Economic history · The 2008 Financial Crisis
Six steps, about nine minutes, a question at most of them. You need no economics and no preparation, only a willingness to guess before you are told.
Pools of American mortgages had been turned into bonds, most of each pool counted as safe, and the firms holding them paid with borrowing they renewed every morning. When the lenders stopped, that borrowing was what broke.
Britain's biggest banks had bought some of the American mortgage bonds. They had also lent far more than their savers had paid in, and they borrowed the difference from other banks and large investors a few months at a time. In August 2007 that lending stopped.
Northern Rock ran out of lenders first, and savers queued outside its branches for the first time in more than a century. Five months passed before anyone decided what to do with the bank. Responsibility had been divided between three bodies: the Treasury, which controls government money, the Bank of England, which sets interest rates, and the Financial Services Authority, which checked banks one by one. No rule said which of the three decided.
Six steps take it in order: who was watching, how far British lending had run ahead of British saving, the bank that ran out of lenders, what the American bonds actually cost, the dollars European banks could not find, and the five months it took to decide what to do with the bank.
What this module covers
Written for every level. Tap any underlined word for what it means, and open the boxes below for the economics behind each decision. If you already know the theory, skip both and the history reads straight through.
Step 1 of 6
By 2007 responsibility for watching the banks was split between separate agencies on both sides of the Atlantic, and none of them had power over the whole system.
Each agency was given one class of firm to look after, so a firm that fitted no class had no agency of its own.
The Congressional Research Service prepares briefings for members of the United States Congress. It wrote afterwards that American financial regulation was spread across many agencies, each given one kind of firm to look after. No , it said, covered every firm big enough to bring the others down.
Supervisors could tell whether one bank was sound. None of them could tell what would happen when every bank had done the same thing at once.
By the first half of 2008 the major British banks had lent out far more money than their customers had paid into them. They borrowed the difference from other banks and large investors, a few months at a time.
A bank that has lent more than its savers have paid in has to borrow the difference from somebody else. Those loans run for months, while the mortgages the money paid for run for decades, so the borrowing falls due long before the mortgage is paid off. Replacing that borrowing depends on other banks and investors being willing to lend that morning. While they are, the arrangement works and costs very little. When they are not, the bank still owes the money, still holds the mortgages, and cannot turn a mortgage into cash quickly enough to pay.
Put it another way. Think of it like paying for a long mortgage with a series of one-month loans: each one is cheap, and the trouble is not the cost but the morning the next loan is not offered.
The mortgages that money pays for run for decades, so the borrowing falls due long before the mortgage is paid off. Each time it falls due the bank has to find the money again, which was easy until August 2007.
HBOS was then one of Britain's largest banks. By 2008 it was borrowing more from other banks and investors, £248 billion, than it held for savers, £243 billion. The Commons Treasury Committee, the MPs who question the Treasury and the banks, published both figures.
The Bank of England watches that gap because the lenders, not the bank, decide when that money has to be paid back and whether to lend it again.
In the first half of 2008, how much more had the major British banks lent than their customers had paid in?
For scale. In 2001 the same measure was close to nothing: what those banks had lent was comparable to what their customers had deposited with them.
Northern Rock, a mortgage lender based in Newcastle, took only a small part of its money from savers. On 9 August 2007 the firms it borrowed the rest from stopped lending to it.
It paid for new mortgages in three ways: money savers put in, bundles of mortgages it had already made and sold on as bonds, and borrowing from other financial firms.
On 9 August 2007 its own traders recorded that the market it borrowed in had stopped working, and after that neither of the two borrowed ways was open.
Money a bank holds for a saver is money it owes them. In 1997 savers' money was 62.7 per cent of everything Northern Rock owed, and over the ten years that followed the bank grew on borrowed money instead.
Savers queued outside its branches from Friday 14 September 2007 until the Monday. The Treasury Committee said it was the first time savers had queued at a British bank since Victorian times.
By the end of 2006, what share of everything Northern Rock owed was money it held for savers?
For scale. Half of what Northern Rock owed came from mortgages it had bundled up and sold on as bonds. Those arrangements ran three and a half years on average, against mortgages that ran for decades.
British banks had two troubles at once in 2007. They owned some of the American mortgage bonds, and they had borrowed heavily from other banks and investors who stopped lending in August.
An owner of a bond that loses value loses what the bond loses. A bank that cannot replace its borrowing has to find the whole of it on the day it falls due, and after August 2007 it could not.
A British bank did not have to own the American bonds to be hurt by them. No lender could tell which banks were holding them or how much had been lost on them, so the lending between banks stopped for all of them.
