Factors leading to the collapse of Northern Rock and their current position - Dissertation Example

? Factors leading to the collapse of Northern Rock and their current position Northern Rock was the eighth largest bank of United Kingdom (UK). At the beginning of the year 2007 it was riding high and in June 2007, the share prices of the bank were seen to touch high records. After it was demutualised in the year 1997, Northern Rock started growing rapidly in order to become the fifth largest mortgage lender of UK. The aggressive expansion of Northern Rock was funded by heavy reliance on unsecured and secured borrowings. Moreover in the year 2006 it entered in to subprime lending by entering into a deal with Lehman Brother. After that it started to adapt aggressive steps in order to move high. The slowdown in the housing price inflation and an increase in the interest rate, Northern Rock issued warning regarding the profit of the bank. Soon the liquidity of the bank started to dry up and eventually pushed it towards collapse. The study tries to find out the factors that are responsible for the collapse of such a huge bank that was showing good business. At the same time it also focuses on the present condition of the bank. Table of Contents Abstract 2 Table of Contents 3 Chapter 1: Introduction 4 Chapter 2: Collapse of Northern Rock 5 Before Collapse 5 Reasons behind its collapse 7 Current Position 11 Chapter 3: Conclusion 12 REFERENCES 14 Chapter 1: Introduction The subprime mortgage financial crisis caused a steep rise in the subprime mortgage market of United States that started in the fall of year 2006 and became the cause of global financial crisis on July 2007. The newly-popular adjustable rate mortgages suffered an increase in the monthly payment due to the rising interest rates. Moreover the demise of the housing bubble caused the value of the property to suffer major decline leaving the house owners unable to meet their financial commitment and the leaders without any means of their losses. This financial crisis resulted into severe credit crunch, intimidating the solvency of many marginal banks and other financial institutions (Jansen, Beulig and Linsmann, 2010). Northern Rock was one of such banks that were severely hit by the waves of financial crisis. Among the entire spill over effects of the subprime crisis in US, the collapse of Northern Rock was the first in UK and was considered to be the most visible and perturbing for the authority of UK. This collapse exposed the tension that the central banks need to take some more stringent steps in order to enhance the liquidity support facilities. It also highlighted on the inherent difficulties that lay with the tripartite arrangements made to deal with the banking crisis, the deficiencies in the banking supervision and regulation in UK and the flaws evident in the deposit protection arrangement of UK (Hall, 2008). It also revealed the fragility of the banking system of UK, by shaking the complacency of the regulators, politicians and bankers, undermining the confidence of the general public on the banking system of UK and creating a calamitous effect on the economy of UK. All these reasons make it important to understand the situation that led to the collapse of Northern Rock. Hence the study highlights on the causes of collapse of Northern Rock and its current position. Chapter 2: Collapse of Northern Rock Before Collapse Northern Rock was the eighth largest bank of United Kingdom (UK). At the beginning of the year 2007 it was riding high and in June 2007, the share prices of the bank were seen to touch 1,000p and at the same time it announced that it has sold mortgage worth ?10.7bn, which was 47% higher than the figures of 2006. After it was demutualised in the year 1997, Northern Rock started growing rapidly in order to become the fifth largest mortgage lender of UK. The aggressive expansion of Northern Rock was funded by heavy reliance on unsecured and secured borrowings. About 50% of the funding came from securitization through a special purpose vehicle called Granite. The funds and retail deposits were seen to fall from 62.7% in the year 1997 to 22.4% in the year 2006 (Klimecki and Willmott, 2009). Though Northern Rock has reliance with the wholesale sector but it was not protected from the potential loss of liquidity (House of Commons Treasury Select Committee, 2008a). Adam Applegarth the CEO of Northern Rock explained the funding model of the bank in the end of June 2007 that was called to be highly influenced stake on interest rate (House of Commons Treasury Select Committee, 2008b). Northern Rock in the year 2006 moved to the subprime lending after entering into a deal with Lehman Brother. The distinguishing feature of the business model of Northern Rock is the exceptional high dependence of its business on the wholesale market and more particularly on securitization of its mortgages. For the first half of 2007, Northern Rock was seen to expand its business rapidly as its loan to the customers was seen to increase by ?10.7bn (House of Commons Treasury Select Committee, 2008a). The slowdown in the housing price inflation and an increase in the interest rate, Northern Rock issued warning regarding the profit of the bank. In such a situation Adam Applegarth forecasted that the growth of profit will remain well within the target range of the bank that is within 15% to 25%, more likely towards the lower limit of the range. He was confident that the bank is capable to raise the target in the medium term (Wearden, 2007; Attwood, 2007; BBC News, 2005). This