In recent weeks the BBC’s business editor Robert Peston has come in for criticism about his role in breaking stories of banks in trouble (see for example these stories in the Daily Mail and Guardian).

Peston was the first to break the story of Northern Rock’s shortage of cash. The bank had enough assets to cover its obligations, but the credit crunch was making it hard for them to manage day to day operations. Peston’s story was quickly picked up by other news media. In the days following, queues of customers wanting to withdraw their savings from Northern Rock became so large at times that police had to manage crowd control. The bank’s operational difficulties, on which Peston had reported, quickly turned into a crisis of epic proportions. 

In normal times banks can safely accept savings deposits on terms which allow rapid withdrawal, then lend that money longer term. Deposits and withdrawals tend to average out and temporary imbalances can be covered by borrowing from other banks. But if unusually large numbers of depositors want their money at once, the cash is just not there. The system works because we trust it. Our money is safe so long as enough of us believe it to be. The breaking story about Northern Rock’s difficulties did not just reflect events it played a substantial role in bringing them about.  This pattern has become familiar as the current financial crisis has unfolded; news has not just followed financial events it has often amplified them.         

Robert Peston.
[image by SouthbankSteve, some rights reserved]

Of course the title of this article is mostly a rhetorical flourish. It would be unfair and untrue to accuse Robert Peston of single-handedly causing a recession. However, it is very much the case that media stories on the current turmoil are not just reflecting events they are also creating them.

Two ideas from social psychology and sociology can be helpful in understanding what is going on here: social amplification and performativity.

Social amplification of risk is the process though which public perceptions of risks can be produced and magnified as a consequence of the ways in which hazards come to public attention. A key issue in social amplification is the interest key parties have in the story. For example, media outlets have an interest in generating high circulation or viewing figures and ‘scare stories’ sell. This media focus on generating headlines can thus be a key factor in amplifying risk perceptions. Indeed the Daily Mail's outrage at the influence of Robert Peston might be seen as a little hypocritical given that paper's role in amplifying risk perceptions of other kinds, not least in relation to health.

If I drop a rock, it will fall to the ground (or perhaps on my toe) whether I believe in gravity or not. Gravity is independent of my belief in it. But many ‘facts’ I believe in are social facts and are true only so long as enough people believe in them; the value of money for example. What you believe does not just reflect our social world it helps create it. Performative statements or beliefs are those which help bring about the conditions they describe.

What you believe does not just reflect our social world it helps create it

The beliefs we subscribe to about banks are performative. By trusting that banks are safe places to keep our money we help bring about the stability which makes this true. By trusting each other with funds, banks ensure the stable operation of financial systems which in turn helps make that trust justified. Equally though, when we withdraw trust we help bring about conditions in which trust would be ill advised.

What we all think and feel about our financial security will have important consequences over the next few months. If we mostly fear the future, stop spending, withdraw our savings from banks, this will be part of the process which makes our fears true. Likewise as businesses take a view on the future and take decisions about investment and disinvestment, new hiring and layoffs these decisions will have a part to play in bringing about the future market conditions which that view is based on.

The media have an important role to play creating this future; they are not just disinterested bystanders. Whether they like it or not, journalists are not just reporting a financial crisis, they are performing it.

For a detailed account of social amplification at work in relation to a wide range of public risks see here. [Please note this link is to a 2.63 MB pdf document which may take longer to download with some internet connections] 

A recent book examines the role of performativity in economies and financial markets: Do Economists Make Markets? By Donald A. MacKenzie, Fabian Muniesa and Lucia Siu published by Princeton University Press.

About the author

Mark Fenton-O'Creevy is Professor of Organisational Behaviour at the OU Business School. His research includes investigations into the performance of traders in financial markets, and the problems that occur when management practices are transferred from one country to another.

He is also a National Teaching Fellow, and Principal of the Centre for Practice-Based Professional Learning.

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Get the facts behind the big business and finance stories from around the world – and down your street, in The Money Programme.

The past nine months have been traumatic for the global financial markets.

The collapse of the US sub-prime market in 2007 has resulted in many banks incurring huge financial losses as their investments in asset backed securities linked to the US mortgage market plummeted in value.

Yet this was only the first domino to fall over in a calamitous chain reaction of financial events that now threatens the wellbeing of the UK economy and particularly the housing market.

The exposure to losses by banks exposed to the US market quickly led the financial markets seizing up. So called ‘inter-bank lending’ stalled with lenders becoming increasingly wary about which financial institutions to place their funds with.

The domino effect.

[photo © copyright Photos.com]

This quickly led to interest rates in the financial markets rising – an inevitability given the lack of supply of funds – with the result that market rates moved over 1 per cent higher than the Bank of England’s official lending rate (which normally dictates the level of rates in the financial markets).

