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Smart Investing
Counting the cost when confidence is lost
 October 15, 2007
Robin Bowerman
Trust and confidence are fragile things.
But in so many ways they are essential ingredients for the effective workings of our modern financial system. While travelling in England recently the drama of what happens when trust in a financial institution is destroyed and confidence lost was dramatically on display.
England’s fifth largest mortgage provider – Northern Rock – went into crisis mode because it was heavily dependent on raising funds on the secondary market rather than from depositor’s funds. The liquidity squeeze that hit the banking system as a direct result of the US sub-prime mortgage market problems effectively saw its short-term funding dry up.
The flawed business model was exposed for what it was – a fast-track to growth while markets were benign but vulnerable if market rules changed which they clearly did.
What was distressing was seeing long, long queues of people waiting patiently to try and get their money out. Ironically, it was the announcement by the Bank of England that they had provided emergency funding to Northern Rock that sparked the rush to the exits for Northern Bank depositors. A market announcement meant to shore up confidence had the opposite effect.
The speed with which the confidence in a well-known brand evaporated was quite breathtaking and the threat of contagion to other banks was real enough to send regulators and politicians into crisis meetings.
The distress that people with their life savings in Northern Rock felt was palpable and sobering given the feeling of financial farce in the media. Although the queues outside Northern Rock branches had that distinctly stoic and orderly British feel – people camping out all night and Northern Rock employees going up and down the line with cups of coffee and tea.
The nearest thing the memory banks could throw up as comparable in an Australian context was the collapse of the State banks of Victoria and South Australia and the Geelong-based Pyramid building society back in the early 1990s.
To put it in context Northern Rock was the first full-scale run on a bank in England since 1866. The queues finally disappeared only after a taxpayer-backed guarantee was effectively forced out of the Bank of England and Government because of the public crisis of confidence that not just threatened Northern Rock but the broader banking system.
Regulators and central bankers play a key role in preserving market integrity and confidence so it was encouraging to see that the Australian Reserve Bank moved to extend the pool of acceptable securities for repurchase agreements. According to the Reserve Bank Governor Glenn Stevens this move is intended "to give market players some additional confidence that quality assets can be turned into cash if needed so they can get on with the job of repricing risk".
With the benefit of hindsight the Northern Rock crisis of confidence may well have been avoided if the Bank of England had moved earlier to do the same. The Bank of England had taken a tough stance and would not accept mortgage-backed securities although the US Federal Reserve and European Central Bank had both moved to do so. That tough line exacerbated the situation and forced Northern Rock to go cap in hand to the Bank of England for emergency funding.
To be fair to the Bank of England governor Mervyn King he argued that financiers should not expect a central bank to bail them out if they took on too much risk. But eventually he had to back down and do precisely that.
Markets are now busy repricing risk and the move by our Reserve Bank is to be applauded to ensure liquidity and the proper functioning of markets because if Northern Rock demonstrated anything it is that you can never take the confidence in our financial system for granted.
More articles from this week's CompareShares newsletter:
Companies: Exclusive interview with the Pratt dynasty
Stocks: Stock picks for the long haul: Reece Australia and ARB Corporation
Politics: Who are the better economic managers?
Commodities: Wheat prices soar
Technical analysis: Elliott Wave theory spells doom and gloom for the US market
Stock of the week: Imdex Limited
Resident trader: How to profit from volatility
Smart investing: Counting the cost when confidence is lost
Economics: Australian employment data signals rate hike
Stocks: Construction: a two-speed industry
Whatever your views, you can discuss this article - or any of Robin's articles - on our message board Your 2 Cents.
Robin Bowerman is Head of Retail at index fund manager Vanguard Investments Australia and the former managing editor of Shares and Personal Investor magazines. To receive this column by email each week go to http://www.vanguard.com.au/ and register with smart investing.
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