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. This is not the case. Banks are essentially financial intermediaries making a profit from borrowing money and lending it at a higher rate of interest to others. They have no power to "create credit" as they cannot lend more than has been deposited from them, than what they have in effect borrowed from depositors.

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). Everybody, even currency cranks, accepts that building societies can only lend what has been deposited with them. They seek deposits by offering savers an attractive rate of interest. Without these deposits they cannot function, and the amount of the deposits they have determines how much they can lend to home buyers. Building societies 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 used to be a building society, but in 1997 they "demutualised" and became a bank. 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 limitation of only being able to lend what it had borrowed. It didn't suddenly 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 who to borrow from.

In recent years Northern Rock seems to have based its whole strategy on taking advantage of the relatively low rates of interest on the money market. The papers are reporting that while its loans and assets are worth £113 billion, only £24 billion of this was covered by depositors. The rest -- well over three-quarters -- coming from money borrowed on the money market.

The trouble has been 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, 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 -- but at 6.75 percent, one percentage point above the bank rate.

Northern Rock is probably not so worried about its depositors withdrawing their money as it is about its inability to continue borrowing money from the money market at a lowish rate of interest --since it is from the difference between this rate and the rate it charges house-buyers that it makes a profit. Already it is forecasting lower profits. And because its share price has fallen -- due to some of its shareholders bailing out too -- is liable to be taken over by some rival. In fact, this is what the papers are predicting.

One thing that won't happen -- because it can't -- is that Northern Rock's beleaguered chief executive, Adam Applegarth, will not be taking out his pen and simply creating the missing credit.

ALB