the run on Northern Rock's spreading to other banks and building societies, there can be no hiding the extreme fragility of the whole system.

As we reported last week, the US subprime mortgage collapse triggered a generalised freezing of bank-to-bank lending. While Northern Rock itself has not been directly connected to the subprime fiasco, it was unable to continue as before: borrowing by means of short-term loans to finance its long-term domestic mortgages.

Depositors panicked. They had no faith in the reassuring blandishments coming from chancellor Alistair Darling and a swathe of financial experts. Queuing for many hours, they withdrew over £2 billion, representing eight percent of the £24 billion deposits that the bank held on September 13. Many closed their accounts.

In order to stem the tide of mistrust in the UK banking system, the Bank of England even tried to sugar the pill for whoever takes over Northern Rock: it has let it be known that the billions provided as a line of credit to the bank would remain in place for use by the new owners in the event of a sale, up to the expiry date. The Bank of England is being coy and unforthcoming about when that expiry date is, however. More worryingly, the justification given by the Bank of England for bailing out Northern Rock - that it was trying to preserve the financial system's stability - only goes to underline how fragile the banking system actually is.

Matters were at a pretty pass. The Alliance and Leicester saw its shares fall 31% due to investors' perceptions that it too might face similar problems and had to issue a statement that it was not seeking Bank of England assistance. Alliance and Leicester has certainly participated in schemes similar to those that got Northern Rock into trouble, so the flight of capital is not irrational. HBOS, with 23 million customers throughout the world, and Bradford and Bingley, which saw a 15% drop in its share price earlier this week, are in the same vulnerable position. Alliance and Leicester let it be known that it thought hedge funds vultures had targeted it, circling over what they saw as the next banking victim.

Up until September 17, only the first £31,700 of all deposits at Northern Rock had been guaranteed. Then, in a last-ditch attempt to curb the continuing run on the bank, Darling announced that the whole of each depositor's money without limit would be underwritten. This guarantee and the Bank of England pledge to extend the emergency credit line to an eventual Northern Rock takeover buyer clearly signalled that Northern Rock would be seen through the crisis and a discount sale of its assets avoided.

On September 18, the Bank of England announced that it was providing £4.4 billion (at its benchmark rate of 5.75%) in a two-day 'exceptional' tender to the money markets, bringing overnight lending rates down to 6.14%. The soothing balm worked: not only did shares in Northern Rock rise by 11%, but those of Alliance and Leicester rose 25%, almost restoring its losses from the previous day. Finally the queues outside Northern Rock disappeared - after a total of £4 billion had been withdrawn by savers.

The Bank of England, Financial Services Authority, and the treasury have begun a review of the banking system aiming to ring-fence depositors' money in the event of a bank's failure, along the lines of the system in the USA. That might prevent such embarrassing spectacles as depositors queuing in the street to get at their money. Clearly, much of what happens is really out of the control of these 'steady as she goes' hands on the economic tiller.

While letting a bank as large as Northern Rock go under was never going to be an option for political reasons, several financial analysts are suggesting that smaller fry, whose demise could hardly effect the UK economy individually, might well be left to flounder and die. The Bank of England could hardly bail out everyone anyway.

Undeniably, every banker, economist and financier was on tenterhooks on September 18, waiting for the announcement of the cut in interest rates by the Federal Reserve Bank, the USA's quasi-official central bank. It was to be, in fact, the Fed's first base rate cut since June 2003.Would it be 0.25% or would it be 0.5% off the current 5.25%? Would 0.5% be a step too far? In the event, the Fed reduced its bank rate by 0.5%. But it was and is clear that what happens to the US economy is a determinant for what happens worldwide. The immediate effect of the cut, however, was that US treasury bills fell.

Lehman Brothers was the first major US investment bank to report third-quarter results this week, and announced that its quarterly profits to August went from $916 million to $887 million, a drop of three percent; the bank blamed a loss of assets in its fixed income capital market division, dealing in mortgage-related instruments. Speculators looking for a silver lining in the gloomy clouds that have been gathering of late saw the drop as less than expected, which led to a small increase in Lehman's share price. Small comfort: its cut in profits is the worst in Wall Street since 2001; and the falls it has already sustained earlier this year have led to the sacking of 250 staff.

In the UK, the City employs a million and contributes 25% toward the UK's GDP. If this sector of the economy gives way, then the ramifications could be widespread. Already there are indicators that London house prices, a powerhouse of the UK economy, are falling. The only certain thing now is uncertainty.