I have been out of contact over the last few days due to the fact I am moving house, so when I finally got my podcasts to listen to there were a few. I saw one from the BBC’s Today program on Northern Rock (warning – multi-megabyte MP3 file) and I thought this may be a good one, in light of my previous experience with them. I was gravely disappointed.
In what is now a continuing meta-story, the journalistic coverage of Northern Rock is showing just how little even financial journalists understand banking.
The errors in this particular piece revolve around a mis-understanding of one of the absolute basics of banking – liquidity risk. The premise of the argument in it was simple – Northern Rock was unable to meet calls on deposits meaning Northern Rock is insolvent and therefore worth nothing.
A basic understanding of banking would show this up as not a logical argument. As discussed in the post on liquidity risk linked to above, banks borrow short and lend long. This gives rise to liquidity risk, which means that if more than a certain amount of deposits are withdrawn in a short period a bank will not have enough physical cash to pay them. This can be, and must be, separated from the overall worth of a bank.
To put it in simple terms (and turn it around a bit) – let’s say I borrow money from a bank to buy a house. I manage to service the loan for a few years, during which time the value of the house goes up by 50% per annum – making me very wealthy (in part due to the leverage effect). Unfortunately, I lose my job and, during the period where I cannot find another one I cannot meet the repayments on the loan.
Am I financially worthless? Clearly not – there is a lot of value in my home. Can I meet the bank’s demands to pay my mortgage? No.
The Today piece confuses these when the journalist and the talking heads pulled in for the piece argue (at some length) that the failure to pay the demands of depositors means that Northern Rock is worthless.