The Failure of the UKs Northern Rock Bank - Essay Example

Critically assess the reasons for the failure of the UK’s Northern Rock bank at the start of the last financial crisis, and assess who was responsible and whether the bank failure could have been avoided. Introduction The Northern Rock (NR) started operations as mutually operated building society, but was disintegrated in 1997. As a mortgage bank, it became the 5th largest of the UK banks with its expansion in the mortgage business increasing 23% from 1997 to 2007. The NR implemented a robust policy in housing mortgage lending, which formed 90% of its loan portfolio, offering housing loans at very competitive rates. Mortgage and personal loans were offered by the Bank in bundles up to 125% of the hypothecated value. Retail business deposits of the Bank were not compatible as the balance sheet grew; thus, the funding resources left to depend upon were the short-term wholesale market funds to match with the mortgage business growth. The NR issued and sold notes that ensured the buyer claim on the liquidity of the loan portfolio. New loans were bundled and the taken accounts were sold through asset-supported securities (Liikanen, 2012). The news of NR becoming cash-deficient and going ‘cap in hand’ to the Bank of England (BoE) for funding was the first-ever run on a British bank since Victorian time (Duncan, 2008). Failures on the part of NR (The Times, 20 March 2009) were many. The Treasury took too much time in resolving the failures of Northern Rock. Primarily, the short-sighted business approach of the Bank made it the first to run to the BoE. No option was left before the Treasury than to nationalise the Bank to secure the investors’ stakes and of the whole financial system. The Treasury did not check the NR from selling the toxic product, Together loan, by relaxing the loan conditions. The wrong lending policies were responsible for the Bank’s failure. Had all the stakeholders, including central banks, regulators and the treasury taken precautionary steps, the collapse of the Bank could have been avoided. Treasury was completely oblivion of the financial market operations and the resultant risks to the economy (The Times, 20 March 2009). According to Liikanen (2012), failure of the NR was caused by its institutional short-term investors not extending their credit lines. This problem was quite severe. The Bank losses in the wholesale market further ignited the scenario, as the Bank was depending greatly on short-term wholesale funding, which it settled when the credit term expired. Lack of trust among banks and the interbank market, facing huge cash-crunch ever seen, forced depositors to rush to the Bank; it was a happening that followed only after the actual NR crisis had occurred. Llewellyn (2009) claims that multi-dimensional kind of the NR was the reason of its failure. The business model of the bank unleashed risk of low-possibility and high impact. Fault was also found with the structural institutional architecture of the UK banking. Mayes and Wood (2009) find flaws with the government and the regulatory control measures. The concept that giant projects cannot fail proved wrong. The central Banks coming to the rescue of failing banks; regulatory non-compliance and lack of interaction among stakeholders were some of the leading causes of the NR failure. Hamalainen (2009) sees the role of high betting in financial markets in the context of the Northern Rock, thus pointing to the need for controlling the market. Onado (2008) finds the business model of the Bank as reason behind its failure. Attaining fast growth through minimum capital and risky approach to profit highly from equity led the NR to the optimum limit of possibilities for regulatory arbitrage hastened by Basel 1; it blurred all of a sudden the view over the essential role of capital in banking. The various issues need to be examined, as based on related concepts. One concept among bankers has been that too big projects are not easily fallible. Stiglitz (2009) finds fault with the agglomeration of banks that too big projects are not fallible. Clearing the banks and the shareholders by injecting more funds so that they do not fail is the beginning of creating the problem of moral hazard. Modern economic theories, including the theory of imperfect information explain the working of markets when information is not accurate. The invisible hand of Adam Smith was not actually there, which hints to the fact that market equilibria were not limited Pareto effective when there were information imperfections and imbalances and when risk markets were not perfect. For any policy to succeed, active government involvement is required. The robust combination of theory and proof of its working has not reduced the greed for uncontrolled markets. The crisis of the NR happened because regulators were least interested to check compliance. Rather than Darwinian natural choice, the Gresham’s law, working on the concept that bad money checks out good, works well, as ungoverned firms compel relatively traditional firms to practice their unruly investment tactics. The basic aim of a financial system is to distribute capital and manage risks, in which it failed miserably in its economic and social outcomes. Not only the capital was wrongly distributed in the past but it also created wide difference between possible and actual GDP. The erroneous economic theories promoted in public and private sector such policies that surely played a leading part in the current banking failure (Stiglitz, 2009). Hellwig (2009) considers moral hazard essential in a monetary exchange. Because institutional assets are quite varied