The Case of Northern Rock
Table of Contents
1 Scope of Study 3
2 Introduction to the Northern Rock Debacle 3
2.1 Introduction to Northern Rock’s Business Model 4
3 Internal Analysis 7
3.1 Analysis of Northern Rock’s Balance Sheet 2006 7
3.1.1 Northern Rock’s Sources of Funding 7
3.1.2 Asset and Liability Maturity Mismatch 2006 8
3.1.3 Peer Group Ratio Comparison to Assess Northern Rock Liquidity Risk 2006 9
3.2 Exposure to Low Probability High Impact (LPHI) Risk 10
4 Analysis of Market Condition 10
4.1 U.S Sub-prime Mortgage Market Crisis 10
4.2 Consequences of U.S. Sub-prime Mortgage Market Crisis 11
4.3 Impact on Northern Rock 12
5 The Collapse of Northern Rock 13
5.1 Bank Run 13
5.2 Nationalization of Northern Rock 14
5.3 Insufficient Due Diligence 14
5.4 Inaccurate Business Forecasts 15
6 Ineffective Depository Insurance Scheme 15
7 Regulators’ Role in Northern Rock’s Failure 15
7.1 Financial Services Authority (FSA) 16
7.2 Bank of England (BoE) 16
7.3 Basel II Liquidity Framework 17
8 Aftermath of the Crisis 17
8.1 Restructuring of Northern Rock into Two Entities 17
8.2 Introduction of Basel III 18
9 Lessons Learnt 18
9.1 For Regulators 19
9.1.1 Instilling Market Discipline 19
9.1.2 Closer scrutiny for systemically important banks 19
9.1.3 Vigilance in pre-empting potential market developments and risks 19
9.2 Bank Managers 20
9.2.1 Awareness of business model and risks undertaken 20
9.2.2 Effective Crisis Management Plans In Place 20
9.2.3 Incentive Schemes to Discourage Excessive Risk Taking 20
10 Conclusion 21
11 Bibliography 22
1 Scope of Study
On the 14th of September 2007, Northern Rock became the first United Kingdom bank to experience a bank run in 150 years(British Broadcasting Corporation, 2007). This study seeks to investigate the reasons behind the bank run and the ensuing aftermath of the Northern Rock debacle, with a specific focus on the liquidity risk faced by the bank due to its extreme business model. In addition, we look at the regulatory failure factors from the different governing bodies, which might have exacerbated the situation. Finally, we conclude with the lessons learnt from the Northern Rock debacle, which bank managers of today can take away to prevent a liquidity crisis of this scale from occurring again.
2 Introduction to the Northern Rock Debacle
Northern Rock became the first bank in U.K. to suffer a modern day bank run after approaching the Bank of England for emergency funding, to replace money market funds, during the recent credit crisis in 2007. The bank run, coupled with the deteriorating market conditions and Northern Rock’s extreme business model, led to the collapse and nationalization of the bank, with huge ramifications to the financial market.
The Northern Rock debacle happened in a few stages, commencing with Northern Rock’s business model, which was deemed very aggressive and extreme in nature, as they had a high wholesale funding ratio. However, it served Northern Rock well for 10 years between 1997 and 2006, propelling it from obscurity to prominence in a short span of time, a remarkable feat for a building society.
However, the US subprime crisis boiled over to the global financial markets which affect liquidity in the market resulting in a global credit freeze. This affected Northern Rock more than any other bank due to the nature of their business model which relied on short term wholesale funding. With uncertainty and cautiousness setting in, Northern Rock found difficulty in selling its new issue of mortgage securitizations which was suppose to bring in fresh funds for its long term obligations.
With the payment deadline creeping in, Northern Rock had no other choice but to approach the Bank of England for a loan facility to replace its money market funding. This resulted in a visible bank run which further crippled Northern Rock’s unsound business model, despite Northern Rock remaining legally solvent. Alas, due to the worsening financial markets and inadequate regulatory oversight, Northern Rock was finally nationalized as the financial crisis claimed one of its largest victims in the ensuing aftermath.
2.1 Introduction to Northern Rock’s Business Model
Figure [ 1 ] Total Assets of Northern Rock (Northern Rock Annual Report and Accounts) Figure 2: Northern Rock Annual Report and Accounts
Figure 1: Northern Rock Annual Report and Accounts
Northern Rock embarked on an intensive growth strategy when it demutualised from a building society to a stock-form bank in 1997. Instead of relying on traditional customer deposits to fund its growth, Northern Rock relied more on wholesale funds to sustain Northern Rock’s operations.
Figure [ 2 ] Profits of Northern Rock (Northern Rock Annual Report and Accounts) This strategy of “originate and distribute” model of funding was the brainchild of Northern Rock’s Chairman, Adam Applegarth, and it thrived as shown by the tremendous increased in asset size and profits of the banks over the years. After demutualising in 1997, Northern Rock’s assets grew each year, and in a span of a decade, it expanded its assets by 6-folds, from $15.8bn to $109.3bn pounds (NR, 2007).
Also as seen in Figure 2, Northern Rock has increased its profit by more than 9-folds in the same time period to $395m pounds. Lastly, it also became the third-largest lender in, with 18.9%(British Broadcasting Corporation, 2008) of the mortgage market share.
Figure [ 3 ] Northern Rock’s Market Share in UK Mortgage Market (Northern Rock Company Accounts) What Applegarth did was to find a lower cost of funding for Northern Rock’s mortgage lending business, which translated to increase in profit margins for the bank. Also, stripped off its heavy regulations as a building society, Northern Rock was able to expand its source of funding, instead of relying customers’ deposits and is not limited to serve residents only from their community – thus increasing Northern Rock’s scale of business. This allowed Northern Rock to have a comparative advantage over its competitors as it consistently provided the best mortgage rates in Britain due to its sheer size. | 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | Securitised Finance ($bn) | 0.6 | 2.3 | 4.7 | 9.3 | 14.8 | 22.1 | 31.2 | 40.2 | % of Customer's loans | 3 | 11 | 18 | 27 | 34 | 40 | 44 | 46 | YOY increase ($bn) | 0.6 | 1.7 | 2.4 | 4.5 | 5.6 | 7.3 | 9.1 | 9.1 | Table 1 Year-on-Year Increase of Proportion of Customer Loans of Securitised Finance
What Northern Rock did was to securitize and package its existing mortgages into mortgage-backed securities (MBS), and sell them to their specially created Special Purpose Entity (SPV) – Granite. Granite in turns breaks these illiquid long term mortgages into smaller and shorter term securities called asset-backed commercial paper (ABCP) and sells them to investors. This process created extra funds for Northern Rock’s mortgage business and increase Northern Rock’s assets considerably. Also, Northern Rock’s SPE – Granite, was located in Jersey, a British offshore tax haven, which resulted in less tax being paid on the original mortgages. Also, the bank increased the amount of mortgage securitizations each year. As seen in the table below, Northern Rock’s securitization increase from 3% to 46% of its total customer loans by 2006 (Milne, 2008), a significant portion of the bank’s operations.
Moreover, to increase funds to its mortgage lending business and to stay focus to its core operations, Northern Rock sold off its credit-card division to inject extra funds into its burgeoning mortgage business. In addition, Northern Rock began to relax its lending conditions, granting mortgages at six times the applicant’s income despite the already inflated home prices in U.K(The Telegraph, 2007). These two factors helped Northern Rock’s business model prosper, and it turned a building society into a mid-size bank in U.K ...