INSIDE the Bank of England’s imposing headquarters, Mervyn King prepared to address the “court” that oversees the Bank’s affairs. It was Thursday evening 10 days ago and King was facing the greatest test of his career.

A big British bank was in trouble and he needed his plans for a rescue to be authorised by the court, a body consisting of himself, two deputy governors and 16 nonexecutive directors. The nonexecutives are an eclectic crew, ranging from City heavyweights such as Paul Myners to Peter Jay, former economics editor of the BBC, and David Potter, best known for the Psion computer.

Some were gathered in the bank; others were linked by teleconference. King, who has run the Bank since 2003, dropped a bombshell: Northern Rock, a mortgage lender holding £24 billion of ordinary savers’ money, was in deep crisis. Unless it received emergency funding from the Bank as “lender of last resort” it could not continue operations.

“A frisson ran round the table,” said one of those familiar with the meeting. No major bank had gone bust in Britain for years. But King was outwardly calm and in control. Details of a rescue were being thrashed out, he announced. Funding would be provided to enable Northern Rock to continue, and the terms would not imperil the Bank’s task of ensuring the integrity of the banking system.

All he needed was the agreement of the court. The meeting lasted 45 minutes and then the court gave its blessing.

“King was calm and convincing,” said an insider. “There was no dissent.”

It should have been a moment when London showed its financial eminence, its skill at handling bad times as well as good. But within hours it had exploded into fiasco: Britain witnessed the biggest run on a bank it had seen for 150 years. Pictures of customers besieging Northern Rock to withdraw their money flashed around the world.

The crisis has destroyed the credibility of Northern Rock, Britain’s fifth-largest mortgage lender; it will struggle to survive in the long term as an independent entity. It has also holed the reputation of the Bank of England and the Financial Services Authority, and it may force reform in the way markets are regulated.

Last week King tried to claim that there was no lasting damage. “Headlines come and go. TV pictures come and go,” he said. So do bank governors.

The events have been burnt on the public consciousness. Panic could resurface if any other bank wobbles during the credit crunch that is still gripping the money markets.

THE MAN who triggered the turmoil was Adam Applegarth, the young, ambitious, some say arrogant, chief executive of Northern Rock. With his shaven head, pithy quotes and liking for flash cars, Applegarth is not in the traditional image of a banker.

His entire career has been spent at Northern Rock, a niche player from Newcastle that has grown with startling rapidity in recent years. Having joined from university as a cashier in 1983, he rose swiftly. At 34 he was an executive director; at 38 he became chief executive in 2001. Nor is he the only executive at the bank with limited experience of the City and wider financial markets. The other key executives have also spent most of their careers with Northern Rock.

Above Applegarth was a chairman unlikely to be a restraining influence: the Honourable Matthew White Ridley, who is best known as a science writer and author of such books as The Origins of Virtue and The Red Queen: Sex and the Evolution of Human Nature. His father, Viscount Ridley, had been chairman of Northern Rock when it was a building society.

Applegarth was barely in his teens when Britain suffered its last banking crisis in 1973-75, and during the early years of this decade he was on a roll. Business was booming and profits were soaring. He could seemingly do no wrong.

The bank had become expert at a new way of funding its loans. Though it still took in deposits from ordinary savers, about 75% of its money came from international money markets. They supplied funds or bought “securitised” investments from Northern Rock, which in turn lent on the money at a higher rate to home buyers, making a profit along the way. The Rock was so efficient at packaging such deals that its share price was soaring.

“We are meeting all our strategic and operational targets and look forward to the future with confidence,” Applegarth said a year ago. When rumours arose that the Rock might be a takeover target, he riposted: “I worry more about Newcastle United buying a decent central defender than I do about getting taken over.”

In January the board, which was putting in place a new incentive scheme for directors, reported the sort of results that generate lucrative bonuses for executives. Lending was up 23% at £33 billion. Pretax profits were up 16.5% at £587m. The dividend was up 20%.

Applegarth, who earned a salary of £690,000 and a bonus of £660,000 last year, was intent on driving Northern Rock from fifth place in the UK mortgage league to third. He said the bank’s balance sheet was “low-risk”. Yet most of the bank’s business depended on one thing: being able to raise funds cheaply in the money markets.

The blistering pace continued. In April, Applegarth announced that the Rock’s residential lending had soared 42% in the first quarter of the year. Critics fretted that the bank was being reckless by offering loans at 100% of the value of houses, and at up to six times borrowers’ incomes – far more than the prudent lenders.

