Bank must restore confidence

ON 2 October 1878, the City of Glasgow Bank - then one of Scotland's largest - suddenly failed as the result of a liquidity crisis in the general banking system. In fright, the remaining Scottish banks banded together to ensure that public confidence in it was restored - they made sure ordinary depositors did not lose their money. Since then we have been spared scenes of customers queuing to save their deposits - until yesterday.

The run on the Northern Rock mortgage lender is a sanguine lesson that all the comforting words from bankers and politicians, that there is not a crisis in the financial system, have failed to convince the public that nothing fundamental is wrong. Fortunately, the Northern Rock incident is less serious than it might appear. But it is a warning that the monetary authorities need to go beyond technical solutions and put greater effort into reassuring ordinary savers and investors.

Since the beginning of August, credit in the short-term financial markets has dried up, except at penal rates of interest. This is not because institutions cannot service their debts. Rather, everyone is hoarding cash in case they have to bail out subsidiaries that have got burned in the US sub-prime mortgage market. Call this being ultra-cautious, which is not a bad thing.

Eventually, institutions will stop hoarding cash and everything should go back to normal. Unless, in the meantime, the squall in the financial markets also undermines public confidence. The important trick is to stop that happening.

The problem is that companies which depend on borrowing from these special short-term money markets are having an especially hard time. A case in point is Northern Rock which raises three-quarters of its funds from other banks. It has suddenly found itself starved of cash to bridge the gap between making loans and getting back mortgage payments. Fears for Northern Rock have been voiced for weeks and, in retrospect, it might have been better if the Bank of England had stepped in sooner. The Bank does not want to appear to provide aid to irresponsible lenders - which is understandable - but that is not the situation with Northern Rock, which is an innocent bystander.

The greater worry is that UK consumer confidence has already been hit by rising interest and mortgage rates over the past year. If that weakened confidence is dented further by new (though unfounded) fears regarding the stability of the banking system, we could see spending, investment and growth start to slow precipitously.

The time may have come for a demonstration of confidence in the economic system. The Bank of England and the government have to indicate they will step in to ensure economic growth will be maintained as a priority.