What’s gone wrong? Roughly speaking, after the defaults in the dodgier parts of the US mortgage industry, financial institutions around the world have become more sceptical about the quality of each others’ assets. This means they’re more reluctant to lend to each other. And that means they’re more susceptible to cash-flow problems.
This is what’s happened to Northern Rock, which has thus opened up a line of credit from the Bank of England so that it can continue operating. This is an expensive resort, both in terms of the interest rate and the reputational damage: hence the big falls in its share price and the queues to withdraw money.
But other UK financial institutions haven’t been so affected (at least, not yet). Why not?
Simply: NR was the most exposed, meaning it needed to borrow more on the markets as a matter of course. Its ratio of loans to deposits was 3.1; the second most exposed, Bradford & Bingley, is well behind with a ratio of 1.8. The average for major banks is 1.1.
David Cameron thinks he’s discovered someone to blame (as do the Lib Dems). You’ll never guess who:
Under Labour our economic growth has been built on a mountain of debt. And as any family with debts knows, higher debt makes us more vulnerable to the unexpected. In short, the increases in debt in the UK have added a new risk to economic stability.
This makes superficial sense. More debt commitments do make you more vulnerable to a rise in interest rates or a loss of income. But interest rates have been lower than in the preceding decade, meaning that while outstanding debt has become much higher, actual debt repayments as a proportion of (rising) income have risen much more modestly.
Furthermore, the higher debt levels across the economy mean that when the Bank of England decides to raise interests rates to slow down inflation, it needs to raise them by far less than in the past to get the equivalent effect. Rates have been stabler, as well as lower.
As I said, NR has got into trouble because of its decision to expose itself to an unusually high loans-to-deposits ratio. Other banks have not done so, and yet they’ve been operating in the UK economy as well. The distinctive feature is the policies of individual financial institutions, not Government policies.
And here’s another thought: would people now be less at risk if they’d been saving more and borrowing less? Well, consider the motives of the queuing NR customers: are they keen to withdraw money in case the bank collapses and they lose their savings, or are they desperate to pay off their debts?
Just one week ago, Cameron offered a more balanced appraisal of the (pre-Northern-Rockiness) situation:
Our hugely sophisticated financial markets match funds with ideas better than ever before. They have facilitated cheap credit that has helped companies expand, helped families achieve their dreams, and helped entrepreneurs put their ideas into practice. Yet that same cheap credit has also increased the social problems associated with over-indebtedness, and potentially has made us more vulnerable to global shocks.
I concede this: if there hadn’t been the amount of borrowing there has over the last decade, then there probably would now be less risk of an economic slowdown. The reason for that, though, is that the economy would have been a lot slower all along.
There’s no such thing as a risk-free investment, and there’s no such thing as a risk-free economic policy. One week of hindsight doesn’t change that.
(One final point. If the housing market is going to crash, could it please happen in the next week or two? I’m about to start flat-hunting for the first time…)
(Update: Chris has a good take on this. As ever, he’s several orders of magnitude better informed than I am.)
(Update 2: the Guardian has nicked my headline. Inadvertently, I'm sure...)
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