Contents
Thucydides describes fear as the first of the three motives that drive people and communities. Fear is not always irrational. Often it is the most rational reaction for the individual, and that is precisely what makes it dangerous for the community. The run on Northern Rock shows Fear, Honor and Interest at work: how fear and self-interest reinforce each other until only the state can stop them.
A business model built on borrowed money
Situation
Northern Rock, a bank from Newcastle in the northeast of England, grows rapidly in the mortgage business in the 2000s. Only a small part of its funding comes from savings deposits. It borrows around three quarters of its money short-term on the capital markets. It bundles mortgages and sells them on to investors as securities.
Link to the principle
The business model depends on other banks and investors being willing to lend the bank money at any time. As long as everyone follows their own interest and sees good returns, it works. As soon as fear comes into play, it collapses.
The market dries up
Situation
In the summer of 2007, after the subprime mortgage crisis in the United States, lenders become cautious. Banks hardly lend to one another anymore. Northern Rock can no longer refinance itself and asks the Bank of England for support. On September 14, 2007, it receives an emergency credit line. The news becomes public through media reports the evening before.
Link to the principle
The emergency support is meant to create security. For many savers, however, the news means the opposite: if a bank needs emergency funding, it must be in bad shape. A precautionary measure turns into a danger signal.
The lines
Situation
On Friday, September 14, 2007, long lines form outside the branches. According to estimates, about £1 billion is withdrawn that day, around 5% of deposits. By Monday, it is about £2 billion. The shares fall by 32% on Friday and by another 40% on Monday. It is the first run to bring down a British bank in about 150 years.
Link to the principle
For each individual saver, it is rational to withdraw their money when others are doing so. If you wait, you may end up with nothing. Fear and self-interest point in the same direction. In 1983, the economists Douglas W. Diamond and Philip H. Dybvig showed that a bank run can become a self-fulfilling prophecy in this way, even at a fundamentally sound bank.
The guarantee
Situation
On Monday, September 17, 2007, Chancellor of the Exchequer Alistair Darling announces that the government and the Bank of England will guarantee all existing deposits at Northern Rock. The shares rise by 16%. The next day, the lines are gone.
Link to the principle
Appeals don’t help against fear; only a response that changes self-interest does. With the guarantee, it no longer pays to stand in line. If you want to stop fear, you have to change the situation so that staying calm becomes rational for each individual.
Nationalization and lost prestige
Situation
The search for a private buyer fails. On February 17, 2008, Darling announces the nationalization, which takes effect on February 22, 2008. For the northeast of England, the case is also a matter of pride: Northern Rock was a regional institution and well known as the shirt sponsor of the soccer club Newcastle United.
Link to the principle
Here the third motive comes into play: honor in the sense of standing. A bank lives on trust in its reputation. Once that reputation is damaged, even a guarantee does little to save its independence. Fear steered the savers’ interest and destroyed the bank’s reputation.
Key takeaways
Key lessons
- Be aware that fear feeds on itself when it coincides with self-interest.
- Check how your reassuring measures come across to others: they can be read as an alarm.
- Fight fear not with appeals but with binding commitments.
- Don’t build anything that works only as long as no one is afraid.
- Look after your reputation before you need it.
Summary
Northern Rock depended on the trust of the capital markets. When that trust faded in 2007, emergency support turned into an alarm signal, and savers stormed the branches. Fear and self-interest pointed in the same direction. Only a government guarantee stopped the run. The case shows how powerful fear is and that it can be checked only by changing the incentives.
Sources
- Thucydides: Der Peloponnesische Krieg (in German). Translated by Helmuth Vretska and Werner Rinner. Stuttgart: Reclam 2000, Book I, 75–76.
- Douglas W. Diamond, Philip H. Dybvig: Bank Runs, Deposit Insurance, and Liquidity. In: Journal of Political Economy 91 (1983), pp. 401–419.
