I have been out of contact over the last few days due to the fact I
am moving house, so when I finally got my podcasts to listen to there
were a few. I saw one from the BBC’s Today program on Northern Rock (warning – multi-megabyte MP3 file) and I thought this may be a good one, in light of my previous experience with them. I was gravely disappointed.
In what is now a continuing meta-story, the journalistic coverage of
Northern Rock is showing just how little even financial journalists
understand banking.
The errors in this particular piece revolve around a mis-understanding of one of the absolute basics of banking – liquidity risk. The premise of the argument in it was simple – Northern Rock was unable to meet calls on deposits meaning Northern Rock is insolvent and therefore worth nothing.
A basic understanding of banking would show this up as not a logical argument. As discussed in the post on liquidity risk linked to above, banks borrow short and lend long. This gives rise to liquidity risk, which means that if more than a certain amount of deposits are withdrawn in a short period a bank will not have enough physical cash to pay them. This can be, and must be, separated from the overall worth of a bank.
To put it in simple terms (and turn it around a bit) – let’s say I borrow money from a bank to buy a house. I manage to service the loan for a few years, during which time the value of the house goes up by 50% per annum – making me very wealthy (in part due to the leverage effect). Unfortunately, I lose my job and, during the period where I cannot find another one I cannot meet the repayments on the loan.
Am I financially worthless? Clearly not – there is a lot of value in my home. Can I meet the bank’s demands to pay my mortgage? No.
The Today piece confuses these when the journalist and the talking heads pulled in for the piece argue (at some length) that the failure to pay the demands of depositors means that Northern Rock is worthless.
3 comments
4 December, 2007 at 12:41
Martin Davies
As written:> Am I financially worthless? Clearly not – there is a lot of value in my home. Can I meet the bank’s demands to pay my mortgage? No.
…
Yes but assume you are unable to sell your home to liquidate your position, are you going to be able to buy a loaf of bread on a promise and security with your asset?
Then there is another downside, what happens if the price of your asset starts to diminish because of a change in market sentiments and of course you are still being charged interest on the loan at an amortised rate and compounded with fees coupled with the fact of no existing cash flow.
How long is such a position sustainable, one month. Two months with accelerated effects on each factor?
That is the catch, on paper it all looks fine but is it really workable?
4 December, 2007 at 15:19
Andrew
Martin,
You are right, in that this sort of thing is not a sustainable business model and, if a bank, would result in at least the current management being sacked and possibly receivers appointed.
I just wanted to make the point that you cannot assume from an inability to pay that the subject is bankrupt.
To me, though, NR should have been allowed to fail and receivers appointed. I know that this may have caused a bit of a problem – people do not like being reminded that banks do not have enough cash on hand to redeem all deposits – but that reminder is a good one and more likely to encourage more prudential discipline from depositors in the future.
A blanket government guarantee, like this one, is not healthy in the long term.
4 December, 2007 at 18:41
Martin Davies
Oh I totally agree with you the problem with NR is that it holds a specific position in the community and has attracted a certain kind of an investor. It was supported because a whole segment would have been damaged. Imagine say Suncorp investments going out backwards, Queensland retirement villages would fall into the toilet.
The sad point to NR is that while it was being propped up by the authorities there were those shorting the negative cycle and profiting from it.