prediction was even supported by some of the reputed analysts like Goldman Sachs, who at that time was recommending hold or buy decision (Fletcher, 2007). The money market started to dry up as soon as the decision of BNP Paribas came into light that they would suspend all the funds that are exposed to the subprime market of US. At that point of time the exposure of Northern Rock to the wholesale market was almost 73%, which included mostly covered bonds, unsecured wholesale funding and securitization (The Telegraph, 2007). The big diversified banks were able to raise the wholesale fund but as soon as the tightening of the credit squeeze started they were gradually facing difficulty in doing so since it was becoming more and more expensive. Immediately Financial Services Agency (FSA) and the Treasury were seen to warn Bank of England regarding the effect of credit squeeze on Northern Rock. The severity of credit crunch was evident from the rise in the Libor, which was highest in the nine years. The Federal Reserve and the European Central Bank started easing liquidity by pumping more money into the banking system; on the other hand the Governor of UK was more concerned about the moral hazards of bailing out the lender rather than calculating the systematic risk associated with the unwillingness to ease liquidity. The major drawback of the business model followed by Northern Rock was dependent upon the wholesale money market that was highlighted by Brian Giles, communication director, when he stated that the trading condition was becoming more difficult. After a month the share prices of Northern Rock was seen to fall by 32%, on the same day when Bank of England declared emergency funding for Northern Rock (Mailonline, 2007). As a response to this situation the experts said that Northern Rock had ?113bn assets that places it in a safe position, but the customers were not seen to be enough confident and ran to the bank for withdrawing money (BBC News, 2007a; BBC News, 2007b). On February 2008, Northern Rock collapsed after its acquisition bids by the private sector was rejected by the government. Reasons behind its collapse The Northern Rock episode is a study of great importance since it highlights on the flaws of the financial supervision and regulation and feasibility of particular business model. Multi-dimensional factors have been identified as the reason for the collapse of Northern Rock. The LPHI Risk: the business model followed by Northern Rock exposed it to high probability risk that is the liquidity would desiccate in inter-bank and commercial paper market and would create a high impact. The high impact is signified as the difficulty in funding the day to day business operation. Risk analysis considers two aspects; firstly the probability of an event to occur and secondly the impact caused by the occurrence of the event. LPHI risk is one of the most difficult risks to be managed. The history of banking crisis suggests that a high proportion of this risk occurs when the banks operate in this area of the matrix. This risk is difficult to handle because it is unrealistic to price them; an attempt to price those risk may lead to the destruction of the bank. The only way out of destruction is to stop the bank from getting exposed to these risks. In case of Northern Rock, the business strategy of the bank focused on unusual and high level of dependency on the short-term wholesale market funding and securitization that exposed it to LPHI risk. A very low probability was linked with desiccating of liquidity of London and other international market; however on the event of occurrence of such a situation the banks that rely upon the short term funding and securitization market would face a serious impact. Though certain generalised alerts were generated by the experts from time to time but no action was taken by the supervisor of Northern Rock which suggested that it has been in the disaster myopia (Llewellyn, 2008). The Business Model: The business model followed by Northern Rock was hazardous and at the same time lacked monitoring from the supervisory committee. Moreover Northern Rock is the only bank among several other major banks that followed securitization as the central piece of the business. This business strategy was the only working force for putting this major bank in the LPHI risk. The business model of Northern Rock highly relied on the strategy of fast growth in mortgage lending that was based on high fraction of wholesale market funding together with the securitization of its mortgages. Therefore there are two important features of the business model of Northern Rock. Firstly as compared to the other banks Rock gave more importance to the wholesale funding. And secondly securitization acted as the most dominant and integral part of the bank’s business model and strategy. Moreover the bank was also seen to lack implementation of any type of liquidity insurance; for example any agreement with other banks on the line of credit. The proportion of wholesale funding was 62% in case of Northern Rock and that for other banks was at an average level of 45% (Llewellyn, 2008). Solvency vs. Liquidity: There needs to be a clear distinction between the liquidity and solvency of the bank. Northern Rock was said to be in a solvent state though in reality the funding of its day to day operation was provided by Bank of England. Hence here a question of solvency arises in case of banks that has problems regarding funding in open market, where the cost of funding crossed the average rate of interest on the assets of the bank and