For institutions reliant for funding on the ‘wholesale’ financial markets – as opposed to the ‘retail market’ of personal savings – this shortage of funds and a squeeze in their cost proved disastrous. The greatest UK casualty was the Northern Rock Bank: with nearly three-quarters of its funding coming from the wholesale markets the bank quickly found that it could not finance its existing mortgage loans and other assets. Ignominiously it was forced to seek help from the Bank of England. What happened next is well known: the personal investors who had funds at the Rock queued to get their money out. This forced the UK government and the Bank of England both to guarantee the Northern Rock’s savings liabilities but also to step in and provide a ballooning level of financial support in excess of £25bn as investors withdrew their money. Eventually in March 2008 – after a failed attempt to organise a sale – the government was forced to nationalise the bank.

For other, more prudent, UK mortgage lenders the ‘knock on’ consequences of the Northern Rock debacle were severe. First they suffered from the higher cost of funds as institutions reduced their lending to the sector – despite the fact that these mortgage lenders had materially less dependence on the financial markets for funds.

With limited funds, falling liquidity and a higher cost of funding mortgage lenders started to raise the cost of mortgages – despite three cuts in UK base rates initiated by the Bank of England taking rates down to five per cent. Additionally funds started to become less readily available with products being withdrawn, and the deposits needed to obtain mortgages rising. Mortgage approvals in April were the lowest since records began in 1993. The days of readily available mortgages – and those offered at 100 per cent of the value of the property being purchased – have now disappeared.

"the nice decade is behind us"

With mortgage availability decreasing the demand for property has fallen. Consequently, property prices have started to fall.  House prices are now, on average, around four percent lower than their peak in October 2007.

The weaker position in the housing market is only making it more difficult for mortgage lenders to borrow money in the financial markets thus reinforcing the vicious cycle – this despite some late efforts by the Bank of England to inject liquidity into the financial markets by taking mortgage backed assets from the mortgage lenders and swapping them for government bonds which may, in turn, be used collateral for borrowing cash.

Perhaps the only winners from this situation are first-time buyers, who may now have an easier step up to that first rung on the housing ladder, and investors, who are now seeing mortgage lenders compete aggressively for their funds by raising savings rates.

As for the housing market – tighter credit, limited funds and the prospect of a buyers’ ‘strike’ spell bad news for house prices and hence for the quality of mortgage lenders’ balance sheets. Mortgage arrears and repossessions may not have risen substantially yet – thanks to the continued buoyant level of employment - but a slower housing market spells slower UK economic growth and, in due course, higher unemployment.

With the added strain of higher food and utility costs and soaring petrol prices household budgets will be coming increasingly under pressure – and there will be less credit available to bail them out. Thus upward pressure on arrears and then repossessions could be the next stage in an uncomfortable scenario for the UK housing market and the mortgage lenders.

As Mervyn King, the Governor of the Bank of England, remarked a few days ago ‘the nice decade is behind us’. Certainly, with the shrinking availability of mortgages, the decade of booming house prices is well and truly behind us.

Weblinks

Northern Rock: a business model unravels
Why do we get into debt? – is debt always a bad thing?
You and Your Money – don't let your money be the boss of you, get help from our interactive
Property slowdown ahead? – expert views
Moneymadeclear – guides and advice from the FSA

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You and your money: personal finance in context
Understanding economic behaviour: households, firms and markets

Take it further – the Open University Business School offer a range of courses covering personal and institutional finance issues.

About the author

Martin Upton is lecturer in finance at the OU Business School. Previously he spent 20 years in treasury management, including 12 years as Treasurer of Nationwide Building Society. Martin's particular interests are financial services, the housing market, financial markets and risk management.

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Get the facts behind the big business and finance stories from around the world – and down your street, in The Money Programme.

Financial institutions have to manage a cocktail of risks. Foreign exchange risk, interest rate risk, credit risk and operational risk can, if poorly managed, dent profits and attract adverse headlines in the press. But what is most feared is liquidity risk - the risk that a bank cannot adequately finance its lending activities.

In September Northern Rock - a bank formed by the conversion of the Northern Rock Building Society to banking status in 1997 - found out the realities of a liquidity crisis with their customers queuing to withdraw their savings. This followed news that the bank had been forced to go ‘cap-in-hand’ to the Bank of England, the ‘lender of the last resort’, for an emergency loan. This was the first ‘run’ on a UK bank by its depositors for more than 150 years.

The immediate cause of the crisis was the drying up of liquidity in the global institutional debt markets - known as the ‘wholesale’ markets - following a rise in mortgage defaults in the US. These defaults were concentrated in ‘sub-prime’ mortgages - home loans to borrowers with a poor credit quality. These events made financial institutions reluctant to lend to each other since no-one was entirely sure how much exposure each had to the losses arising from the impaired US mortgage market. Inevitably with the shortage of liquidity the cost of money - interest rates - was driven upwards. In the UK, money market rates rose to close to 7% despite the fact that base rates were still at 5.75% (normally money market rates are very close to the prevailing level of base rates).

