The Crisis of the Northern Rock - Coursework Example

68 Crisis of Northern Rock Detailed below is a discussion of the financial crisis that severely affected the Northern Rock bank in 2007, forcing intervention by the Bank of England as well as the British government. The Northern Rock had originally been a building society yet it had grown significantly in terms of both size and turnover after the company’s conversation into a bank. The Northern Rock had offered high rates of return for savers and investors, whilst also offering competitive loans, mortgages, and remortgages to borrowers. The Northern Rock alongside other banks were keen to take advantage of relatively low interest rates that tempted people into getting ever increasing levels of debt, which had harmful consequences as soon as the Bank of England raised interest rates, and similar trends in other financial markets. However the senior management of the Northern Rock arguably took excessive risks in attempting to boost their company profits even further during the period when interest rates were low and demand for loans, mortgages, and remortgages were high.1 The following discussion will debate whether crisis that embroiled the Northern Rock was a result of poor decisions by the senior management of the company, or if that debacle could have been avoided or prevented by the Bank of England and the F S A. Although banks and to a lesser extent building societies may chose to take higher risks in the search for greater profit margins they are also provide to financial security for both their savers and their borrowers.2 The F S A is there to monitor the decisions and actions of banks to prevent fraud or serious error in order to protect borrowers, investors, and savers. When things go drastically wrong with banks and building societies the Bank of England, and in the most serious of circumstances the British government must decide whether or not to intervene to prevent severe financial crisis. The sheer scale of the crisis centred on the Northern Rock bank brought large-scale intervention by both the Bank of England and the British government. The crisis has also prompted debate as to how banks are managed, as well as when the F S A, the Bank of England, and the British government should step in to prevent a similar crisis happening again.3 The banking industry in Britain has been highly competitive in recent years, meaning that some senior management teams felt the need to take risky decisions. British banks though do not just lend, borrow, and invest money in Britain alone.4 By investing, lending, and borrowing money in many financial markets across the globe leading British banks frequently make higher levels of profits than by only being involved in the British financial market alone.5 Of course the greater the number of financial markets that British banks become involved with the higher the risks of their investments going wrong, or debts becoming unpaid. 6 Banks such as the Northern Rock have senior managers and financial experts who would decide upon which financial markets offer the highest rate of return at the lowest risk of defaults or loses to their respective companies.7 Banks not only offer loans, mortgages, remortgages, and savings accounts to potential customers; they also take over each other’s debts or liabilities. The taking over of the debts and the financial liabilities of other banks is another way in which the senior management teams could increase the profit levels of their particular banks, yet there are certainly higher risks of those debts turning bad or being defaulted upon. During periods of low interest rates in Britain and in other countries such as the United States, the taking over of debts and liabilities can be regarded as being more attractive ways of making increased profits. Low interest rate levels of course generally increase the demand for loans, mortgages, and remortgages, as the cost of borrowing is lower for borrowers. Such demand for credit will usually begin to decline as soon as interest rate levels begin to rise. Logically enough reduced levels of demand for borrowing caused by higher interest rate levels can be damaging to the revenues and turnover of banks. Banks that are able to accurately predict trends in financial markets and variations in interest rate levels improve their prospects for sustainable long-term profits. Unfortunately for the long-term prospects of the Northern Rock its senior management were not able to maintain such ability.8 The crisis that nearly destroyed the Northern Rock resulted from factors inside and outside the immediate control of the company’s senior management. Leading British and international banks have had to operate in generally less favourable conditions in the last two or three years that has challenged their revenues as well as their profits. However only the Northern Rock has had to be baled out by the Bank of England and the British government. In Britain the Bank of England raised interest rates several times between 2004 and 2007 in order to slow down levels of consumer spending and control inflation.9 The effect of such rises for banks was that the demand for loans gradually reduced as well as making it harder for many borrowers to repay their loans and mortgages. The senior management of the Northern Rock had increased the risk of such a credit crunch threatening its own operating viability by allowing its customers to borrow larger amounts of money