The Northern Rock crisis; A chain of events that have determinated a Bank-run.
The purpose of this paper is to analyze all the factors that have generated and influenced the Northern Rock (NR) crisis during the summer of 2007.
David T. Llewellyn's article shows many elements that can have contributed to this event, with my analysis I would like to point out, how all the factors resulting to be correlated and, at the same time, make a distinction between the real causes and those that can be considered concomitant causes of the failure.
To start, it's important to remember that the Northern Rock as been affected at the same time from internal and external factors, like the sub-prime crisis and the depositors' lank of confidence from the outside world, wrong strategies and risk management from the domestic reality of the bank.
As a first cause I would like to consider the one that has been the more evident to everyone, that is the deposit withdrawn.
Has been estimated that �2 billion were withdraw by the depositors, everyone have seen on TV the lines outside the NR branches, so was the easiest solution for the failure. The depositors has been pushed by the media, in fact it's only after that the BBC announced the intention of Central Bank to support NR that there was the run to withdrawn. For sure the depositors' fear was concatenate to the USA sub-prime crisis, even if there was not a connection between UK mortgage and the one in USA. The fact that NR was still legally solvent neither the government reassurance could stop the deposits dry-up.
However this can't be considered the cause of the failure, as the withdraw started after that the NR problems begun. Between all the NR liabilities only the 23% was in the form of retail deposit, the graph below shows that customers deposits falls has been of only 2.6 billion in contrast with the huge run of the other, so it's more correct to consider the NR bank-run as a crisis created not by individuals but by institutional investors.
However a lesson from NR is: Despite the financial theory that consider the funding cost connected to withdraw- risk, with an inverse relation for which if the bank gives high interests there is less risk of withdraw, because the depositor is pushed to leave his money. Now we know that sometimes this rule is affected by external factors which are set from the relationship; Bank-Depositors.
NR was a Bank deeply dependant on the capital market ( I will analyze this aspect successively with the Bank strategy) so the dry-up that pushed NR into the crisis has been caused by the investors and other banks decision to denied founds because scared about the liquidity problem that the bank was facing.
The one that happened was a general lank of confidence around the Bank caused as I said before from different reasons; international situation ( Sub-prime crisis), media, a general dry-up of the credit, but if the NR was solvent and was not strictly connected with sub-prime products, why all the subjects (investors, depositors) were so scared? Why the crisis that was affecting all the financial world hit the NR so hardly?.
Even if the NR's official line was that "it could happened to anybody" I believe that the causes of the failure has to been searched inside the NR reality. All the others elements are nothing else that concomitant cause or factors that have compounded the crisis, if I have to point out a reason for this bank-run, I believe that the answer is around the strategy and risk- management adopted by the NR.
The NR strategy has been at the same time the reason of fast increase and terrible drop of this bank. The point of contradistinction was an aggressive strategy that could allowed NR to compete against the Big of the sector.
NR was a building society characterised as saving and mortgage bank, that couldn't compete on price with the Big Banks which had cheaper founding alternatives as a bigger retail deposit. So in the 1997 it flatted its shares on the stock market and one year after during the demutualization it decided to adopted a different strategy, something that could permit to confront the sector. It address itself to a mortgage business model founded in the capital market. In few years the aggressive strategy ,based on attracting the riskier part of the market and using competitive price, brought the bank to be the fifth most important supplier for mortgage in UK. During the period between 1997 and 2007 NR's assets grew more or less of 200� billion, with a rate of growth equal to the 23 percent. NR's great ambition pushed the bank to use a fine interest margin to generate business in the short term and at the same time to grew rapidly, it was taking risk in lending and borrowing. Between all the mortgage banks NR was different, it was deeply dependant on nonretail found. Among all its liabilities only the 23% (from the 60% in 1998) was constituted by retail deposit, despite the rise of all the assets the deposits increased just of 14 billions in ten years. The rest of NR's found was constituted by a mix of short term borrowing in capital, interbank market and securitized notes. These are exactly the elements that distinguish the NR aggressive strategy. Thanks to an heavy use of securitization and counting on capital market and interbank market to find new found, NR could grow rapidly, but at the same time drove the bank in to a terrible crisis.
The connection between the crisis and NR's strategy is multidimensional in fact it affected more than one aspects. This strategy even if aggressive and really risky could worked in most circumstances but the things that happened was a simultaneous closure of both the market where NR demanded founds. When there is a lack of confidence, depositors are not the only one that run, even in the Interbank market rumors of problem about liquidity or solvency can froze other Banks to accord new loans.
