Eric Rasmusen’s Weblog

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The Northern Rock bank run is interesting (background below from a newspape account). I’ll make three points: 1. Stupidly low deposit insurance limits caused a rational run, 2. The government should have made Northern Rock pay for the free full deposit guarantee it just got, and 3. It’s time to get out of savings accounts and bank stock shares if you’re British..

1. Stupidly low deposit insurance limits caused a rational run. In the U.S., up to 100,000 dollars of a depositor’s account are fully covered. That is way more than any person ought to have in a savings account anyway, so depositors can and do feel safe. In the UK, only about the first 4000 dollars are fully covered. The next 66,000 dollars or so are 90% covered. Suppose you have $10,000 in savings. That’s not a lot, and you might need to spend it on short notice, so you rationally do not think about buying fancy securities or splitting it among three banks. Instead, you put it in a savings account. Now you hear that the bank might possible be insolvent. If it is, you could lose up to $600, plus all your assets might be frozen for some time. For that, it’s worth spending an hour in line in a bank run to get your money out..

Why is the coverage limit so absurdly low? Did they forget to raise the limit after 1940?.

2. The government should have made Northern Rock pay for the free full deposit guarantee it just got.. The government swung to the opposite extreme of covering all depositors, regardless of size. Naturally, this helps with the bank run, but (a) it is perceived as, and is, a gift to Northern Rock, and (b) it encourages people to put huge deposits in reckless banks..

What the government should have done instead was (a) to extend the coverage limit to some reasonable level such as 30,000 pounds, and (b) make this guarantee a business offer to Northern Rock, for a substantial price (say, 10 million pounds). Then, once the crisis was over, they should have raised the deposit insurance limit for all banks, at a small charge to them..

3. It’s time to get out of savings accounts and bank stock shares if you’re British. If the current limit is not raised, savings accounts of more than 2000 pounds are a risky investment. Beyond the limit, if you put 8000 pounds in a savings account, it is like putting all your assets into the commercial paper of a single bank. Nobody should put all their savings into a single company’s assets. Banks are especially risky companies too– essentially they are investing in real estate (though with reverse leverage at least). It would be better to put your money into a money market fund, which at least invests in many companies’ commercial paper..

I predict bank earnings will fall now, so bank stock prices will fall too, and this will be true for all banks in Britain, not just speculative ones. The reason is that people will follow the advice I just gave and reduce their savings accounts. In particular, the foolish people who have put 100,000 pounds in savings accounts thinking they are safe will realize they are not. In fact, they will probably swing to the opposite extreme. The banks will thus lose a source of below-market credit. And it won’t help much with this kind of depositor even if the government increases the deposit insurance limit to a million pounds. These depositors only have a rough idea of finances, and they have learned two things: (a) deposit insurance limits are a lot lower than they thought, and (b) the government is willing to wildly shift its deposit insurance policy from one day to the next during an emergency. They won’t trust what the government says, at least for a few years..

September 19 evening postscript:
Professor Buiter has several good posts on Northern Rock. I thank Graeme for linking to it in his comment below. He says that the Bank of England had an unlimited line of credit out to Northern Rock already, even before the government deposit guarantee, so deposit insurance is unimportant. The line of credit strikes me as even worse, though. It would allow all kinds of crazy borrowing by Norhtern Rock. Moreover, it is secured lending, which is good in that it does limit the borrowing in effect, but bad in that it soaks up all the bank’s assets as collateral, leaving nothing for general creditors such as the depositors. A bank could leverage up by mortgaging ll its assets to get BE money, use the money for pure speculation, and then declare bankruptcy if the gamble didn’t pay off, leaving the depositors with zero. Maybe there are bond covenants that would prevent that, but if there are, they would block the BE credit too.

As I comment below, another thing to do is to make bankruptcy law to give high priority to small creditors. That should be done for all businesses, to save on transaction costs, but especially for banks, with their thousands of small depositors.

Here’s a newspape account:.

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The panic surrounding the future of Northern Rock finally began to subside yesterday as savers took comfort from the Government’s promise to underwrite the bank’s entire £28bn savings book..

Queues formed outside just four of Northern Rock’s 76 branches yesterday, while the bank’s internet site saw half as many people logging in as the previous day – most of whom, the bank said, were successful at the first attempt….

The Newcastle-based bank has promised to refund all lost interest and charges incurred by savers who withdrew their money out of concern about the current situation, as long as they pay the money back into their accounts by 5 October. ….

The stock markets also reacted positively to the Government’s pledge yesterday, with shares in all the banks rising, and the FTSE 100 closing up almost 100 points. Shares in Northern Rock bounced more than 8 per cent to close the day at 306p. However, they are still 75 per cent below the highs they hit earlier this year…..

Alliance & Leicester, which saw its share price dive more than 30 per cent in the last half an hour of trading on Monday – as rumours circulated that it was about to become the next victim of the credit crisis – recovered almost all of the previous day’s losses, rising more than 32 per cent. Bradford & Bingley, whose shares also fell sharply on Monday, saw a 6 per cent bounce..

The Prime Minister, Gordon Brown, reiterated yesterday that the Government was doing everything in its power to bring the situation under control, while the Chancellor of the Exchequer, Alistair Darling, confirmed that the Treasury would be willing to extend its financial backing to any other British bank affected by the current turmoil in the credit markets. ….

Mr Darling held talks with both the Bank of England and the Financial Services Authority to assess the current situation. One of the topics for discussion was an extension of the Financial Services Compensation Scheme, which is designed to protect savers in the event of a large financial institution going bust..

Currently, the FSCS only guarantees 100 per cent of the first £2,000 of any bank deposits, and 90 per cent of the next £33,000. Furthermore, it can take several months to pay out. The FSA’s chief executive, Hector Sants, said the regulator would now look at the possibility of improving the scheme’s protection, conceding that the run on Northern Rock may have been exacerbated by the compensation scheme’s limitations. “Investors are aware of the limitations of the scheme, and in the light of events it would be right to look at it again,” he said..

This entry was posted on Wednesday, September 19th, 2007 at 5:53 am and is filed under Economics. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.