and fungible, outside investors cannot keep a check and take precautions in advance. In financial theories, the Diamond model leaves no scope for any moral hazard, as it stipulates the role of an intermediary to be critical for holding a totally varied portfolio of assets. The Diamond model depends on the quality of debt finance to tackle moral hazard when default risk is zero. This encourages the borrower to take undue risk if investment tactics are not mutually decided with financiers. Any possibility of additional return is accrued to the debtor while the creditor’s interest is harmed as based on the principle of “heads, I win – tails, my creditors lose”. This theoretical analysis creates doubt over the securitisation of credit risk, causing moral hazard to the robustness of the financial system. Although the Diamond model ensures that moral hazard is not a possibility in banking but system failure occurs due to assumptions that returns on various mortgages have to be correlated. The lender’s returns depend on property value, which is decided by common and asset-specific elements. Asset related elements can be diversified but commons like change in interest rates or in macroeconomic conditions cannot be diversified away. As properties’ business is affected by both at the same time, a correlation emerges into the default risks that are related with various mortgage securities. In turn, diversification in the portfolios beneath the mortgage-supported securities becomes less efficient and default risks for top and medium finances become more critical than predicted. Milne (2009) analyses the problem of moral hazard when the central banks provide market liquidity. Willem Buiter of the London School of Economics is highly in favour of providing liquidity by the central banks against collateral to commercial as well as investment banks. The only limitation is that this should not create any exposure to credit risk; a penalty rate should be charged to check any financial subsidy. In contrast, Mervyn King, the Governor of the BoE, warns that providing liquidity for longer terms can cut market interest rates at longer maturities. It demands a balancing act between two different assumptions. In his speech of 9th October 2007, in Belfast, King stressed on the important role of the central banks to check that incentives are there no to encourage overt risk-taking and devaluation of risk so that crisis in future could be avoided. Irrespective of the moral hazards, the central banks cannot get away from their responsibility of acting as lender of the last resort. A better solution needs to put a levy per unit of short time wholesale funding, to be fixed at a threshold that rightly indicates the outside liquidity costs of short term funding. Conclusion Returning back to determine the cause of the NR failure, it could neither be blamed on the borrowers, nor on the depositors, but a way out by its creditors. The NR case study highlights on the wisdom of computing the balance sheet, including all sections’ output by eying the total system other than its different sections, as something micro-correct could be macro-wrong. Other noticeable learning includes sophistication in retail business conduct and all blame cannot be put on bad management. Capital market and economy wide factors are part of the modern banking. Banking and inter-banking offers a challenging perspective of liquidity, organisations and legal compliance. The failure of NR happened due to dynamic growth in credit provision and too much dependence on time constraint funding and high profit-earning. References Bruni, F., & Llewellyn, D. T., 2009. The failure of northern rock: a multi-dimensional case study. SUERF – The European Money and Finance Forum: Vienna. Available at: http://www.suerf.org/download/studies/study20091.pdf Duncan, H., 2008. Analysis: the Northern Rock aftermath. This Is Money. Available at: http://www.thisismoney.co.uk/money/news/article-1641543/Analysis-The-Northern-Rock-aftermath.html Hamalainen, P., 2009. Fallout from the credit squeeze and northern rock crises: incentives, transparency and implications for the role of market discipline. SUERF – The European Money and Finance Forum: Vienna. Available at: http://www.suerf.org/download/studies/study20091.pdf Hellwig, M.F., 2009. Systemic risk in the financial sector: an analysis of the subprime-mortgage financial crisis. De Economist, 157 (2), pp. 129-207. Springerlink doi: 10.1007/s10645-009-9110-0. Liikanen, E., 2012. High-level expert group on reforming the structure of the EU banking sector. Bank of Finland. Available at: http://ec.europa.eu/internal_market/bank/docs/high-level_expert_group/report_en.pdf Mayes, D.G. & Wood. G., 2009. The Northern Rock crisis in the UK. Cass Business School, City University, London. SUERF – The European Money and Finance Forum: Vienna. Available from: http://www.suerf.org/download/studies/study20091.pdf Milne, A., 2009. Can central bank provision of market liquidity create a problem of moral hazard? Cass Business School, London. SUERF – The European Money and Finance Forum: Vienna. Available at: http://www.suerf.org/download/studies/study20091.pdf Onado, M., 2008. Banks’ losses and capital: The new version of the paradox of achilles and the tortoise [Internet] Available at: http://www.voxeu.org/index.php?q=node/1555 Stiglitz, J. E., 2009. The current economic crisis and lessons for economic theory. Eastern Economic Journal, 35, 281–296. Available at: www.palgrave-journals.com/eej/ The Times, 2009. Northern Rock - a catalogue of failure. The Times. 20 March. Available at: http://www.timesonline.co.uk/tol/comment/leading_article/article5941261.ece Read More