The €2.3 billion in deposits lodged by almost 25,000 Irish savers with the troubled UK mortgage lender Northern Rock is as safe as the Bank of England. The bank's decision to bail out the beleaguered British mortgage lender is based on its assessment that it is solvent, adequately capitalised and possesses a quality loan book.
Should circumstances require - and they do not at present following the Bank of England's intervention - a second line of defence is provided for Irish depositors by the UK Financial Services Compensation Scheme. This unfurls a safety net of last resort for depositors where any authorised bank cannot pay its claims. In such cases, the scheme guarantees repayment in full of deposits up to €2,900 (stg£2,000), and repayment at a rate of 90 per cent for the next €47,850 (stg£33,000) deposited.
Northern Rock is a casualty of the uncertainty and erosion of trust that has bedevilled international financial markets since the sub-prime lending crisis raised its head in the US during the summer. The mutual suspicion that has characterised relationships between banks in recent months has crystallised into an increasing unwillingness to lend each other money in inter-bank markets, the wholesale money markets. This has led to a severe tightening of credit availability. Interest rates in inter-bank markets have soared well above official rates as a result.
Most financial institutions raise roughly half their funding resources from depositors and the other half from wholesale money markets. Northern Rock's specific problem stemmed from the fact that it has depended on the inter-bank market for as much as three-quarters of its funding. The credit crunch squeezed Northern Rock in two ways. First, by increasing its cost of cash, rising inter-bank interest rates eroded its profitability. Second, it simply ran out of credit; other banks were unwilling to lend it the funds it needed.
The Bank of England, in its role as lender of last resort, then took the stage, providing Northern Rock with emergency funding through short-term lines of credit that will allow it to continue in operation. The lifeboat launched by the Bank of England to save Northern Rock caused steep falls both in sterling's value and in banking shares yesterday. Against the euro, sterling fell to levels not seen for more than a year. The London stock market saw a decline of more than 1 per cent while shares in Northern Rock fell by almost one-third. Paradoxically, the Dublin market suffered a greater reverse than its London counterpart in yesterday's trading. Share prices retreated by a further 3.5 per cent and the Irish equity market has now fallen by more than 20 per cent since its high point last February.
More broadly, Northern Rock's difficulties provide a grim reminder that the virus released by the US sub-prime crisis continues to infect every financial corner of the globe. In truth, given current levels of distrust and uncertainty in financial markets, a return to stability remains some distance away.