So bullish was Applegarth that the bank began to enter the sub-prime lending market for borrowers who are not good credit risks.

By fateful timing, the Rock plunged in just as that market was imploding in America. On the same day that the bank launched its scheme, one of America’s biggest sub-prime lenders, New Century Financial, filed for bankruptcy.

A few weeks later the investment bank UBS suffered large losses in one of its hedge funds because of the sub-prime melt-down. Then on June 19, two Bear Stearns hedge funds with holdings supposedly valued at $3 billion tanked; they would end up near worthless.

Talk of a credit crunch spread rapidly. Some savvy investors spotted the threat to Northern Rock: on June 22 one trader bought “put options” for 9.1m shares in the bank – a bet that the shares would fall. Last week the buyer cashed in, making £50m, nearly 30 times his original investment.

Applegarth and his team were also aware of the risks and issued a profit warning. But they didn’t rein in their dash for growth. “We made a decision to carry on lending, which will feed through ultimately into the earnings of 2009 and 2010,” said Applegarth on July 25. “We saw this as a land-grab opportunity.”

The land was turning decidedly swampy: that day the credit crunch blew huge holes in the funding of two big buy-outs, for Alliance Boots and Chrysler. The cheap money on which the Rock relied was disappearing.

For Northern Rock – and probably for the Bank of England and the Financial Services Authority (FSA) – the sirens should have been screeching and the warning lights flashing.

THE governor of the Bank of England is the antithesis of Applegarth. A bespectacled, grey-haired economist and former academic, King is steeped in the caution of old-school central banking.

For him the primary task of the Bank was to control inflation and ensure the integrity of the country’s system of payments. “Behind the design of our monetary institutions is a simple principle,” he told guests at the Mansion House in the City this summer. “It is that the value of paper money depends on trust. Trust that it will hold its value. Trust that others will accept it as a means of payment.”

If banks indulged in risky investments or lending, that was their problem and they should pay the price. It wasn’t King’s job to save reckless bankers and their shareholders. If he did so, he risked a “moral hazard” in condoning recklessness, which would ultimately undermine trust in the whole system.

King had long expressed concerns about the arcane, complex derivatives – such as those infected with sub-prime losses – that banks had developed to boost their profits. As the sub-prime problems grew, the Bank canvassed views from City experts. The consensus was that the credit crisis was serious and that the Bank should be ready to respond to it.

But on August 8, when King presented the Bank’s quarterly inflation report in the conference theatre of the Old Lady’s building in Threadneedle Street, he was anything but concerned. The governor referred to “tremors” in financial markets and insisted it was not a crisis.

“It’s not an international financial crisis,” he said. “It’s developments in spreads which reflect a more realistic pricing of risk, and that’s to be welcomed.”

The message of the report was that interest rates needed to rise further. City bankers were shocked.

“I was flabbergasted,” said one City expert. “Everybody had told them how serious [the credit crunch] could be and yet Mervyn King virtually dismissed it as a storm in a teacup. This was extraordinarily complacent.”

On August 9 interest rates in European money markets spiked, hitting their highest level for six years. With the credit crunch threatening serious damage, the European Central Bank (ECB) made a massive amount of liquidity available. Major banks snapped up €94 billion (£65 billion).

In America the Federal Reserve also acted, though on a more modest scale. It injected $24 billion (£12 billion) into the system. But in London, King did nothing, though executives from big banks were urging him and the FSA to act.

Soon afterwards Northern Rock contacted the Bank, warning that it was facing potentially severe difficulties.

King had postponed a holiday because of the turbulence, but Sir John Gieve, the deputy governor of the Bank responsible for financial stability and a board member of the FSA, was away for two weeks. He had gone to his mother’s funeral and, at King’s insistence, had taken the week off after it; he then went on holiday in France.

Gieve was, he said later, “in touch with the office, but the governor thought it wasn’t necessary” for him to return.

Nor was Alistair Darling, the chancellor, well positioned to appreciate the seriousness of events. Though he had just returned from holiday in Spain, he had been in the post only a few weeks and was still reading his way into the job.

King remained focused on his prime objective of controlling inflation; he saw no need to inject money into the banking system to ease the credit crunch, let alone to help Northern Rock. With hindsight, if he had pumped money into the markets in early August, would Northern Rock have been saved?