The Bank of England put the major British banks' s in the second half of 2007 at US$14 billion. Of that, US$11 billion was on American sub-prime lending, which means lending to people the banks themselves rated high risk.
Which cost the British banks more?
For scale. At the end of 2007 the same banks still held US$192 billion of American bonds of that kind, far more than they had written down on them.
European banks, British ones among them, had lent a great deal in dollars and bought American bonds priced in dollars. Their own customers paid them in euros and pounds.
A bank in Europe that has lent money in dollars, or bought an American bond, owes dollars for it, and it takes its own money in euros or pounds. It covers the difference by exchanging its own currency for dollars for a set period and agreeing to exchange them back, then making the same arrangement again when the period ends. Each arrangement lasts months, and the American bond or dollar loan it pays for lasts years. When the banks that hold dollars stop making those arrangements, a European bank needs actual dollars, and its own cannot create them.
By 2007 these banks did not take in enough dollars to cover what they had lent in dollars. They got the rest by giving another bank pounds or euros for a few months in return for dollars, which is a .
The Bank for International Settlements, which the world's central banks own between them, put European banks' dollar holdings at more than $8 trillion by the middle of 2007. That was more than $800 billion above what those banks owed in dollars, and the extra had been paid for with pounds and euros.
A European bank had to find real dollars instead once the banks holding them stopped making those exchanges.
Why could the Bank of England not end a shortage of dollars in London?
For scale. The Federal Reserve Bank of New York, part of America's central bank, estimated that between $1.1 trillion and $1.3 trillion of what European and Swiss banks held in dollars was paid for with borrowing they had to renew quickly.
Britain had divided responsibility for its banking system between three bodies in 1997. When Northern Rock failed, nothing said which of the three would decide.
The Treasury wrote the law, approved a rescue and answered to Parliament. The Bank of England set interest rates and kept a broad view of the system, and no individual bank answered to it. Individual banks were checked by the Financial Services Authority, or FSA. All three were called the Tripartite.
Northern Rock's savers queued in September 2007. The Treasury announced on 17 February 2008 that the bank would be taken into public ownership. Parliament passed the law on 21 February, and the bank was the following day.
The Treasury Committee found a significant failure of the Tripartite arrangements in September 2007. The Treasury's own review says it had never been settled which of the three would ultimately decide, and that this held up the answer.
Three of these were somebody's job in Britain in 2007. Which one had no law written for it at all?
For scale. Five months separated the queues outside Northern Rock's branches from the decision about what to do with it.
Module 3 of 7 in The 2008 Financial Crisis
Who was watching the whole banking system
no single agency had power over the whole system: the work was split three waysWhat British banks had lent beyond their savers' money, first half of 2008
£700 billion of lending they had not taken in from saversNorthern Rock's savers' money, end of 2006
22.4% of everything it owed, against 62.7% in 1997What British banks wrote down, second half of 2007
US$14 billion, of which US$11 billion on American sub-primeEuropean banks' dollar assets, mid-2007
more than $8 trillion, and more than $800 billion above what they owed in dollarsNorthern Rock, queues to public ownership
14 September 2007 to 22 February 2008, slowed by a job split three waysYou met four terms in this module
, , ,
The damage came through borrowing British banks had to find again every few months, and no rule said who would act when one could not.
[1] The gap between what British banks had lent and what their savers had paid in: Bank of England, Financial Stability Report, Issue No. 24, October 2008. Read twice, the second time for the words. "In 2001, UK customer lending was comparable to customer deposits. But by 2008 H1, the surplus of lending over deposits — the customer funding gap — was £700 billion (Chart 1.7)." That chart is titled "Major UK banks' customer funding gap, household saving ratio and foreign interbank deposits", so the subject is the major UK banks as the Bank groups them rather than every bank in the country. On why the lending between banks stopped, the same report says "opacity in the distribution of exposures across institutions added to perceptions of heightened counterparty credit risk in interbank markets", and that valuation uncertainty "generated a system-wide rise in counterparty risk" whose consequence was "a breakdown in interbank funding markets".
[2] What British banks lost on the American bonds they owned: Bank of England, Financial Stability Report, Issue No. 23, April 2008. Table A, "Major UK banks' and LCFIs' structured credit and monoline-related write-downs and exposures", read twice. Major UK banks, 2007 H2: total write-downs 14, of which US sub-prime 11; remaining exposures at end-2007, 192; all in US$ billions. The footnote reads "Total write-downs on trading book assets and available-for-sale financial instruments announced on or before 24 April 2008", so the figure counts what had been announced by that date and the date travels with it.