Simultaneously the USA sub-prime mortgage crisis created a dry-up of the money market. One of the aspects that I find interesting is that NR's manager received bonus packages for the growth, despite there were already signal of an imminent crisis, this can be a reason for which NR continued to use the same strategy.
All the analysis about NR failure turns around one single element: Securitization.
"Securitization is a process of packaging individual loans or other debt instruments, converting the package to security, enhancing their credit status to further their sale to third party investors"( Dr. Roman Matousek 2009) . Securitization as been created to sell balance sheet asset or better to convert illiquid loans or dent instruments into liquid securities that gives a cash flow compensation. There are many kind of assets that can be securitized but the one that characterized NR was the mortgage securitization. To understand the reason of the failure of this instrument it's better to explain is mechanism. Banks are the seller that gives asset to SPV which generate cash flow, the SPV has an important role because act as a shield separating assent from the seller in this way the bank are not responsible for any losses. Securitization is characterised even by a form of insurance, which assigns different seniority level this method gives the opportunity to have a risk differentiation, because it creates a thing called Waterfall of Cash Flow/Losses. The flows generated by the securitised asset arrives to investors on the based of the seniority level.
As I said before there was a huge gap between the amount lent out and the deposits, this gap was made manly by securitised notes which in NR were of medium to long term maturity ( with a maturity average over one year), so the thing that happens was a mismatch between short-term liabilities and long-term. assets.
The problems that affected NR in 2007 impacted two elements of the securitization structure: Credit issuer which guaranteed part of the credit were not more able to cover the risk, but most important thing, NR was not able to sell other securitized products because the lack of confidence generated by sub-prime mortgage crisis had dried investors market.
Despite Sec. is considered the main reason of the crisis in my personal opinion it's not exactly like this. The used of Sec. increased sharply during the last years, not only NR but all the banks are hardly dependant from these products, in particular for is benefits.
Like improve the ROE, diversify the risk and find new sources of liquidity, and most important it allowed to free capital for new uses. Sec. brings many different benefit to all the subjects involved in the transaction, originators, investors. The aspect that I would like to underline is that Sec has been responsible for the growth of many banks not only NR but even Capital One and MBNA, so the reasons of the crisis should be not seen in the securitization itself but maybe in the use that has been done of it. In general the speculative excesses such as Collateralized debt obligations.
I find interesting how securitization under the Shariah law is a process that works perfectly, exactly because Shariah limitated the speculative excess typical of the western world. Particularly in the NR case with the process of repackaging risk, the situation was that nobody was even more sure of who was bearing the risk. Securitization helped NR to grew thanks to low price of the risk, but the indiscriminate used and an inappropriate risk pricing caused problems to all the system. Aspect of financial innovation is quite interesting, in fact the securities owned by NR were different kinds of financial instruments, there were asset-backed securities, residential mortgage securities and CDOs.
I would like to analyse briefly the last financial instrument that I mentioned. CDOs derives their values from underlying securities, "are securitisations of corporate bond credit or loans default swaps" (Barbara Casu, Claudia Girardone, 2006), " Synthetic CDOs use credit derivatives to sell only the risk of a pool of assets, or a fraction of their risk, while keeping the assets on-balance sheet, and still saving capital" (Joel Bessis 2002). Both Bank of England and FSA showed to be worried about the use of CDOs, the Governor of the Bank of England during his annual speech on 20 June 2007 said "new and ever more complex financial instruments create different risks" he admitted that was difficult to understand it with great precision. CDOs are able to spread the risk, that is not concentrated in a single institution but can be divided between more financial subjects. Despite that characteristic, the continuous process of repackaging can create many problems. In fact the final investors will be not able to evaluate the risk of the product that he is buying. Secondly CDOs are the instruments that has been hit more hardly by the USA sub-prime mortgage crisis, because the hedge founds were invested in that sector.
As I said before this failure as been led by NR strategy and by its risk management.
Llewellyn analysed the LPHI, low-probability-high-impact, but in my opinion the problem is multidimensional as multidimensional is risk nature. There are many different kind of risk and a bank can't avoid to face it, because "The fact is that bankers are in the business of managing risk. Pure and simple, that is the business of banking" (Walter Wriston , Former CEO of Citibank; The Economist, 10 April 1993).
Between all the typologies of risk, some of them affected NR crisis. Market risk is the risk of losses generated by movements in the market prices, this is a normal type of risk that emerges when a bank trades asset and liabilities instead hold them as a long-term investment.
