£2000 and it's safe as Bank of England

Sep 17 2007 by Iain Laing, The Journal

Q&A: What is the promblem?

What exactly has happened?

Northern Rock has agreed emergency funding with the Bank of England to help it through a short-term liquidity problem, but it has stressed that while the funding has been agreed it has not yet needed to use it.

It has also warned that its 2007 profits will be more than £100m lower than expected this year, at between £500m and £540m – well below the £647m expected by the market.

Why does Northern Rock need the emergency funding and what have American mortgages got to do with it?

High levels of defaults on US sub-prime mortgages – which are lent to people who would be turned down by mainstream banks – have caused widespread volatility in international financial markets.

Unlike most banks, which get their money from customers making deposits into savings accounts, Northern Rock is heavily reliant on these wholesale money markets to raise cash for lending.

It also raises money through the sale of bonds based on its mortgage debts – so-called asset-backed securities.

Its costs have soared in the current environment as banks have stopped lending to each other due to market fears over exposure to potential losses on high-risk US mortgages. Investors have also become more cautious about buying asset-backed securities.

Put simply: Northern Rock is not seeing the flow of money that it would normally enjoy and needs to keep its business going.

How is the bank still going to make a £500m profit if it has had to ask for emergency funding?

The bank has had to ask for emergency funding because the credit market has effectively dried up. However, this is a short-term cash flow issue and the underlying business remains sound and solvent. Northern Rock has also stressed that although it has agreed the emergency funding it has not yet had to use it.

Is it time to panic for Northern Rock customers?

Experts say that the Rock is still a profitable and viable business and there is little prospect of it going bust. The Government message is that the very fact that the Bank of England has agreed to provide emergency funding indicates it believes the problems are temporary.

I have savings with Northern Rock, should I move them because of this?

No, commentators and financial advisers are urging savers not to panic. Northern Rock has a short-term liquidity problem, but the Bank of England would not have given it the funding if it was not solvent.

But what will happen if large numbers of people withdraw their savings?

Northern Rock will be expecting some savers to withdraw their money, and this expectation will be reflected in the funding agreed with the Bank of England.

I have applied for a mortgage with Northern Rock, will I be affected?

No, Northern Rock has said that borrowers will not be affected by the current situation. People who have already had new mortgages approved should receive their funds without a problem.

What would happen to savings customers if a major bank did go bankrupt?

Anybody who loses money as a result of a firm which is regulated by the Financial Services Authority going bankrupt is entitled to compensation through the Financial Services Compensation Scheme. This pays savers the first £2,000 of any money they have lost in full, as well as 90% of the next £33,000.

What does it mean for Northern Rock as a business?

In the short term, it means it is borrowing money at a rate well above the market rate – essentially a financial penalty for getting itself into this position.

The bank will also be lending much less to new home buyers in the coming months, as it restricts fresh mortgage offers to its customers.

Is it common for a firm to have to turn to the Bank of England in this way?

No. This move is extremely rare, which is what makes it such massive news.

It is thought that the Bank of England last acted as a "lender of last resort" to a bank in the 1970s, and the decision has been made after consultation with the Treasury and the City watchdog, the Financial Services Authority.

On its website, the Bank of England says that it would expect to take such a step "very rarely" and it "would normally only be undertaken in the case of a genuine threat to the stability of the financial system to avoid a serious disturbance in the UK economy".

Was it expected?

There has been concern for some weeks in financial circles about Northern Rock’s position and problems it may face. However, most agree that for things to have become this bad is still a big surprise.

Earlier this week, the Governor of the Bank of England, Mervyn King, told the Treasury Select Committee that the Bank would be prepared to provide emergency loans to a bank that ran into difficulties, so long as those difficulties were the result of temporary market conditions.

What is happening to Northern Rock's shares?

The firm's shares have already fallen in value by about 50% this year, including losing about 5% on Thursday. Yesterday, its shares plunged another 20%.

How will Northern Rock have to change its strategy to avoid a similar problem in the future?

Northern Rock has been able to expand so quickly over the last five years at least partly because it has borrowed heavily from the lending markets, particularly abroad. This makes up around 75% of its funding.

By borrowing on other loans it has bought in, including those vulnerable to the risky sub-prime market in the US, it has become increasingly short of cash as banks have stopped lending to each other during the current stock market turmoil.

In the future, it will have to rely less on this kind of funding and more on the cash invested by savers. This will mean it has less cash to spend on expanding its business, in relation to the number of savers on its books. It is likely to expand more slowly, but more steadily, in line with the other major banks.