Rock of the North

In August 2007 the United Kingdom experienced its first bank run in over 140 years. The over publicised queues outside the bank in Newcastle did not help because it encouraged the savers to remove their savings which exacerbated the problem even more. Although Northern Rock was not a particularly large bank (it was at the time ranked 7th in terms of assets) it was nevertheless a significant retail bank and a substantial mortgage lender. In fact,only ten years earlier it had converted from a mutual building society whose activities were limited by regulation largely to retail deposits and mortgages. From the outset, it adopted a securitisation and funding strategy which was increasingly based on secured wholesale money (by issuing mortgage-backed securities) and other capital market funding. At its peak, Northern Rock had assets of over £ 100 billion and a growth rate of around 20 percent for over a decade. Everything was operated within the rules set by the FSA and Bank of England.

 

 


                                   

The bank became heavily dependent on short-term funding in the money and capital markets. And while the business model was successful for some years, the risk eventually emerged in the context of global financial turbulence focussed initially on sub-prime mortgage lending in the US. As the amount of savers deposits were not enough to provide new mortgages to customers the bank raised funds by using the existing mortgages as collateral.

On the face of it the Northern Rock crisis pales into insignificance within the global context. Nevertheless, the Northern Rock is particularly significant because it represents in a single case virtually everything that can go wrong with a bank. Consider the business model of the bank and how, in particular, it exposed the bank to a low-probability-high-impact risk.

While there is no doubt that Northern Rock’s business model was extreme, one can argue that its underlying philosophy was shared by many other banks. The combination of aggressive asset growth, minimisation of capital, and funding risks designed to maximise rates of return on equity as a common denominator.

The Rock's model suggests that, the lower are the cash-assets and capital-assets ratios, the riskier are the banks’ operations.

A decade before the Northern Rock crisis, little attention was given to crisis management arrangements.

The point is made that the retail depositors’ run was specific to the UK .

The Northern Rock episode revealed a unique new role of the government in effectively over-ruling the established Financial Services Compensation Scheme (FSCS) by intervening to guarantee all deposits at a troubled bank.

In 1997, the in-coming Labour government announced a major overhaul of the institutional arrangements for financial regulation and supervision. Since the 2000 Financial Services and Markets Act, the UK has adopted a unified supervisory model. In particular, the supervision of banks was taken away from the Bank of England and all regulation and supervision of financial institutions and markets was vested in the newly-created Financial Services Authority. While responsibility for systemic stability and the provision of market liquidity remained with the Bank of England, it was no longer to be responsible for supervising the institutions that made up the system. There were several ways in which the crisis was managed badly there were public disputes between the three agencies, the Treasury, Bank of England and FSA. The major conclusion of the tripartite authorities following the Northern Rock experience is that the UK needs a special resolution regime for banks.

There is an overwhelming case for having prudential regulation and supervision of all financial firms located in a single agency. Whether it is optimal to have the central bank responsible for systemic stability while not at the same time being responsible for prudential regulation and supervision of the institutions that make up the system. Equally, whether it can act as an effective lender-of-last-resort without having prudential oversight of banks.

The reaction of giving a stronger role to the central bank in times of stress makes sense as it is the organisation responsible for financial stability and in the main such actions can take place without access to taxpayer money, which would require ministerial consent.

There are 5main lessons from this experience that need to be considered in all countries and not just in the UK:
1. Deposit insurance needs to be designed so that;
a. The large majority of all individual’s balance are fully coverd;
b. Depositors can all have access to their deposits without a material break.
2. The activation of emergency liquidity assistance arrangements needs to give confidence that those being assisited will survive, and should be seen as the system working as it should, rather than signalling some breakdown;
3. There needs to be a regime of prompt corrective action for supervisors whereby prescribed actions of increasing severity are required within short time according to a set triggers based on capital adequacy and risks of failure.
4. There needs to be a legal framework such that the fuctions of systemic importance in banks that fail can be kept operating without a material break;
a. Such ‘failure’ should occur before the bank becomes insolvent so that there is little change of losses to the taxpayer;
b. This will normally invovle a special insolvency regimes for banks.
5. Some designated insititution to be in change of intervention in failing banks to ensure rapid and concerted action.

Finally I would like to say that the depositors never lost any of their money because it was covered by the government. But the original shareholders did loose money because although Northern Rock previously had assets of over £1 billion when the government took over they only paid the shareholders a fraction of the true worth. The share holders were, and still are, very unhappy about this and formed the 'Northern Rock Shareholder Action Group'. They say “ We believe it is morally and legally wrong for the Government to dictate the terms of reference for the determination of compensation to be paid to Northern Rock shareholders. We have therefore supported a legal challenge to the approach the Government has taken with a view to obtaining a fair value based on a truly independent and unbiased valuation process using normal commercial principles.”


Sources: The Failure of Northern Rock: A multi dimensional case study, Northern Rock shareholder group,