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Northern Clay

Currency cranks claim – echoed in some badly edited economics textbooks – that banks have the power to "create credit" by a mere "stroke of a pen": that if someone deposits, say, £100 in a bank, then the bank can lend out many times this amount, effectively creating new purchasing power at will. But this is not the case – banks are essentially financial intermediaries making a profit from borrowing money (typically from depositors) and then lending it out at a higher rate of interest to others; they do not create something effectively out of thin air.

This is obvious in the case of other financial institutions such as a building society or a credit union. A building society accepts deposits from savers, which is lends out to others to buy a house (originally it was only to its members, the savers, a principle still maintained in credit unions). Without these deposits they cannot function – building societies generally make a surplus (which in theory belongs to their members) by charging house-buyers a higher rate of interest than they pay their depositors. Which is why when interest rates go up and they have to pay more to depositors, they also have to charge house-buyers more and mortgage rates go up too.

Northern Rock, currently the focus of one of the most serious financial debacles in modern British history, used to be a building society, but in 1997 they "demutualised" and became a bank that is listed on the London Stock Exchange. From then on the surplus it made from charging borrowers more than it paid depositors became "profit" which belonged to its shareholders and the explicit aim became to maximise this. This essentially legal change did not change its economic function as a financial intermediary nor free it from the financial limitations common to other banks – and it certainly didn't acquire any right to create credit by the stroke of a pen. But it did allow it access to a wider range of sources from which to obtain money to lend. Instead of being restricted to savers it could now borrow money on the "money market" where short term debts that can easily be converted into cash are traded. It was still a financial intermediary borrowing at one rate and lending at a higher one, only it now had a wider range of sources to borrow from.

Northern Rock seems to have based its entire banking strategy on taking advantage of the relatively low rates of interest available on the money market in recent years. The papers are reporting that while its loans and assets are worth £113 billion, only £24 billion of this has been covered by depositors. The rest – over three-quarters – has come from money borrowed on the money market.

This use of the money markets to underpin long-term lending such as for mortgage loans is what is sometimes known as ‘borrowing short and lending long’, and is traditionally considered bad banking practice. Although all banks have done it at the margins of their operations to smooth-over short-term fluctuations in deposits and loans, it is only in comparatively recent times that some banks have developed entire strategies based around it and Northern Rock appears to be one of the more extreme examples of it.

The main problem that has now developed is that since the beginning of August the money market, like other financial markets, has been in turmoil. Banks and other financial institutions have been reluctant to lend money on it because of the US sub-prime mortgage crisis, so institutions such as Northern Rock who have been relying on it to borrow cheaply have been in trouble. So much trouble in the case of Northern Rock, that it has had to go cap in hand to the Bank of England, which, as the "lender of last resort" to banks has loaned them the money – or rather opened a credit line for them – so that the bank can survive its current problems. The Bank of England is reportedly charging them an interest rate at around one percentage point above the London Inter-Bank Offered Rate (‘Libor’, the rate at which the banks lend to one another). This amounts to what has been described as a ‘penal’ rate of around 8 per cent in total.

Indeed, Northern Rock is probably not just worried about its depositors withdrawing their money (and at the time of writing the government has taken the unusual step of guaranteeing all deposits to stop the ‘bank run’ that had been developing across the country). The underlying issue is more about its inability to continue borrowing money from the money market at a lowish rate of interest – since in many respects it is from the difference between this rate and the rate it charges house-buyers that it makes its profit. Already it is forecasting lower profits for the current year and because its share price has fallen – due to some of its shareholders bailing out too – it is liable to be taken over by some rival. In fact, this is what the papers are predicting and it is probably the only way to save it now that its credibility has been shattered.

One thing that won't happen – because it can't – is that Northern Rock's beleaguered chief executive, Adam Applegarth, will take out his pen and simply create the missing credit. Indeed, what has happened to Northern Rock is further proof that banks cannot create multiples of credit from a given deposit base. If they could do this, Northern Rock would never have had to go cap in hand to the money markets to finance its lending operations in the first place.