“That’s a tough one,” said James Hutson, banking analyst at Keefe, Bruyette and Woods. “It would have helped to oil the cogs. If it could have tided Northern Rock over into a period of much less aggressive wholesale money pricing, things might have been different. But it all comes down to how much oil the Bank could put into those cogs.”

King later maintained that saving Northern Rock would have required “massive amounts” of liquidity – far more than what was provided by other central banks.

To be fair to the governor, too, it wasn’t his job to police the individual banks and ensure that they remained solvent. That task lay with the FSA, led by Sir Callum McCarthy, a former civil servant and international banker.

Soon after August 9, Applegarth warned the FSA that it would have funding difficulties if the paralysis in the credit markets continued. Northern Rock was under pressure to raise £2.7 billion to refinance existing mortgages it had made and fund new lending. It also feared that if it issued a second profit warning, depositors might take fright and withdraw their money, intensifying its woes.

The FSA, which sent a team up to Newcastle to find out if there was a “black hole” in the bank’s books, was divided on what to do. Officials in charge of the orderly operation of the stock market thought Northern Rock should come clean and issue another profit warning. But other officials said Northern Rock could claim exemption because there was a risk of a run on the bank.

Did the FSA do enough? Should it have seen earlier the dangers of Northern Rock’s helter-skelter growth? Last week Michael Fallon, a leading Tory on the House of Commons Treasury committee listened to evidence from officials at the Bank and emerged into the corridor. To a small group of observers, he said: “Callum McCarthy now has arguido status” – Portuguese for official suspect, a reference to the Madeleine McCann case. “It’s McCarthy now,” he said.

THOUGH the FSA had found no black hole, the situation for Northern Rock was so desperate that the bank’s board called in Merrill Lynch to find a buyer for the business. More than a dozen British and foreign banks, including Lloyds TSB, Royal Bank of Scotland, Barclays, HBOS, HSBC, France’s Crédit Agricole, Santander of Spain and American giant Citi were sounded out.

But the credit crisis is a result of banks hoarding money precisely because they are unsure what losses are looming from derivatives or where they will emerge. The banks had stopped lending to each other fearing they might need the money themselves or that they would lose it elsewhere.

So they were reluctant to come to the rescue of Northern Rock – unless it was at a bargain basement price. Only Lloyds TSB entered serious discussions about a takeover, which on the surface would have provided a neat solution.

Lloyds offered just 200p a share – less than a third of the price in the market – and in addition Lloyds wanted a back-up facility from the Bank of England to support all of Northern Rock’s £24 billion in deposits and about 20% of its £105 billion mortgage book in case things got worse.

King refused, later arguing that regulations meant he could not offer a secret bail-out.

Time was running out for the Rock. On Monday September 10, hopes of a takeover faded and Applegarth spoke to Gieve at the Bank about “lender of last resort” emergency funding. It would be at a penal interest rate and King was still determined not to be seen bailing out reckless lenders.

THE Bank, the FSA and the Treasury still had a few days grace in which to prepare the public for the biggest shock to confidence in the financial system for decades. But they had failed to grasp one simple fact: when trouble strikes, the public’s immediate concern is the safety of their own cash, not the theoretical possibilites of moral hazard.

Yet King and Darling set out on a preemptive strike to reinforce their lofty message on moral hazard. On Wednesday, September 12, King sent a letter to the Treasury committee at the House of Commons, arguing that it was imprudent to provide liquidity and bail out banks for their risky behaviour. That could “sow the seeds of a future financial crisis”, he warned.

At the same time Darling gave a newspaper interview, delivering a similar homily. He said banks should rein in their more risky activities. “Institutions need to open their own eyes and be more honest,” he said. “When someone comes up with a fantastic way of making money they need to ask, how is this money being made and what are the risks?”

The chancellor urged a return to “good old-fashioned banking”. It meant nothing to ordinary savers. Hours later, as news of the Northern Rock rescue seeped out, a good old-fashioned run on the bank began – something that had not occurred since 1866.

In a teleconference from his office in the Treasury’s new headquarters overlooking St James’s Park, Darling had agreed with King, McCarthy and other officials that he, the chancellor, would take on the task of reassuring Northern Rock savers and the public.

Even as Darling toured the television and radio studios on Friday morning, the queues were growing outside Northern Rock branches. Treasury and Bank officials claim not to have been surprised. “There was good news and bad news in the lender-of-last-resort announcement,” said one. “The good news was that we were supporting Northern Rock. The bad news was that it needed it.”

