When I learnt about banking, many years ago now, the principle was this:

1)      Banks took deposits from customers and lent the money  to others.

2)      Because they were unlikely to be asked to repay more than a small proportion of what had been deposited with them, they could lend a large multiple of what had been deposited

3)      A chunky part of what they lent would be used by the borrowers to pay suppliers

4)      These suppliers would deposit this money with banks and the banks could then lend a multiple of these new deposits. As a result more “money” was created

5)      In order to stop the whole thing getting out of hand, regulators required banks to hold a percentage of their assets in a form that could be quickly turned into cash

6)      As a back up, the central bank stood as guarantor and would in an emergency lend the banks cash at a high rate of interest

All this was fine until original depositors wanted their money back in a larger percentage than normal (typically from a failure in confidence). If they did, then you would have a run on the bank.

That is where Northern Rock is now. If what we have been told is true, then we are lucky for the money withdrawn from NR is being re-deposited with other banks and so is rejoining the merry-go-round. Also, NR has lent money to fairly sound borrowers (though one may question the rate at which they have expanded at a time when house prices have already risen so much,  so a rival bank will probably be interested in taking over its loan book and funding its cash requirements. What would be really bad is if a big bank with dodgy loans on its books found itself in a similar position. There may well be some of those.

You will find more about this and a simple (I hope) explanation of the American sub-prime crisis that started it all at: http://www.thinkhard.org/2007/09/a-really-simp-1.html