Northern Rock Bailout is not for the share holders

Recently I've heard all kinds of comments about the UK bank Northern Rock that's being helped by the British government. The gist of those comments is that it is a bloody waist of money by Gordon Brown to use taxpayers money to give it to the share holders. Here's my take on it:

First of all, the money is not handed over to Northern Rock, it's a loan, so the taxpayers will get it back, with interest. The real issue, however, is a settlement risk. All financial institutions loan money to each other all of the time in all kinds of currencies. They do this to either earn a few cents on money they have temporarily available, or to cover a temporary liquidity shortage they have. These periods can be very short. They can be as short as a few hours, but mostly they are a few days. And the money lent out can go around the world in a day. In fact it can go around the world several times in a day. This of course means that the whole financial sector is very much tied into each other. So what would happen if one party could not pay of one of its day-loans? The receiving end could well be defaulting as well to their creditors. This is what we in banking risk management would call a system wide failure. The most well know occurrence of this is the failure of a small German bank called Bankhaus Herstatt to settle their Deutsch Mark payments (see http://riskinstitute.ch/134710.htm and http://en.wikipedia.org/wiki/Herstatt_Bank. The Swiss link is much better). In result a whole chain effect of defaults rippled through the financial world. This prompted the G10 to create the Basel I framework mentioned in my previous post.

So if Northern Rock would not have had that loan, it would not be able to settle their own outstandings and that would result in other financial institutions getting into trouble too. It has nothing to do with share holders, nothing to do with deposit-holders, but everything with the stability of the financial sector. And that is by the way exactly the remit of the FSA and the Government.


Zaaf