The reactions of the UK and US Central Banks were starkly contrasting. In the US, the Federal Reserve Bank pumped billions of dollars into the markets to restore liquidity. Additionally it prompted the Bank of America to take a stake in the troubled home loan company, Countrywide, thereby averting the risk of its collapse. In the UK the Bank of England was less interventionist and only offered limited support to the beleaguered markets.

But of all the financial institutions in the UK why did the Northern Rock turn out to be most vulnerable to the shortage of funds in the wholesale markets? Here we need to examine the underlying causes of the crisis.

Northern Rock was becoming more and more reliant on the wholesale markets

Recently the Northern Rock had been building up its mortgage portfolio very rapidly, with growth of 12% in the first half of 2007. Simultaneously it was becoming more and more reliant on the wholesale markets for finance, with 70% of its funding coming from this source. By contrast only 27% of its finance came in the form of ‘retail funds’ from personal savers. Additionally, like many other banks, the Northern Rock had been parcelling up their mortgage assets and placing them into ‘special-purpose’ companies. These companies raise funds in the wholesale markets to finance the mortgages by issuing ‘asset-backed securities’. By operating in this way banks are able to boost the amount of lending they are able to undertake. Northern Rock engaged extensively in this activity through its ‘Granite plc’ companies.

Building the mortgage portfolio using this approach is fine so long as the global financial markets are operating smoothly, with funds readily available, and the borrowing institution remains creditworthy. But with the drying up of liquidity in the wholesale markets the Northern Rock’s business model began to unravel.

Compare the Northern Rock’s position with that of the building societies who are legally unable to fund more than 50% of their business from the wholesale markets. The rest has to come from personal savers. Indeed the largest building society, the Nationwide, has a wholesale funding ratio of only around 30%. So as funds became scarcer in the wholesale markets the Northern Rock found itself in an exposed position and was unable to fund its mortgages and loans.

The crisis also exposed the maturity mismatch that banks and building societies have to manage. Most of their funding - be it retail or wholesale - is short term in nature and either matures or can be withdrawn by investors within months. By contrast mortgage advances are usually for long term periods of up to 25 years. This mismatch helps to generate profits since short term borrowing is cheaper for the banks than long term. But it comes with the risk of a liquidity crisis if those short term funds become scarce. Even with the store of liquidity that the Northern Rock was required to retain to accommodate possible outflows of savings, the high wholesale funding ratio and the subsequent ‘run on the bank’ by personal customers, when news of the emergency loan from the Bank of England materialised, were enough to send the Northern Rock into financial submission.

All this happened despite the fact that there is no evidence that the credit quality of the Northern Rock’s assets - its mortgages and loans - is in question. It currently has relatively low levels of both arrears and property repossessions. Despite some fears that house prices in the UK are currently overvalued, house price inflation remains close to 8% p.a. So what we are looking at here is not a credit crisis in respect of Northern Rock’s assets - rather an inability by the bank to fund those assets.

In response to the crisis the Chancellor of the Exchequer, Alistair Darling, announced that customers of the Northern Rock would have their savings guaranteed by the Government. This move effectively ended the ‘run’ on the bank. Subsequently he announced that the maximum investor protection for all UK savers would be raised from £31,700 to £35,000.

The whole episode has raised questions about the operations of the Bank of England. Critics say it moved too slowly to deal with the growing lack of liquidity in the financial markets. Would it also have been wiser not to disclose publicly the loan deal for the Northern Rock - since disclosure resulted in the collapse in the confidence amongst Northern Rock’s customers? The role of the Financial Services Authority (FSA) has also come under scrutiny. Did it fail to identify the scale of the financial risks being run by the Northern Rock with a business model that was so dependent on there being no disruption in the wholesale markets?

As for the Northern Rock, with its once respected brand in tatters, with the emergency Bank of England loan now totalling £16 billion, with its credit ratings cut and with its share price down by over 80% since the start of the year the bank is now prey to predators looking to make an acquisition.

Find out more

• Join the discussion - how do you think the Government should have handled the crisis? Should banks change the way they operate?
• Calling companies to account
• Run on the Bank: Northern Crock - the Money Programme investigates the fall of Northern Rock
• Timeline: Northern Rock bank crisis
• Why do we get into debt? - is debt always a bad thing?
• You and Your Money - don't let your money be the boss of you
• Take it further - the Open University Business School offer a range of courses covering personal and institutional finance issues

About the author

Martin Upton is lecturer in finance at the OU Business School. Previously he spent 20 years in treasury management, including 12 years as Treasurer of Nationwide Building Society. Martin's particular interests are financial services, the housing market, financial markets and risk management.

Subscribe to Martin Upton's posts