As King later admitted, once people had begun withdrawing money from Northern Rock, other depositors acted “rationally” in following suit. With a run under way, Northern Rock posed a higher risk than other banks even though emergency funding was in place. Ergo: get your money out while the going was still good.

Darling and King had gambled that a run would not start in the first place or would peter out swiftly. As Gieve later testified: “If we had known a [full government] guarantee [of deposits] was going to be essential on Monday, we might have offered it on Friday. But at the time that wasn’t the case.”

The Treasury and Bank were following events, not shaping them. Once again King had been cautious, with his eye on longer-term moral hazard, not the risk of immediate panic.

“A government guarantee – it’s a big step,” he later argued. “To have done that earlier might have caused problems.”

By Saturday he had plenty of problems to worry about – they were stretching scores of metres from Northern Rock branches across the country. Alarm bells finally rang loud and clear at the Treasury and Bank. Darling’s reassurances had failed, and so had those of the Bank and FSA. Applegarth’s pleas that all was well were ignored and his chairman was nowhere to be seen.

The chancellor tried again, with television interviews on Saturday evening. But Sunday morning confirmed the worst fears. King, who has a flat in Notting Hill and an oast house in Kent, was at his country home. Darling was in his constituency. The Sunday newspapers, far from predicting an early end to the crisis, warned that it was likely to intensify.

In phone calls, King warned Darling that the source of pressure was the inadequacy of the Financial Services Compensation Scheme (FSCS), which guaranteed only the first £2,000 of savings entirely, and 90% of the next £33,000. Many of the older people queuing to withdraw their life savings from Northern Rock had savings of well over £100,000. It could have been predicted long ago.

Darling consulted Gordon Brown and Treasury officials, and they agreed to extend a guarantee to all the savings of Northern Rock customers.

When reporters turned up at the Treasury for a joint press conference between Darling and Hank Paulson, the US Treasury secretary, the chancellor broke the news of the guarantee, in time for the evening news bulletins and the following morning’s papers. By now the panic was so widespread that he extended the guarantee to all banks “during the current crisis”.

One Treasury adviser said: “We were worried that customers of other banks, seeing the television pictures, would lay siege to their banks.” Moral hazard was history: the taxpayer would pick up the tab for all depositors.

The next day the big banks repeated their pleas, both to the Bank and the FSA, for action to ease the liquidity crisis. That evening bankers including Mike Geoghegan, chief executive of HSBC, gathered to make their point. They warned King that his stance was in danger of damaging the entire banking system.

A day later King announced that the Bank would, after all, inject £10 billion into the money markets in a bid to ease the credit crunch. He claimed it was merely a logical step to help the markets following the Northern Rock rescue; the City saw it as a massive u-turn.

“Having talked a good game, the Bank of England pulled the most amazing handbrake turn,” said Paul Mortimer-Lee of BNP Paribas.

Suggestions that King was forced into it by the Treasury are firmly denied by both sides. Rumours that the governor considered resigning are dismissed.

Nevertheless the authority of King and the Bank was badly hit.

IN the Wilson Room of Portcullis House, the modern extension of parliament, the Treasury committee last Thursday took off their jackets, smiled, and picked up their cudgels.

They set about giving a battering to King and his Bank colleagues who sat arrayed before the committee. Why hadn’t the problems been spotted? Why didn’t the Bank act earlier?

John McFall, the committee chairman, described King’s testimony as “unconvincing” and accused Gieve of being “asleep in the back shop while there was a mugging out front”.

Nor did the FSA escape censure. Peter Viggers, another committee member, said: “It should really be the FSA answering many of our questions.”

Yesterday that view was endorsed by Angela Hayes, a financial-services specialist at the law firm LG who advised on the creation of the FSA. “The FSA needs to have a fundamental review of its approach. This has been a huge shock to the banking system and would not have been nearly so severe if the FSA had handled this better.”

King defended his actions and tried to maintain that, despite the bail-out of Northern Rock and the £10 billion injection into the money markets, he is still intent on tough love. “We want to make clear to banks that if things go wrong, they and they alone bear the consequences,” he said.

Nobody knows quite what those consequences are because the sub-prime crash is unwinding with painful slowness. As losses filter through the banking system, central banks find themselves caught between a credit crunch and fears of inflation. Their moves on liquidity and interest rates have taken on even more importance than normal – and at such times confidence in their authority is vital.

