Essays /

Northern Rock Term Paper Essay

Essay preview

-------------------------------------------------
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 ...

Read more

Keywords

-25 /2/hi/uk_news/england/london/7802807.stm. /2009/08/04/northern-rock-together-mortgages-push-up-arears/. /30-second-guides/article.html?in_article_id=429885&in_page_id=53611. /corporatecommunications/news/article.asp?newsid=235. /investorrelations/corporateprofile/ /pages/library/communication/pr/2010/066.shtml. /tol/business/industry_sectors/banking_and_finance/article2459583.ece. /tol/business/industry_sectors/banking_and_finance/article3628701.ece. 0.6 000 000.2 010.6 010.60 091.6 1 1.7 10 100 100.8 101 108.4 109.3 109.40 10years 11 110.3 111.3 12 12.1 122.5 13 131.3 135.50 136.2 136.20 137.3 137.6 139.5 13th 14 14.8 143.9 14th 15 15.0 15.8 150 16 16.0 163.6 1680.6 17 175.6 17th 18 18.9 18.97 1823.8 18bn 19 191.1 1997 1998 1999 2 2.1 2.3 2.4 2.92 20 20.62 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 201.80 2010 2011 209.4 21 210.6 210.60 22 22.1 22.4 225.70 228.40 22nd 23 23.1 236.60 25 25.73 253.0 26 26.07 27 27.31 28.20 28.32 29 294.3 296.6 2nd 3 3.1 3.1.1 3.1.2 3.1.3 3.2 3.67 30 31 31.2 316.0 319.8 33 33.05 33.7 33.9 34 355.6 361.7 364.8 372.9 392.5 392.50 395m 4 4.1 4.2 4.3 4.5 4.6 4.7 40 40.2 402.5 430.0 44 44.36 45 46 471.6 485.1 49.67 5 5.1 5.2 5.3 5.4 5.6 5.67 53.0 53.58 54.80 5483.8 569.9 587.3 589.0 593.3 598.5 6 6.9 62.7 621.3 621.30 621.4 630.4 630.40 631.00 638.40 64 64.46 66.64 683.6 689.7 7 7.1 7.2 7.3 70 700.7 72 725.4 736.2 75 762.4 774.5 79.7 796.10 8 8.1 8.2 8.7 800.0 803.6 83.5 8335.9 84.1 847.2 85.93 86 864.6 867.6 871.3 876.3 88.4 885.1 898.8 9 9.1 9.1.1 9.1.2 9.1.3 9.2 9.2.1 9.2.2 9.2.3 9.3 90 900.1 917 93.0 947.4 950.9 956.0 97 989.7 991.5 abandon abcp abl accept accord account across action activ adam addit address adequ adjust adjustable-r adopt advanc advantag advis affect afford aftermath aggress agre ahead aid ala allevi allow almost alon alreadi also although ambit among amount amplifi analys analysi analyst analyt and/or announc annual anoth applegarth applic approach appropri approxim april argu arrear assert assess asset asset-back assign associ assum assumpt attain attempt attent audit august author avail avert awar away back bad bailout baker balanc bank banker bar barclay base basel bbc becam becom began behalf behind benchmark best bibliographi bid billion blame bn bnp bodi boe boil bond bonus book borrow brainchild break bring britain british broadcast buffer build bulk burgeon busi business.timesonline.co.uk business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article2459583.ece. business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article3628701.ece. buy buyout c calcul call came cannot capabl capit capitalis card care carri case cash categor categori caus cautious central certain chairman chang cheaper chief choic chosen circumst citi claim clawback clear close closer closest collaps collater combin come commenc commerci commit committe communic communiti compani companyinfo.northernrock.co.uk companyinfo.northernrock.co.uk/corporatecommunications/news/article.asp?newsid=235. companyinfo.northernrock.co.uk/investorrelations/corporateprofile/ compar comparison competitor compli complianc compon comprehens compris concern conclud conclus condit conduct confid consequ consid consider consist contact contagion contain content conting continu contract contrast contribut control convent cope core corpor cost could counterpart counterparti coupl cover coverag creat credit credit-card creditor creep crippl crise crisi critic criticis cross cross-sect crunch culmin culprit cushion custom daili danger data daunt david day deadlin debacl debt decad decemb decid decis declin decreas deem default delinqu demand demonstr demutualis depart depend deposit depositor depositori deputi deriv despit deterior detriment develop differ difficult difficulti dilig director disciplin disclos disclosur discourag discuss disrupt distribut diversifi divid divis done drastic dri drop due earlier earn eas economi effect effort either elev embark emerg employe empt enabl end enforc england enjoy enough ensu ensur enter entir entiti entri equiti erad ernst especi essenti establish estim european even event eventu everi evid exacerb exampl exceed excess exchang execut exhaust exist expand expect experi experienc expert expertis explos expos exposur extend extent extern extra extrem face facil fact factor fail failur fall far fargo fear feat feb februari feder fell figur final financ financi find first fix flaw flow fluctuat focus fold follow forc forecast form formal former found