On 9 August 2007, the European wholesale money markets froze up, after BNP Paribas announced that it was suspending withdrawals on three of its money market funds. These funds were heavily invested in U.S. subprime credit instruments, which had suddenly become difficult to trade and value. In the preceding two decades, many banks and financial intermediaries, in a number of countries, had financed their assets by borrowing from wholesale sources rather than from retail branch networks. In the U.K., Northern Rock, which had once been a cautiously‐managed building society in mutual ownership, was one of these organizations.
With the wholesale money markets closed to new business, Northern Rock could not issue new securities or even roll over maturing debt. As significant liabilities were coming up for redemption, it faced a serious challenge in funding its business. In the years leading up to August 2007, Northern Rock had been consistently profitable, with sufficient capital and liquidity to meet regulatory norms. Readily available funds from the wholesale market had facilitated Northern Rock’s rapid expansion from its demutualization in 1997; however, by mid‐2007, it was highly leveraged (with assets that were over 60 times equity capital), and threatened by its inability to secure new wholesale finance.
Unable to secure the necessary short‐term funding, Northern Rock informed its regulator (the Financial Services Authority) of its problems. Top FSA staff sought for potential buyers for Northern Rock, and they soon found one in the shape of Lloyd’s Bank. But there was an inherent issue: Given that the money market was paralyzed by a lack of confidence and the fact that Lloyd’s Bank had a similar reliance on the interbank market for financing, Lloyd’s board was not 100% certain that it could obtain sufficient retail deposits or an interbank line to fund both its existing business and the purchase of Northern Rock. For the deal to go ahead, Lloyd’s needed a standby loan facility perhaps as large as £45 billion. With the money market closed, only the Bank of England (BoE) could provide this facility.
By the end of the first week in September 2007, all of the FSA’s senior staff and Paul Tucker, the Bank’s senior executive for markets, wanted the Bank to provide Lloyd’s with a standby facility. But, there was an obstacle: The governor of the BoE, Mervyn King would provide no help. To quote from Ivan Fallon’s book Black Horse Ride, “‘No,’ [King] said decisively and abruptly, ‘I could not in any way support that. It is not our job to support commercial takeovers. I’m not prepared to provide any liquidity on that basis’”. The truth is that King — who had come from a modest background in England’s unremarkable West Midlands — loathed bankers and the City of London. The crisis gave King an opportunity to translate the loathing into action. Fallon quotes one banker as saying, “Mervyn saw his job as being to teach the banks and the markets a lesson.”
Somehow or other, the tensions between the various players could not be kept quiet. The situation became so desperate that Northern Rock had to be provided with an emergency loan facility from the BoE. Without that, it would no longer be able to pay cash over the counter to retail depositors (or to transfer money to other banks via the online service at its website, which crashed). However, the British Broadcasting Corporation (BBC) bungled the announcement of the facility, provoking a massive run disproportional to Northern Rock’s potential losses. The BoE was obliged to lend Northern Rock tens of billions of pounds to preserve the convertibility of bank deposits into notes. On 17 September 2007, the Chancellor of the Exchequer, Alistair Darling, decided to announce a state guarantee on Northern Rock’s deposits, which brought the run to an end.
The underlying issue raised by the Northern Rock affair was the eligibility of commercial banking organizations, which are profit‐making (or at any rate profit‐seeking), for loans from the central bank. The traditional understanding in the U.K. before 2007 had been that solvent banks, and certainly solvent banks that had complied with regulations, could seek central bank help in funding their businesses if normal market sources (such as the interbank market) had become unreliable. Usually, they would have to offer good collateral and the central bank would be expected to charge a penalty rate. The standard vocabulary in these cases is that the central bank would be a “lender‐of‐last‐resort.” In no way did this imply that the central bank would be indifferent to the concerns of all stakeholders, including shareholders.