And now a bank bail-out in UK

Today's papers noted with some sorrow that the Sensex came off the day's high and took a dive towards the end of the day following news about a bank failure in the UK. The culprit was Northern Rock, one of the smaller British banks. The bank could not get finance to service its liabilities and had to be rescued by the Bank of England.

Is the Bank of England merely providing liquidity or this is a bail-out of a failed bank? We do not know yet except that the line of credit provided is said to be large. Indications are that the bank may have turned insolvent - FT reports that market capitalisation is below thevalue of Tier I equity. If so, the Bank of England has really eaten humble pie- its Governor has been very vocal about central banks not rescuing institutions that made imprudent business decisions.

The Bank's predicament is made worse by the fact that Northern Rock is a small bank and its failure would not pose a threat to financial stability. Inevitably, there is talk of political pressure- Gordon Brown does not want a financial mess on his hands so early in his tenure.

FT's Lex column summarises the cause of failure at Northern Rock:

Should the end come, the rise and fall of Northern Rock will become a case study in failed alternative banking models. Compared with the UK banking average of 7 per cent, Northern Rock used wholesale market securitisation for 43 per cent of its funding. Eschewing customer deposits kept down costs – the bank has just 72 branches – and facilitated a rapid expansion of the loan book. But this over-reliance on one form of funding now looks foolish, irrespective of exceptional credit market conditions.

The Bank of England will soon look for buyers for Northern Rock- among the possible suitors being mentioned are Lloyds TSB and HSBC.

One cannot help noting that India's commercial banks provide a study in contrast to the likes of Northern Rock- not only are they well capitalised, the retail deposit to total liabilities ratio is among the highest in the world and a big chunk of liabilities is low cost current and savings account.

With a business model of that sort, you are likely to be pretty stable. Then, on the asset side you have a large slice of housing loans (with among the lowest default rates in the world) and corporate loans in a time of 8-9% economic growth. Retail is the key to stability in banking- it makes for stable liabilities and it provides for stability in income streams as well.

This must explain why foreign banks are positioning themselves for the retail market post 2009 when barriers to foreign entry will come down. Foreign banks have been making big money on fees on cross-border transactions but they refuse to take their eyes off the retail segment. Northern Rock's failure tells you why.