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Northern Rock Risk Management Essay

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Northern Rock plc
Risk Management Home Assignment
Northern Rock plc
Risk Management Home Assignment

Authors:
Serghei Leahu
Alexandru Mangir
Mihail Mavrin

Seminar leader:
Herbert Windsor
Authors:
Serghei Leahu
Alexandru Mangir
Mihail Mavrin

Seminar leader:
Herbert Windsor

Table of Contents
Executive summary 2
Economic and financial environment description 3
Causes and circumstances of incurred losses 5
Errors by the organisation 8
Errors by internal and external supervising authorities 10
The internal authorities 10
The external authorities 10
Effects on other commercial organisations 12
Conclusions 14
References 15

Executive summary
According to the House of Common’s Treasury Committee’s Fifth Report of Session 2007-08 “The run on the Rock”, on the evening of Thursday 13 September 2007 at 8.30 PM the BBC announced that Northern Rock plc had asked for and received emergency financial support from the Bank of England. The terms of the funding facility were finalised in the early hours of Friday 14 September and announced at 7.00 AM that day. That day, long queues began to form outside some of Northern Rock’s branches; later, its website collapsed and its phone lines were reported to be jammed. The first bank run in the United Kingdom since Victorian times was underway. The purpose of this home assignment is to critically discuss the Northern Rock plc bank run from a faulty risk management perspective. We seek to examine what were the causes of the collapse of Britain’s fifth largest mortgage lender, associated consequences for both the bank and other financial institutions (both domestic and international), the way authorities coped with this event and possible lessons to be drawn about proper and improper risk management.

Economic and financial environment description
For a better understanding of the details of risk management problems that engulfed Northern Rock plc, it is of vital importance to first and foremost take a look at the financial environment during the period of the loss. Real GDP growth projections as of 4 April 2007

Country/Region | 2006 | 2007 | 2008 |
United States | 3,25 | 2,25 | 2,5 |
Western Europe | 2,75 | 2,5 | 2,25 |
United Kingdom | 2,75 | 2,75 | 2,5 |
Other West Europe | 3,75 | 3 | 2,75 |
Euro area | 2,75 | 2,5 | 2 |
Emerging markets | 7,25 | 6,5 | 6,25 |
World(WEO weights) | 5,25 | 4,25 | 4,25 |

In August of 2007, the UK found itself affected by global financial chaos. Citing bank Credit Europe (2007), the liquidity crisis originated from the US subprime mortgage market. In mainland Europe, the crisis is believed to have been triggered when French based bank BNP Paribas suspended three of its investment funds that were exposed to the US markets that traded 'toxic' assets, as reported by BBC News on 9 August 2007. As a result, share prices plummeted and banks would not continue lending to each other. So, all major central banks around the world started injecting liquidity into their domestic markets in similar attempts. The European Central Bank sought to calm the tide by reportedly pumping $130 billion in the European banking system. It sought to satisfy Eurozone liquidity demands as fast as possible, unlike the Bank of England who left UK banks' claims for liquidity unsettled. The Bank of England did not follow suit and took no contingency measures in order to protect against moral hazard. Their rationalisation was that an injection would induce banks to take on more liquidity risk, resting sound knowing that the Bank of England would find a way to save them.

Injecting money into economy to prevent crisis have two major risks, first one is slowing growth too much in case of trying to avoid issuing new money, and second one is that inflation pressures will rise in case of issuing too much , at the end even with a greater slowdown. Due to these risks, the bank of England did not inject money into the UK financial system.

Also, behind the economic environment a large effect on any business has the political environment. Its effects are even greater during a period of critical time in financial systems where trust and confidence is very significant. In the UK for example, the financial system is regulated by the Tripartite system: the Bank of England, the Financial Services Authority and the Treasury. According to Aldrick (2007), although their roles are clear, there was no overarching authority when the crisis struck, which meant that everyone was pointing fingers around, but nobody was able to take the large chunk of responsibility for reactionary measures.

In retrospect, how come Northern Rock, out of all of the UK’s financial institutions, proved to be the weakest link? Why had the credit crunch affected it in such drastic fashion? Was it a victim of its own doing or were other external forces involved in the bank run? We aim to answer these questions under following headings.

Causes and circumstances of incurred losses
According to ex-Unilever, British Gas and KPMG manager Mike Barnato, risk is the antagonist of opportunity. No ships would ever leave port if captains wanted to avoid risks associated with sea travel. Therefore, risk must be managed in order to achieve objectives at all levels: private, corporate, state. However, the old-fashioned approach to risk management such as detect risk, measure probability, gauge effect, and identify reactions, habitually disregards broader people and strategic matters. As stated by the Financial Services Authority, liquidity risk is defined as “the risk that a firm, although balance-sheet solvent, cannot maintain or generate sufficient cash resources to meet its payment obligations in full as they fall due, or can only do so at materially disadvantageous terms.”

Originally established as a building society, Northern Rock demutualised in October of 1997 and became a plc. The bank's consolidated balance sheet grew no less than sixfold, as a result of a complete overhaul in its corporate strategy. According to the Treasury Committee Report (2008), CEO Mr Adam Applegarth claimed that Northern Rock's assets "increase by 20% plus or minus 5% for the last 17 years".

Sustainability for the high growth of assets was to come from a restructuring of its liabilities. The year 1999 marked the beginning of the so-called "originate and distribute model", which involved originating or ...

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