when the banks are seen to dependent upon Bank of England. When the crisis emerged Northern Rock was legally solvent but at the same time it was forced to borrow from Bank of England during severe liquidity squeeze (Llewellyn, 2008). Role of Central Bank: Another reason for the downfall of Northern Rock was the irresponsibility of the central bank. The Northern Rock episode reveals that the liquidity operations of the central bank in the money market have significant implications on the financial position of the bank when the banks themselves are seen to face problems related to funding. Moreover the fundamental requirement put down by the central bank for other banks regarding the consistency and credibility of its operations has been questioned after the Northern Rock collapse. Bank of England was seen not to have too many information about Northern Rock, which suggests that it has disengaged itself from supervising the banks individually in the fear of indulging too much in the role of FSA (Llewellyn, 2008). Structure of regulation: Financial Services and Markets Act has been incorporated as the unified supervisory model in UK since 2000 (Llewellyn, 2004). The FSA is not only responsible for prudent supervision of all the banks and other financial institutions but also conducts supervision and regulation of business. On the other hand Bank of England is responsible for having a clear insight of the system as a whole, lender last resort role and money market operations. Faults were there in the structure of this operation. Several flaws were revealed in the conduct of supervision in case of Northern Rock. Firstly the bank followed an exceptional business model and no comprehensive review was done in the last 18 months. Secondly despite of several public warning related to liquidity risks made by the FSA and the Bank of England, no stress testing was done. Thirdly the stress testing done by Northern Rock was not sufficiently based upon extreme assumptions and adverse conditions. Moreover it was quite strange that on June 2007, FSA was seen to lower the required capital ratio of the bank in order to enable the bank to pursue asset growth, which was quite late and financial problems have been revealed before that. Role of the Government: In case of Northern Rock the government intervened in an ad hoc manner by guaranteeing all the deposits held by Northern Rock. This was an exact contrary to the entrenched DPS of UK. This raised question regarding the deposit guarantee system in place. The government was seen to take an unprecedented move after the supervisory authorities announced the bank to be safe and solvent. Government started to guarantee all the deposits of Northern Rock irrespective of their sizes (Llewellyn, 2008). Corporate Governance: The various aspects of risk management in case of a financial firm, related to the corporate governance issue, the board is responsible for the ultimate fortune of the company. The position where Northern Rock was standing before the collapse raised questions regarding the role of the Board of directors of the bank especially the role of the non-executive directors. For a bank there are formal, informal and market monitors. The formal monitors are those agencies that are responsible for supervision of the banks; in case of UK it is the FSA, Bank of England and board of the bank. The informal monitors are the consumer associations, media and academic analysts. Market monitors are the bank analysts, rating agencies and other banks. Each group has different interest and different focus but all of them perform the identical roles of supervision or monitoring. Hence when so many supervisory agencies are monitoring the bank then how could Northern Rock collapse? This stresses on the fact that there was insufficient monitoring or lack of informed judgement while judging the risk characteristics (Llewellyn, 2008). Current Position After the financial crisis in the year 2007, Northern Rock was at the brink of getting collapsed, the government of UK nationalised it and segregated it into two parts. From the beginning of 2010, these two parts started operating as two separate banks namely Northern Rock Plc and Northern Rock Asset Management (NRAM). Depending on the quality of the assets they hold, the two banks were called as ‘good bank’ and ‘bad bank’. About 90% of the mortgages advanced by Northern Rock, the original bank, were retained by NRAM. The mortgages that were at more than 100% of the value of the property were secured and discontinued lending. The remaining 10% was taken by Northern Rock Plc and lending was continued. It also acquired all the business related to savings and continued to attract the customers using competitive accounts. Virgin money has bought Northern Rock Plc and has taken over its 1 million mortgage and savings customers along with its network of 75 branches. This represents savings deposit of ?16bn and mortgages worth ?14bn (Osborne, 2011; Crown, 2012). The bank was nationalised in the year 2008 and now “Northern Rock Plc has been rebranded as Virgin Money” (Brennan, 2012). Virgin Money has bought Northern Rock from government for ?747m. Soon after buying, Virgin Money has pledged not to go for any job cuts for the next three years. Currently there are 2500 employees working with this bank. It is claimed by the government that the acquisition of Northern Rock by Virgin money will not cause any change in the services and accounts and no action is required to be taken. The purchase of Northern Rock by Virgin Money has made the taxpayer of Britain to move out of