History lesson for lender that failed to keep illusion afloat

Bankers dwell in marble halls, which they do to encourage deposits and discourage withdrawals. Ogden Nash, who said so, was right. They need to look rich and they need to look safe. Once the depositors are queuing round the block to take their money out, it is all over.

Banks are by no means as rich as they look. All the banks in the world live by borrowing money and, of the money they lend, perhaps only one tenth is their own. When that is lost, so are they. They may borrow money overnight and lend it out for years, so that their business is only as good as their credit, and every so often their credit runs out.

Bank failures are as old as banking. In this country, no bank has shut its doors on its depositors since BCCI, the Bank of Cocaine and Colombia, which was exposed as a fraud. We have come to assume banks are inherently safe, which suggests the illusion is working, or was until the queues began at Northern Rock. It also suggests that when it comes to managing a crisis, we have learned from history.

The lessons began as long ago as the 1820s, when the City's banks discovered the joys of lending abroad. Some lent to a Latin American country that turned out not to exist. Down they went like dominoes and in came the Bank of England, lending with both hands: "Seeing the dreadful state in which the public were," said the Governor, "we rendered every assistance in our power." Even so, the Bank needed help from the Rothschilds.

Many years and failures later, experience had shown that a panic in the money markets was a fever and ought not to be starved. When Rothschilds' great rival, Barings, got into deep water in the 1890s - Latin American water, again - its competitors were rounded up and firmly encouraged to join the rescue. If they did not, they were warned, they would be the next dominoes.

This was the first of the lifeboats coxed by the Bank of England and sent out to leaky banks. The biggest of them was pushed out in the Seventies, when dozens of so-called fringe banks were at risk. The Governor, Lord Richardson, called on the high street bankers to man the oars: "Gentlemen," he told them, "I am not appealing to altruism."

When the storm died down, the Bank tried to make rules about the next rescue. It had to avert what Richardson called the contagion of fear and keep the system going. This might mean baling out a leaky bank, or at least its depositors, but shareholders would have to sink or swim. When Barings got into trouble a second time - in the Nineties - it was left to sink. The Bank judged that its going would

not be a threat to the system. A run on a major mortgage bank with its own high street presence was, obviously, another story. If Northern Rock ran out of cash, who might be next? Fear is still looking contagious. Last week Mervyn King, today's Governor, set out his stall. If the failure of a bank would lead to serious economic damage, including damage to customers, he said, the Bank of England would lend to it - but only against good security and only at a high price.

Today's banks have a shorter view of self-interest and the Bank of England is on its own with its £4billion credit lifeline. That is too much to put at risk on its own balance sheet. In effect, it is trading off the back of its owner, which means the Treasury, or the taxpayer at large. No wonder the Chancellor has to put his name to decisions like this and no wonder politics has to come into them.

That, too, has its price. Politicians will always be happy to rescue voters, to compensate them for financial misfortunes and release them from the consequences of their choices. Already Northern Rock's depositors have started to complain that the deposit insurance scheme only covers the first £35,000 of their money. Why isn't it limitless, they want to know?

In America, which had a limitless scheme, all the loose money was sucked into bad banks, offering high rates of interest. When they crumpled, the cost was prodigious.

Now, Darling has given an unprecedented and limitless guarantee on all Northern Rock's desposits. This may hold the line, but it is a hideously expensive precedent.

People in markets, too, can persuade themselves that an allwise provider will look after them. So they blithely run risks and then complain that the provider should have kept them out of trouble. That has been and will be the sure way to store up trouble. It rewards foolish virgins at the expense of the wise ones. It encourages herd behaviour, so King says, and increases the intensity of future crises.

Now Northern Rock has earned its place in the financial history books, one lesson is evident. A bank which cannot stand on its own feet and has to stand on the Bank of England's has no future. It will be tidied away.

The depositors will have got off with a nasty shock and there may be some value - though not much - left over for its shareholders and the banking system will have been kept going, which is what matters. All concerned must then try to do better next time, for there will be a next time. Banks are like that.

Christopher Fildes OBE is the Evening Standard's senior City expert, columnist and historian