Monday, September 17, 2007

The logic of bank runs

As it turns out, there is anarchy in the U.K.! The run on Northern Rock has intensified and threatens to expand to other financial institutions. As a result, the British government has had to step in and guarantee the value of all deposits in Northern Rock. The full story is here.

This is not a surprise. I predicted that the Bank of England's credit lifeline wouldn't stop the crisis. This is not the result of special insight, but of having lived through the 1995 Mexican financial crisis, when the whole system went belly up. A key lesson was that once confidence was lost in a bank, the government has to step in massively and decisively, taking over the institution or lining up an emergency buyer.

Why? Well, if everyone knows the bank is insolvent, there will be a run. And runs, even in fairly small banks, tend to undermine confidence in the whole system, specially in unsettled times like these. Without confidence, a bank is worthless.

The question is why did the government/regulators wait so long to take action? There is nothing so dangerous as a bank in desperate trouble. Facing bankruptcy, executives and directors only have one course of action: double down the bets to gamble for salvation (or, as happened in Mexico, looting the bank mercilessly). Of course, this usually fails, but not before hugely increasing the losses.

Thus, either they were inexcusively asleep at the wheel or, as usually happens, forgot the lessons of past banking crises.