Northern Rock Bank was open late on a Friday.
Friday evening, well past the closing time.
Long queues of people lined up outside the branches of the bank.
It was raining, and yet the people did not dispurse.
The chaos did not settle for a few days. This was in September 2007.
The people wanted their money back. All of it. They said it was their hard earned money and they didn’t wish to risk it. Many of these depositors were retired and relied only on their savings to sustain themselves.
The branches remained open trying to give cash to as many depositors as possible.
Only a few hours earlier, the bank’s website had crashed from the sheer traffic it faced.
A news article had been published. The article informed readers that Northern Rock, a British bank, had approached the Bank of England (their version of the RBI). Northern Rock was asking for ‘emergency support’.
Robert Peston, a journalist, had received this confidential news. And he published it.
How Banks Work
Everywhere in the world, banks’ business models are more or less the same.
They accept money from depositors. Almost everyone uses banks to store their money.
Banks promise to keep this money safe, and give you the money whenever you ask for it — all of it.
This money that they store is used by the bank. They primarily give out loans to borrowers using depositors’ money. The banks earn interest from these loans.
This is their business model.
Some of the interest earned is shared with the depositor. This is why your savings bank account gives you some interest (around 2-3% per annum).
The bank sets aside some money in case some depositors want all of their deposits.
Example: a bank charges 8% per annum interest for a home loan. They give savings account depositors a return of 3% per annum. So, (8% - 3% = 5%) goes to their pockets.
The difference between the interest the bank earns and the interest they share with depositors is called Net Interest Margin (NIM).
Since the bank has promised depositors that it will give them their money back whenever needed, they must be ready for it.
So, they keep a certain amount of the total deposits always ready. This is called the Reserve Requirement.
In modern times, many countries use more evolved methods to keep reserves like using Liquidity Coverage Ratio (LCR).
This number varies from country to country.
Some countries’ regulations require banks to keep 1% of the total deposits (combined total of all depositors). Most are between 1% and 10%.
In developing countries, the ratio can be as high as 20% too.
Here, the assumption is that not all depositors will ask for all their money back at the same time.
When more depositors ask for more money back than the bank has available, the bank has a few options.
It can sell some of its loans off and then use that money to return depositors’ money. Or, it can ask the central bank of the country to give it some cash as emergency cover.
When there is news of a bank being low on cash, depositors fear the worst. They feel the bank has only a limited amount of money left. Which means, the first few people who go to the bank will get their money while the rest will be left with nothing.
So everyone rushes to the bank.
Since everyone is now asking for their money back, the bank is unable to give all of them their money.
This is how banks can collapse.
This situation is called a bank run.
Who Caused It?
Robert Peston was really in a tricky situation when he discovered the news about Northern Rock.
As a journalist, what should he have done? Should he publish the news and inform the depositors that their bank is not as stable as they think it is?
The risk with that is that news like that is guaranteed to set off a bank run as depositors rush to withdraw their money.
Or, should he keep quiet and try to prevent any panic from erupting; and hope that the emergency cash requested from the central bank is enough to satisfy the immediate needs?
Robert obviously chose to publish the news. Depositors panicked and rushed to the bank branches.
Some accused Robert of having caused the bank run. The belief was that had he not published the report and waited a few days, the problem would have never arisen in the first place.
Banks do request emergency support of cash and survive. It is not unheard of.
Many also pointed out how the banks were too close to the edge; that they should have kept a greater buffer.
What Finally Happened?
When one bank fails, everyone becomes cautious. It might happen that in fear, people also start rushing to other banks asking for their money.
That would lead to a multi-bank collapse. Almost an entire annihilation of the financial system.
In situations like these, the government steps in.
In the case of Northern Rock too, the government stepped in.
At first, the Bank of England (the central bank of the UK) stepped in and assured depositors that it would supply the bank with enough money to resolve all depositors’ withdrawals.
They assured the depositors that their money was indeed safe.
In the meantime, the emergency support remained in place while they looked for a bank that would acquire Northern Rock.
Failing to find a buyer, the solution was finally found by nationalising the bank.
The bank run was contained. The spread of panic was prevented.
Why Did It Happen?
Many would have heard about the 2008 crisis and how it was caused because of lending money to poor quality borrowers.
The poor quality borrowers were less likely to pay back their loans. That triggered the collapse of the system.
That was not the case with Northern Rock. Its lending was actually of a good quality.
In Northern Rock’s case, it was not a lending crisis. It was a liquidity crisis.
The bank relied heavily on loans from other banks to keep itself well funded. It also relied on selling its own loans.
In 2007, the US subprime mortgage crisis had suddenly caused a lot of distrust in the financial system. Inter-bank lending had massively reduced.
This lower lending made it difficult for Northern Rock to borrow. It reduced the amount of money it had access to.
Wait, so why would a bank borrow money?
We discussed how banks use money from deposits to give out loans. They also take loans (at a lower interest rate) and use that money to give out loans (at a higher interest rate).
This is okay if done within a certain limit.
In the case of Northern Rock, the reliance on borrowed money was just too high.
Generally, banks rely mostly on the depositors’ money and borrow a smaller portion. In the case of Northern Rock, this was flipped. Most of their money came from borrowing and a smaller portion from depositors.
Since it had less cash on hand, it started talking to the Bank of England seeking emergency support.
And that news was published.
Bank runs are rare, but they happen.
An almost-bank-run is more common. Thankfully, central banks are often able to rescue such banks.
Quick Takes
+ The US Supreme Court declared the global tariffs imposed by President Trump to be illegal. After this, Trump announced 15% global tariffs under an alternative trade law. The India-US trade talks have been delayed due to this.
+ The central government approved 3 railway projects across Maharashtra, Madhya Pradesh, Bihar, and Jharkhand at a total cost of Rs 9,072 crore.
+ India and the Gulf Cooperation Council (GCC) signed a Joint Statement to formally launch negotiations for a Free Trade Agreement (FTA)
+ The US has imposed preliminary 126% tariffs on solar imports from India, citing unfair subsidies for domestic manufacturing.
+ The central government approved Rs 871 crore worth of railway infrastructure projects across Rajasthan, West Bengal and Kerala to modernize and expand capacity.
+ Private sector listed non-financial companies saw a net profit growth of 5.2% year-on-year in the Oct-Dec quarter (vs 1.5% in the previous quarter). Sales saw a growth of 10.1% (vs 8% in the previous quarter): RBI
+ India and Israel now have a Special Strategic Partnership, aiming to expand cooperation in defense, trade, innovation, energy, space, and digital payments.
+ India’s real GDP grew 7.8% year-on-year in the Oct-Dec quarter (vs 8.4% in the previous quarter). GDP estimate for FY26 has been revised to 7.6%.
+ India’s forex reserves fell by $2.1 billion to $723.6 billion in the week that ended on 20 Feb.
The information contained in this Groww Digest is purely for knowledge. This Groww Digest does not contain any recommendations or advice.
Team Groww Digest