One of the Worst Economic Meltdowns of Modern History - Essay Example

Credit Crunch- Case of Northern Rock requiring official assistance /intervention. Introduction What is happening in the developed world today is one of the worst economic meltdowns of modern history. The financial institutions are trembling like nothing else whereas the impacts of such a failure of financial institutions are clearly felt by the rest of the world as well. The reductions in consumer spending, the increasing level of unemployment as well as forecasts of negative growth are some of the aftereffects of this economic downturn. In the wake of these crises, there are many important concerns which are being expressed as the potential effects of the credit crunch can easily be felt against other economic variables too. (Campbell, 2008). Apparently, the current crisis may be attributed to the subprime lending made by the different financial institutions. However, at the core of it is a whole plethora of different variables which are not only correlated with each other but also created a combined effect on different macroeconomic variables too. The failure of financial institutions to regularly check in their appetite for taking more risk not only resulted into the current credit crunch but also indicated the degree of the regulatory control over such institutions to discipline their behavior. Northern Rock is such a financial institution in UK which required intervention from the government because of its apparent failure to sustain the losses incurred due to subprime mortgage episode. In this research study, the current credit crunch will be discussed with special focus on Northern Rock as a firm requiring official intervention. Credit Crunch- A historical overview The credit crunch started to emerge during 2007 when in US, especially financial institutions started to witness defaults on payments of subprime mortgages. Subprime borrowers are termed as those borrowers are who have relatively high risk due to their past credit history. Therefore, under normal banking rules and practices, lending to such borrowers are riskier as in comparison to other borrowers. It is because of this reason that such borrowers are categorized as subprime and are charged relatively higher rates on the lending made to them. Historically, banks were more conservative in their lending practices and avoided to lend to such borrowers who lacked the capability to repay. However, with the innovation in the financial markets corroborated by liberalization of financial markets allowed financial institutions to innovate and roll out products which carried relatively high risk. This phenomenon was further aggravated with the globalization of the financial markets as advances in information technology allowed free flow of financial transactions across the borders. This also resulted into financial integration which not only allowed the emergence of risks which were external to the economy of a country but were also created loose monetary control over financial institutions to restrict their risk taking appetite. (Gangopadhyay, 2005). Capitalizing on such environment, most of the financial institutions started to look for opportunities to earn more at the cost of running high risk and were more than willing to lend to such areas which offered higher returns. This attitude, therefore, gave rise to the phenomenon of subprime lending- mostly into the mortgage market- where financial institutions started to lend to subprime borrowers at higher rates. This was also done because of the reason that mortgage loans are backed up by the real estate property and given the historical appreciation of property prices in UK and US since 1980s’ it was assumed that the property prices would continue to appreciate or at least would remain stable. Therefore, financial institutions have the level of comfort in the form of substantial cushion available against such a lending. It is also important to note that most of this problem was culminated as a result of the securitization efforts undertaken by most of the financial institutions. In a bid to recoup the lost liquidity, financial institutions started to securitize their mortgage portfolios so that the outflows made in the form of mortgage loans are regenerated by issuing corresponding securities collateralized against the real estate property held as collateral against these mortgage loans. Securitization is defined as “a financial transaction in which assets are pooled and securities representing interests in the pool are issued. An example would be a financing company that has issued a large number of auto loans and wants to raise cash so it can issue more loans. One solution would be to sell off its existing loans, but there isnt a liquid secondary market for individual auto loans. Instead, the firm pools a large number of its loans and sells interests in the pool to investors. For the financing company, this raises capital and gets the loans off its balance sheet, so it can issue new loans. For investors, it creates a liquid investment in a diversified pool of auto loans, which may be an attractive alternative to a corporate bond or other fixed income investment. The ultimate debtors—the car owners—need not be aware of the transaction. They continue making payments on their loans, but now those payments flow to the new investors as opposed to the financing company.”