Banks (5) - Flight to Quality

The Northern Rock bank in the United Kingdom has experienced a run with depositors queuing to withdraw their money. The same thing has happened in New Zealand as depositors have withdrawn their money from finance companies.

Experts speak of a flight to quality, but quality is relative in this game. Northern Rock and the New Zealand finance companies all borrow short and lend long. This is why a flood of withdrawals is such a serious problem.

People are moving their deposits to more established banks. However, they should understand that these banks play the same game. They also take deposits for short terms and make loans for long terms. If all depositors tried to withdraw their money at the same time, they too would struggle to meet the demand.

Commentators are saying that the subprime problem is confined to the United States. That is not true. Banks throughout the western world have been competing to throw money at homebuyers. They are not called subprime here, but plenty of people have borrowed ninety percent or more of the value of their house. These people often had no savings even though they had been working for several years, so they must be a high credit risk. If house prices fall or unemployment becomes a problem, they will struggle in the same way.

The central bank is expected to come to the rescue as lender of last resort. But the only way that central banks can deal with a run on the banking system is to print money. In a situation where inflationary pressures are increasing, expanding the supply of money might only exacerbate the problem.

The full series can be viewed at Bank Deposits and Loans.