than other leading banks in Britain.10 The Northern Rock offered loans, mortgages, and remortgages to customers that other banks would either not lend to, or lend as much to, such a policy increased short-term profits, yet risked higher levels of reduced or defaulted repayments. The senior management of the Northern Rock thus inadvertently increased the potential for plummeting revenues and increased financial loses when the next economic downturn or credit crunch happened. The Northern Rock took the lead amongst British banks and building societies in offering potential borrowers mortgages, remortgages, and also secured loans several times their annual incomes, and for total loan amounts higher than the value of the mortgaged properties. The Northern Rock also offered good returns on its savings accounts, which attracted millions of savers in Britain. During the period up to the Bank of England raising interest rate levels in 2004 the strategy of the Northern Rock seemed to be a highly successful one, only the harsher economic conditions demonstrated that the senior management of the company had made flawed decisions. Other leading British banks offered similar high-risk mortgages and loan packages as the Northern Rock but not to the same scale and scope. The volume of high risk loans lent by the Northern Rock in Britain only partially explains the reasons for that company being so adversely affected by the credit crunch when other banks were not. The senior management of the Northern Rock had in hindsight made the almost fatal error of getting involved in the United States financial market shortly before a problem of millions of American borrowers defaulting upon their unrealistically high mortgage repayments became apparent. In order to gain a greater share of the American financial market, the senior management of the Northern Rock had taken over the loans as well as the liabilities of American banks. The same American banks that had themselves given mortgages and secured loans to millions of customers that turned out to be unable to meet their repayments over the long-term.11 The Northern Rock had speculated that taking over loans and other liabilities would increase its profits over the long-term as well as within the short-term. The senior management of the Northern Rock overestimated the length of time that such deals would be profitable for, whilst underestimating the scale of potential defaulters once the economic situation deteriorated markedly in the American financial market. When interest rates and later unemployment increased sharply in the United States so did the number of people that could no longer afford to repay their mortgages. Irresponsible and unwise lending in the American financial market came back to haunt the banks that made such loans or had taken over the liabilities for such lending. As the Northern Rock was the British bank which had invested most heavily in the American financial market it was therefore the bank most severely affected by the collapse of the mortgage sector there.12 The critical damage done the Northern Rock by the poor decision-making of its senior management team had serious repercussions for the British economy besides having major consequences for the Bank of England and the British government. At first the F S A and the Bank of England seemed unaware of the scale of the crisis threatening to shut down the Northern Rock.13 For the Bank of England and the British government if the Northern Rock collapsed due to its huge loses then it would be disastrous for the economy as a whole, a realisation that eventually prompted intervention from the Bank of England backed up by funding from the government.14 The problems facing the Northern Rock were so grave that its senior management feared that if all the bank’s savers withdrew their entire deposits then the company would collapse. The situation for the Northern Rock was so detrimental that should its savers wish to close their accounts then the company could not guarantee that it could give everybody all of their money back. Media reports of the severe dire straits of the Northern Rock brought about the run on the bank that its senior management, the Bank of England, and the British government had feared. Over several days millions of the Northern Rock’s savers queued for hours to close their accounts, taking billions out of the company’s capital reserves. The run on the Northern Rock only slowed down when the Bank of England with Treasury backing pledged to guarantee all withdraws from the Northern Rock.15 Now the company is waiting to be sold to other banks or, to a less likely extent facing nationalisation if it cannot restore it’s financial position. The Bank of England and the F S A were very slow to react to the problems that the Northern Rock faced, despite the root cause of those problems being the poor decisions made by the senior management team of that company. Bibliography And the good news is ... hard to find, Ruth Sunderland, The Observer, Sunday January 6 2008 Daily Telegraph - Darling and King fell out over Northern Rock Tuesday, 27th November 2007 Daily Telegraph - Northern Rock edges closer to nationalisation Wednesday, 19th December 2007 Do the tipsters really know their stuff? Proinsias OMahony, The Guardian, Saturday January 5 2008 Embattled King steps into the Cobras nest-The Bank of England chief may not see out 2008, says Heather Stewart The Observer, Sunday January 6 2008 Read More