Northern Rock woes reminder of bank runs threat

By Andrew Hurst and Boris Groendahl

ZURICH/VIENNA (Reuters) - Banks have always lent out more than their clients have on deposit but just once in a while savers lose trust and demand all their money back, exposing one of the optical illusions at the heart of finance.

The run on British mortgage lender Northern Rock NRK.L, although exceptionally rare in Europe, is a stark reminder that practically no bank has enough cash to pay back its depositors if they all turn up at the same time.

An unequivocal commitment from authorities to guarantee everybody's savings appears to be the only way to stop a run in its tracks and save a bank from going under, say analysts.

Just such a promise from the British government on Monday may finally have turned the tide in favor of lender Northern Rock after a full-scale run started on Friday.

"The decisive action by (British Finance Minister Alistair) Darling to underwrite the entirety of the assets of the bank shows that the authorities are confident that the bank is solvent," said Ian Harnett at Absolute Strategy in London.

Darling said after the stock market closed Monday that if necessary the government and Bank of England would guarantee all Northern Rock deposits during the current instability.

Britain's system for protecting and compensating customers of banks that get in to trouble needed reviewing, Darling said on Tuesday.

Northern Rock's woes echoed a run on deposits at Austria's BAWAG P.S.K. last year after creditors of collapsed U.S. futures trader Refco Inc sued BAWAG for $1.3 billion for its role in Refco's collapse.

There the government also stepped in decisively after initially hesitating over how to handle the crisis.

Both crises showed that, once shattered, the confidence that is central to banking can only be restored by drastic action.

"I would never have expected in my career to see people queueing up outside an English bank," said Harnett.

Northern Rock's shares started to recover on Tuesday after losing more than 70 percent of their value in two successive trading days - on Friday and on Monday - and queues outside the lender's 76 branches showed signs of receding.

FOLLOW THE CROWD

Raw fear and crowd psychology appear to play a big part in whipping up a seemingly unstoppable tidal wave of panic when a bank run takes hold. "If a crowd is heading in one direction, people are loathe to go the other way. In a world of uncertainty often the best thing is to follow the crowd," said Avinash Persaud, a risk consultant who heads Intelligence Capital.

The problems at Northern Rock, which relied heavily on short-term funding in wholesale markets which suddenly came unstuck as a global credit crunch struck, took a dramatic turn last week when the Bank of England threw a financial lifeline to the bank but did not disclose its exact details.