the business of owning banks. However it also comes with increase in the choices for the High Street customers, safeguarding jobs and value for money (Treanor, 2012). Virgin Money has decided to keep the headquarters at Newcastle, where Northern Rock was previously operating. They have also decided not to close any existing branches of the bank and go for opening some new branches. If Virgin money lists or sells the combined business in the stock exchange in the coming five years then the bank has to pay an additional amount to the Government that ranges from ?50m to ?80m. The chief Executive of Virgin Money Jayne-Anne Gadhia stated that locking the two businesses together creates a great business combination. Virgin Money Deals in insurance, credit cards and investment, whereas Northern Rock deals in current and savings account and mortgages. Merger of these two businesses are expected to create superb growth story. The executive Chairman of Northern Rock, Ron Sandler said that it was one of their key objectives to bring back Northern Rock to the private sector and they assumed that it would be done in a right condition and right time, in the best interest of the stakeholders and the taxpayers. The restructuring process has been seen as a positive outcome for the company and the news of the sale of Northern Rock to Virgin Money will lead to securing the future of the workforce (BBC News, 2011). Chapter 3: Conclusion The exposure of the financial institutions of UK to the US subprime crisis was limited. However the shockwave was seen to travel through the international financial market and revealed the weaknesses and stresses on the arrangements of UK to manage the banking or financial crisis. The main players like the Treasury, the FSA and the Bank were questioned regarding their mechanism that are used to protect depositors and ensure cooperation and coordination between the parties responsible for delivering financial stability. The Northern Rock episode stands as an example highlighting on the fragility and deficiency of the UK banking system. This paper has focussed on the discussions of the factors that lead to the collapse of Northern Rock. The main factor that was found be the driving force behind the collapse of Northern Rock was the business model of the bank that strongly depended upon the securitization. This compelled the bank to move into LPHI risk which was difficult to manage. Apart from these the faults of the central bank, credit rating agencies, the government and corporate governance of Northern Rock was also highlighted. After 2008, when Northern Rock was at the brink of collapse the government took over it making it nationalised and segregated into two parts. In the year 2012 Virgin Money bought Northern Rock Plc from the government and makes it again to move into private sector. This was taken as a positive indicator in regards with the fortune of the bank. REFERENCES Attwood, K., 2007. Northern Rock hit by housing slowdown [online] Available at < http://www.questia.com/library/1P2-7526407/northern-rock-hit-by-housing-slowdown-business > [Accessed 16 May 2013]. BBC News, 2005. Northern Rock shrugs off slowdown [online] Available at < http://news.bbc.co.uk/2/hi/business/4207945.stm> [Accessed 16 May 2013]. BBC News, 2007a. Northern Rock shares plunge 32% [online] Available at < http://news.bbc.co.uk/2/hi/business/6994328.stm> [Accessed 16 May 2013]. BBC News, 2007b. Rush on Northern Rock continues [online] Available at < http://news.bbc.co.uk/2/hi/6996136.stm> [Accessed 16 May 2013]. BBC News, 2011. Northern Rock sold to Virgin Money [online] Available at < http://www.bbc.co.uk/news/business-15769886> [Accessed 16 may 2013]. Brennan, H., 2012. Virgin Money retires Northern Rock brand [online] Available at < http://www.moneymarketing.co.uk/mortgages/virgin-money-retires-northern-rock-brand/1059585.article> [Accessed 16 May 2013]. Crown, 2012. Northern Rock Plc: change of name to Virgin Money plc [Online] Available at < http://www.ros.gov.uk/public/news/northernrock_to_virgin_name_change.html> [Accessed 16 May 2013]. Fletcher, N., 2007. Shining knight of Wall Street lifts the gloom [online] Available at: < http://www.guardian.co.uk/business/2007/jun/30/marketforces> [Accessed 16 May 2013]. Hall, M.J.B., 2008. The sub-prime crisis, the credit squeeze and Northern Rock: the lessons to be learned. 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The Northern Rock crisis: a multi-dimensional problem waiting to happen. Journal of Financial Regulation and Compliance, 16(1), pp. 35-58. Mailonline, 2007. Shares in Northern Rock plunge by 32% as Bank of England bails it out over cash crisis [online] Available at [Accessed 16 May 2013]. Osborne, H., 2011. Northern Rock sold to Virgin Money: what it means for you. Theguardian [online] Available at < http://www.guardian.co.uk/money/2011/nov/17/northern-rock-sold-virgin-money> [Accessed 16 May 2013]. The Telegraph, 2007. Is Northern Rock rocked or still rock steady to grow profits? [online] Available at < http://www.telegraph.co.uk/finance/markets/2814223/Is-Northern-rocked-or-still-rock-steady-to-grow-profits.html> [Accessed 16 May 2013]. Treanor, J., 2012. Taxpayer gets extra ?538m as Virgin buys more Northern Rock mortgages [online] Available at < http://www.guardian.co.uk/business/2012/jul/23/virgin-money-buys-northern-rock-mortgages> [Accessed 16 May 2013]. Wearden, G., 2007. Northern Rock says higher rates will hamper profit growth [online] Available at < http://www.guardian.co.uk/business/2007/jul/25/northernrock.banking> [Accessed 16 May 2013]. Read More