internet banking & the northern rock bank run

The Northern Rock Bank run (a bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent) - is just an emblematic illustration of how internet can accelerate the speed at which a bank run can occur since depositors in a uncoordinated manner can decide to transfer instantly their account to another bank. This case raises questions regarding the impact of internet banking on the way banks and banking authorities need to handle liquidity crisis:

1. the easy access to individual accounts created by internet banking makes depositors more tempted to test whether or not their bank is bank-run proof. These uncoordinated action may ultimately lead to an illiquidity problem that a bank can hardly predict. this situation has greater chance to occur take place under "troubled" times since depositors can reasonably doubt the "true" state of their bank.

2. as the information confirming the ailing state of the bank is released, the run takes place instantly. Network breaks down can still slow down the process a it has been the case for Northen Rock but it is reasonable to assume that this will improve in the near future.

3. the run has been limited to Northern Rock and started only when the leak from the BBC alarmed the public about the state of the bank. This shows despite the easiness of transferring accounts to another bank by internet banking depositors use that opportunity only when they have been directly informed about the fragile state of the bank. Moreover, there has not been any contagion to other banks. This proves that internet banking does not aggravate spillover effect despite the unfavourable banking context.

There are two related issues at stake here:

1. the uncoordinated "bank run" can jeopardize the of the solvent bank. Indeed in order to meet the withdrawals the targeted bank need to borrow quickly. The problem is that under troubled times, the conditions in the interbank market get tougher and the bank can end up not being able to borrow despite its solvent state because the other market participants prefer hoarding liquidity as a buffer. At that point the only alternative for the bank is to turn to the central bank in order to get the liquidity unavailable in the market. In that context the action of the central bank has to be prompt in order to stop the run on the targeted bank and its potential extension to other banks because of a general suspicion about the state of the banks. the difficult part for the central bank is to make sure the bank is turly illiquid but still solvent.

2. when the bank run concerns an ailing bank that financial troubles have finally been confirmed to the public, the action taken by the central bank as the lender of last resort in agreement with the banking authorities must be prompt. In particular, this requires from the central bank to have a consistent view of its role as a lender of last resort. It needs to avoid the king of confused behaviour the Bank of England demonstrated with Northern Rock. To begin with, if the targeted bank is retained to be truly solvent but just illiquid, the central bank needs to give its unconditional support to the bank in order to stop the run. Unconditional support means that it should accept any good collateral in exchange of the emergency loan priced at a fair rate even if it includes a penalty. On that occasion the central bank can temporarily broaden the range of eligibleassets.

This unconditional support sends a reassuring signal to the interbank market, allows the bank to face the massive withdrawals and maximises its chance to go back to normal business. In this case the prompt intervention of the central bank just confirms that the bank's problem wa just a liquidity problem. On the contrary, if the targeted bank is retained to face solvency issues like Northern Rock because of a deteriorated portfolio, the extent of the central bank action depends on whether or not it supports a policy of "too big to fail" and the risk of contagion that the bank represents. In any case if the central bank retains that the bank cannot fail, it needs to take prompt action as well in order to stop the bank run that would otherwise precipitate the bankruptcy of the targeted bank.

3. there is another alternative to prevent instant bank run because of internet banking; the banking authorities could decide to offer full coverage of all retail deposits without any limit. Indeed the case of Northern Rock shows that if retail individual depositors had been insured on a full coverage basis, they would not had ran the bank in the first place. The main drawback with full coverage is that it may undermine the incentive for "big" retail depositors to monitor their bank.

In conclusion, the case of Northern Rock Bank shows that the inconsistency of the Bank of England policy led to the initial bank run and that because it persisted in that direction it further led to the bank's bankruptcy. Internet banking did not cause the failure of the bank bu tit certainly accelerated the fall of the bank. This calls for a greater consistency of the central bank role as a lender of last resort since internet banking drastically reduces not only the lag between "the bad news" and the effective bank run but makes it easier for depositors to check if their bank is run proof during troubled times.

Indeed the creation of the lender of last resort facility and the deposit insurance in most of the countries since the last century eliminated traditional panics. To that respect the Northern Rock bank case has been a dramatic episode that reminded the old times with people queuing at the bank's branches even though the run started electronically. What the Northern Rock bank's failure taught us is that despite the existence of lender of last resort and deposit insurance scheme, market participants and individual depositors in particiular do not like confusing messages during certain times. With the access to internet banking services, confusion can have a devastating impact since the reaction of the public is instanteneous and leaves more room for uncoordinated action. Therefore, initial temporary liquidity shortage may become quickly major and permanent liquidity shock since interbank markets participants may hoard liquidity for precautionary reason. At that point the prompt corrective action of the monetary authorities is crucial if their objective is to avoid major failures due to liquidity shortage. Under these circumstances the lender of last resort should lend uncondtionally against good collateral to the banks avoid its extension to other banks. If it turns out that some illiquid banks happen to be insovent as well and do not hold good portfolios, the monetary authorities in agreement with the banking authorities need to decide whether or not they are ready to endorse the consequences of a "too big to fail" policy if they retain the banks "too big to fail". To that regard the Northern Rock bank case and generally speaking the crisis offers a unique opportunity to the authorities to give a clear understanding of the role they intend to play in the future.