[3] Northern Rock: where its money came from, and the run: House of Commons Treasury Committee, The run on the Rock, Fifth Report of Session 2007-08, HC 56-I, 26 January 2008. Read twice. Paragraph 17: "retail deposits and funds had fallen from 62.7% at end-1997 to 22.4% at end-2006", and, from the evidence of the bank's chief executive in the same paragraph, "50% was securitisation, which had an average life of three and a half years; 10% was covered bonds, which had an average life of about seven years; and of our wholesale borrowings, which is 25%, half of that had a duration longer than one year and the other half was less than one year's duration." Paragraph 23: "on 9 August 2007, Northern Rock's traders noted a 'dislocation in the market' for its funding." The summary: "The period from Friday 14 September 2007 to Monday 17 September saw the first run on the retail deposits of a United Kingdom bank since Victorian times", and "There was a significant failure of the Tripartite arrangements in September 2007, and lessons must be learned from that failure." The report heads a box "1866 and all that" and nowhere dates the previous run to 1866.
[4] HBOS: borrowed money against savers' money: House of Commons Treasury Committee, Banking Crisis: dealing with the failure of the UK banks, HC 416, 1 May 2009. Read twice. Paragraph 43: "As HBOS entered 2008, it was drawing a greater proportion of its funding from the wholesale markets than from retail deposits with £248 billion of wholesale funding exceeding the £243 billion of retail deposits."
[5] European banks' dollar assets, and the gap under them: Bank for International Settlements, 79th Annual Report, June 2009. Chapter II, section "Money market funds amplify instability in the wake of the Lehman failure", read twice: "European banks in particular had increased their US dollar assets sharply over the past decade, to more than $8 trillion by mid-2007. Moreover, these exceeded their estimated US dollar liabilities by more than $800 billion, implying cross-currency financing and hence a heavy reliance on instruments such as foreign exchange swaps."
[6] How much of it had to be borrowed again quickly: Linda S. Goldberg, Craig Kennedy and Jason Miu, Central Bank Dollar Swap Lines and Overseas Dollar Funding Costs, Federal Reserve Bank of New York Economic Policy Review, May 2011. Read twice: "The on-balance-sheet dollar exposures of euro area, United Kingdom, and Swiss banks were estimated to exceed $8 trillion in 2008, of which $1.1 trillion to $1.3 trillion was funded through short-term sources."
[7] How the work was divided, and what nobody had: HM Treasury, Review of HM Treasury's management response to the financial crisis, March 2012. Read twice. Paragraph 2.8 divides the work three ways. The Treasury was "responsible for the institutional structure of financial regulation and legislation and, in the event of a crisis, for authorising certain types of financial interventions and keeping Parliament informed". The Bank "gained powers to set interest rates, independent of Government, but relinquished responsibility for banking supervision to the FSA". The third body was "responsible for prudential and conduct of business regulation of all financial services including banks and building societies". Paragraph 2.11: "The war games revealed the lack of a statutory resolution framework to deal with a failing bank." Paragraph 4.36: "the unresolved question of who ultimately would decide, hindered resolving issues." Paragraph 3.8: "On 17 February 2008, the Treasury announced that Northern Rock would be taken into public ownership. The Banking (Special Provisions) Act 2008 was passed on 21 February, to provide the Government with temporary powers to nationalise banks. Northern Rock was nationalised the following day."
[8] The same division, written for MPs at the time: House of Commons Library, Northern Rock and financial supervision, SN04478, 1 February 2008. Read twice. The Bank of England's listed responsibilities include "maintaining a broad overview of the system as a whole" and "undertaking, in exceptional circumstances, official financial operations". The supervisor's include "the authorisation and prudential supervision of banks, building societies, investment firms". The Treasury's include "the overall institutional structure of financial regulation and the legislation which governs it". On the nationalisation: "22 February, NRB moved into a period of 'temporary public ownership'." The briefing calls the run "the first run on the retail deposits of a United Kingdom bank since Victorian times" and gives no earlier date.
[9] The same hole on the American side: Congressional Research Service, Causes of the Financial Crisis, R40173. Read twice. Under "Fragmented Regulation": "U.S. financial regulation is dispersed among many agencies, each with responsibility for a particular class of financial institution." Under "No Systemic Risk Regulator": "No regulator had comprehensive jurisdiction over all systemically important financial institutions." Four more bodies state the same finding and are recorded at link 15 of the research file: the Financial Crisis Inquiry Commission chapter 4, the Federal Deposit Insurance Corporation chapter 4, the de Larosière report for the European Commission of 25 February 2009, and the Financial Stability Board section V.
Country data from the World Bank (CC BY 4.0) and the UNDP Human Development Report (CC BY 3.0 IGO)
Games · Learn · Atlas · Privacy