That confidence is wounded, as The Economist, a financial publication read around the world, demonstrates this weekend. Its cover carries a picture of a glum King with the headline: “The bank that failed: how Mervyn King and the government lost their grip”.

King may still hope that headlines come and go; he can also take some comfort from the fact that liquidity in money markets has improved in recent days. Rates for three-month lending have come down and there are other hints of optimism.

However, the credit crunch is not over. As one director of the Bank admitted last week: “There is still a long way to go, and there still could be setbacks.”

And under the guarantee covering all banks, which was the result of Darling and King’s handling of Northern Rock, the taxpayer is on the hook.

BLAME GAME: THE MEN IN THE DOCK

ADAM APPLEGARTH, CHIEF EXECUTIVE OF NORTHERN ROCK

The charge: That Northern Rock was reckless. Its spectacular growth over the past 10 years was based on the mistaken notion that it could always borrow enough money short-term in the wholesale money markets to provide long-term mortgage lending in the retail market. The defence: Northern Rock has been smarter than most in using the wholesale money markets and built a thriving business. The bank had 2,000 staff when it converted from a building society. Today it has almost three times that number. If it was going wrong, why did the City value the Rock at £5 billion only six months ago?

MERVYN KING AND SIR JOHN GIEVE (RIGHT) OF THE BANK OF ENGLAND

The charge: The Bank’s handling of the crisis was clumsy. Last week it made an extraordinary u-turn, agreeing to make it easier for banks to borrow. A week earlier it warned liquidity support could lead to a financial crisis. The defence: The Bank was hamstrung by overlapping pieces of legislation. It would have loved to put together a deal under which Northern Rock was quietly folded into a larger, strong bank. But the Companies Act means takeovers must be announced. Had the Bank covertly lent money to Northern Rock, it could have been accused of market abuse. The u-turn was vital to avert the danger that people would lose trust in all banks.

ALISTAIR DARLING AND GORDON BROWN FOR THE TREASURY

The charge: Labour has presided over a ballooning of debt, making the financial system vulnerable to disruption. Furthermore, Labour stripped the Bank of England of its responsibility for supervising individual banks and created another body, the Financial Services Authority, to do this. It set up a system with gaps. The defence: Are you seriously suggesting a return to credit controls? In any case, Northern Rock’s problems were not caused by customers defaulting. The Bank is responsible for monetary policy – setting interest rates. Its decisions might be compromised if it was also worrying about individual institutions.

SIR CALLUM McCARTHY OF THE FSA

The charge: The Financial Services Authority should have stepped in to challenge Northern Rock’s heavy reliance on the wholesale money markets to raise funds to finance its mortgage lending. The danger was plain for all to see. So why didn’t the FSA act sooner? The defence: Nobody could have been expected to foresee the drying up of the money markets in August. It was unprecedented. In any case, the FSA has to work within a tripartite system – sharing responsibilities with the Bank and the Treasury. When all is said and done, no Northern Rock depositor has lost money.

WHAT NEEDS TO CHANGE

- Better protection for depositors is inevitable. At the moment, the Financial Services Compensation Scheme guarantees the first £2,000 of savers’ money. Of the next £33,000, the scheme guarantees to pay out 90%. Anything above £35,000 is at risk. Chancellor Alistair Darling has already suggested that there may be a 100% guarantee up to £100,000.

- The FSA is likely to raise the amount that banks have to hold in liquid assets to cover a sudden rush by depositors to take their money out if a bank gets into difficulty.

- Mervyn King, Bank of England governor, says overlapping legislation prevented the Bank from dealing swiftly with Northern Rock. Legislative changes are essential.

- The crisis exposed gaps in the ‘tripartite’ regulatory system involving the Bank, FSA and Treasury. Those holes need to be plugged and liaison between the parties improved. The Bank was too slow to pick up on the FSA’s concerns.

THE FSA: BROWN’S BRAINCHILD

THE Financial Services Authority (FSA) was the brainchild of Gordon Brown. He announced its creation less than three weeks after Labour came to power in May 1997.

The FSA replaced a cluster of regulatory organisations, each of which was meant to oversee different parts of the financial- services industry. The authority also took over responsibility for the supervision of banks, a role previously handled by the Bank of England. The FSA started operations in December 2001 and was subsequently given responsibility for the regulation of mortgages and general insurance.

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