Market risk raised with the use of securitization, more precisely what happened at NR was a Specific market risk because the price of a specific instrument (securities) was altered by the market. Strictly connected to market price is Interest rate risk, a problem that affect those institutions that mismatched the maturity of its liabilities and assets. As for market risk even the changes in interest rate has grow, as a result of the increase of volatility inside market interest rates. NR during the crisis couldn't securities and sell new mortgage so was oblige to keep it in its balance sheet, "and it faced a sharp rise in interest rates in the money market with the result that borrowing cost rose above the yield on its mortgage assets" (David T. Lllewellyn 2008 pag.40). The only way to reduce this kind of risk is matching the maturities of assets and liabilities but this process reduce the profitability of the banks, and it's for this reason that NR's managers didn't adopt this solution, because was against its aggressive strategy.
At last I'm going to consider the type of risk that more than the others affected NR; Liquidity Risk. It's "the risk that a sudden surge in liability withdrawals may leave a bank in a position of having to liquidate assets in a very short term period of time and at low price" (Saunders A. & Cornett M. 2007, " Financial Institutions Management" pag. 181). The one that happened for NR was not a day to day liquidity risk but a real liquidity crisis, where depositors demands for a larger amounts of money that usual. In this situation banks are obliged to borrow new funds at an elevate interest rate to cover depositors demand. The problem was that NR was hit even by another aspect of Liquidity risk: Funding Risk, "that depends on how risky the market perceives the issuer and its founding policy. An institution coming to the market with unexpected and frequent needs for founds sends negative signals, which my restrict the willingness to lend to this institution." (Bessis J, 2002, second edition,"Risk management in banking" pag.16). So the NR's mismatch between size and maturity of its assets and liabilities drove the bank in a lack of confidence from depositors and borrowers.
Banks have to manage their liquidity in case of predictable and unpredictable liquidity demands, they can reduce the liquidity risk holding more liquid asset as cash or treasury bond. The problem is that liquid assets in particular cash earns less interest, so a bank has to choose between more liquidity risk exposure or profitability. As I said before for interest rate risk, NR's strategy was focus on growth and profitability, without pointing attention on risk management.
In final analysis I'm going to consider some external aspect that affected NR events.
Around Northern Rock crisis have acted many different institutions: Bank of England, FSA, Government and rating agencies.
All these subjects have been analysed by Llewellyn in his article, but in my opinion it's important to make a distinction between those elements that have really influenced NR, that could prevent or avoid the crisis, from those that have just participated at the chain of events and can be seen only as a joint cause.
The thing that emerge from NR story is that there has been a general failure of regulation, all the institutions have failed in different way. The Government reacted too slowly to the crisis, was blocked in discussion about moral hazard when the situation demanded fast decisions.
On its defence we can say that before NR the last bank to failed was in 1866, so maybe the Government was not ready to face a real crisis, then (even if in late) the deposit insurance modification was the only thing that could really stops depositors-run.
Bank of England was guilty too, if we consider its actions during the summer of 2007 is obvious that it was more afraid of consequence of is actions in the future, considering just the monetary inflation it forgot the risk of a general market instability that could started from NR.
Rating agencies have been particularly affected by the NR crisis, in fact what happens after was a lack of confidence in them. This kind of agencies valuates securities, bond or other instruments on the based of their risk and assign them a score that in general follows an alphabetic order, where the securities considered "investment grade" are the one with the highest possibility of return of investment. The role played by these institution is important in the financial world, in fact they can drive investors' choices, thanks to a good rating it's easier to sell financial instruments. Mark Carl Rom (Public Administration Review, July/August 2009) underlines three main problems connected to those institutions. At first the incentives, in fact Rating Agencies receives money from the company that have to evaluate and this is a clear conflict of interest. Secondly R.A. works is based on information, but there were not a lot of information about securitization because it's relatively a new instrument and then the repackaging process made the valuation quite impossible. Thirdly the agencies were nor ready to face the incredible increased in the use of securities, CDOs and other produscts in proportion with the grew of the staff that should do the ratings.
The fault of these institutions is clear but the point that I want to underline is that their actions affected a bank (NR) that was already in crisis. Differently FSA should reacted before the others institutions. Its role is to supervise banks checking how they are working and what they are doing. FSA didn't notice that NR's strategy was too aggressive and too dangerous connected to what was happening on the market. Despite a general failure in communication and control between all the institutions, the one that should be blame is FSA, because was the only one, understanding the risk of NR business model, able to prevent the crisis.
In conclusion I would like to emphasize that is true that NR case is a multidimensional problem, but differently from Llewellyn's article in my opinion not all the events that the Bank faced during 2007 can be considered caused of the failure. Even if probably any bank could not survive to the same mix of adverse events, NR pushed itself in deep of the crisis even before that external problems hit all the others banks. The choices that NR did, an aggressive strategy, a preference for profitability and a fast growth instead that an accurate risk management, condemned Northern Rock
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