framework freez french fresh froze fsa ftse full function fund furthermor futur g gain gap gelina general generat geograph get given glare global goldman good govern gradual granit grant greater grew group growth guarante guernsey guidelin half handl happen haven head heavi heavili held help henc high higher highest highlight hike histor hold home hous howev huge identifi ignit ignor ii iii illiquid illustr impact impli implicit import improv inabl inaccur inadequ incent includ incom incorpor increas indentifi index indic indirect individu industri ineffect inevit inflat inform initi inject instanc instead instil instrument insuffici insur integr intens inter inter-bank interbank interest intern internet introduct invest investig investor involv ireland issu item j januari jersey june kept key kingdom known lack larg large-scal larger largest last lcr lead leak learnt led legal lend lender less lesson level liabil libor light limit line liquid list llewellyn lloyd llyod loan loan-to-deposit locat london long long-term look lose loss lost low lower lphi m macroeconom made magnitud mail main maintain mainten make manag manger mani march margin market matter matur may mbs mean measur medium meet mention mere mid mid-siz might mil million miln mind minim mismatch mitig model modern money moneyfact monitor month montia moodi moreov mortgag mortgage-back mths much multifacet must nation nationalis natur ndong necessari need negat neither net never new news news.bbc.co.uk news.bbc.co.uk/2/hi/uk_news/england/london/7802807.stm. newsroom next normal northern northernrock note noth nr nrs oblig obscur obtain occur occurr off-bal offer offshor omit one oper optimist order origin originate-to-distribut other outflow outlook outstand over-reli overlook oversight owner ownership packag paid panel panic paper pariba parliament part parti particular payment peak peer penal perform performance-bas perhap period place plan plc pls plung point polici poor portion posit potenti pound practic pre pre-empt pre-exist precari press prevail prevent previous price prima primarili prime principl privat proactiv probabl problem process product profil profit programm promin prompt propel proper proport prospect prosper protect prove provid provis public purchas purpos put qualiti quantit question quick rais rake ramif rang rank rapid rate rather ratio rbs reactiv realiti reason receiv recent reckless reclaim record reduc refer reflect reform refus regard region regul regular regulatori relat relax releas relev reli relianc reliant reluct remain remark remedi repaid repay repeat replac report request requir research reserv reset resid residenti resort respect respons rest restat restructur result retail retain retract retriev retrospect revenu revis richard right ringshaw risk risk-adjust risk-mitig riski rmp robust rock role roll rose rough run sach sale save saver scale scenario schedul scheme scope scrutini second section sector secur securit securitis see seek seem seen seib seiz sell sensit septemb serv servic set sever share sheer sheet short short-term shortag shortcom shorter shortfal show shown side sign signific similar simplifi sinc situat six size smaller societi sold solvent sought sound sourc sovereign span spe special specif spike split spot spread spring spv squeez stabil stabl stage stanc standard start state statement stay steepli sticki still stock stock-form stop strategi stress strict stricter strike strip structur studi sub sub-prim subordin subprim subsequ substanti success suffer suffici sunday sungard supervis supervisor support suppos surviv suspend sustain system tabl take takedown taken taker tax taxpay team telegraph temporari term termin test thereaft therefor third third-largest thisismoney three thrive thus tier time timelin today tool top total tough toward toxic track tradit train translat transpar treasuri tremend trend trigger turmoil turn turnov two u.k u.s uk ultim unabl unavail uncertain uncertainti underlin understand undertaken unencumb unexpect uniqu unit unknown unlik unrealist unsecur unsound unsuccess unsustain unusu unwil upcom updat us use user valid valu vari variabl vehicl victim vigil virgin visibl volum w warn way websit well went wherebi wholesal whose wider withdraw withdrawn within without work world worri worsen worst worst-cas would wound write www.financemarkets.co.uk www.financemarkets.co.uk/2009/08/04/northern-rock-together-mortgages-push-up-arears/. www.fsa.gov.uk www.fsa.gov.uk/pages/library/communication/pr/2010/066.shtml. www.thisismoney.co.uk www.thisismoney.co.uk/30-second-guides/article.html?in_article_id=429885&in_page_id=53611. year year-on-year young yoy zero