(www.rikglossary.com. 2009). The above example clearly demonstrates the attitude and overall mood of financial institutions prevailing before the credit crunch as most of them involved themselves into this innovative method. However, what is critical is to understand the fact that when initial signs of the crisis started to emerge, it was basically the securitization which further magnified this problem. As the borrowers started to default on their payments, financial institutions have to divert their funds to repay the mortgaged backed securities issued by them. The assumption was that the cash flows to be received from the repayments of the subprime loans would have to be matched with the outflows to be made in repaying the mortgage backed securities. However, this did not seem to work as the mismatch between the two created serious imbalances between the two and financial institutions have to divert their other resources to repay their own issued securities. This resulted into credit crunch as the credit extension to businesses started to shrink as the financial institutions had to divert funds to repay their securities rather than lending. Role of Regulatory authorities As discussed above that securitization and subprime lending may be key reasons for this crisis. However, It may not entirely be true as many analysts views it as a collective failure of the “integrated governance and control system”.(Gentle,2008). One of the key reasons have been the failure of financial regulators in the country as Bank of England as well as Financial Services Authority (FSA) failed to properly govern the financial institutions. The failure of Northern Rock- our case in point- clearly indicates how critical the overall regulatory risk can be and its mismanagement can result into serious economic problems for a country. (Mcllroy, 2008). IMF in its one of the reports also indicated that the innovation in the financial markets allowed banks to go beyond their original capacity to sustain a consistent level of risk and as such went beyond to a level where it was too difficult for them to manage the risk of the lending made by them. This was further ameliorated by the fact that the existing regulatory base was so lax that it implicitly permitted financial institutions to engage into innovative financial transactions which were beyond their capabilities to control. It was also argued that the regulators properly stand against the might of the stronger financial institutions which came up with different business as well as risk models to consistently reduce the impact of financial regulations and as such continued to exploit new opportunities to grow. (Mainelli, 2008). UK’s financial regulatory environment is integrated in nature as there are three different entities which are controlling the financial system in the country. Bank of England is the central bank of the country and is responsible for the monetary policy regulation in the country. FSA has the responsibility of regulating the financial system and most of the financial institutions come under its control. Treasury- the third entity- has a completely separate role. Campbell (2008) however, is of the view that there was a complete lack of coordination between these institutions and many. Therefore, criticize FSA, especially for failing to clearly assess and warn in case of Northern Rock regarding the potential risks of such a risk taking behavior of the bank. Another important lacuna on the part of the regulatory authorities was the fact that most of the regulations were directed at assessing the legal form of the entities rather than their economic substance. Therefore, due to this anomaly in the very role of financial institutions, there was a wider gap between the regulation as well as the actual banking practices prevailing in the industry. The above were some of the theoretical reasons which are often cited as the key reasons behind the failure of Northern Rock as a successful financial institution and have to ask for official assistance and intervention from the British Government. Following section will detail the circumstances leading to this episode. Financial Globalization As discussed above that the last two decades of the 20th century witnessed a radical shift into the financial and economic policies of many developed countries as more and more emphasis was being placed on the liberalization of financial policies in order to provide the market forces a chance to function on their own. This, therefore, also resulted into the globalization of the financial system also as financial systems of the many countries were integrated and connected with each other through advances in information technology. Introduction of best practices such as BASEL II further integrated the financial markets and allowed banks to substantially look for the off-balance sheet transactions which basically encouraged financial institutions to create Special Purpose Vehicles (SPVs) to conduct off-balance sheet transactions such as securitization etc. Financial globalization, however, also resulted into a complete change into the very nature of the financial institutions also. Traditionally banks offered deposits and lending services. However, as the financial integration increased, financial institutions started to become universal in nature offering many services under one roof. This, therefore, not only broadened the scope of the banks and other financial institutions also but changed the very nature of the business model followed by all the financial institutions. (Atkinson, et.al. 2008). Financial institutions increasingly relied on deriving more value for their shareholders rather than protecting their deposit holders. The focus of managers was largely on concluding transactions which only provided high commissions to them but also prove beneficial in improving the overall value of the shareholders also. Northern Rock too engaged into such business practices where it went far too ahead of its capabilities to manage the down side risk of such transactions. (Atkinson, et.al. 2008). Northern Rock The run on Northern Rock was one of the most severe blows to the financial system of UK as many realized how fragile UK’s financial system can be as this run unfolded a burning volcano in the financial sector of UK.(Keasey & Vernoesi,2008). Northern Rock was the fifth largest mortgage lender in the country and run on it was the first on any British Bank in almost a century as the prevailing funding related problems forced the bank to seek official help from the British Government. Northern Rock was considered as a successful bank by any standards. However, run on it, despite emergency funding from the Bank of England indicated that the depositors were not willing to bet on a falling star. The primary factor behind the failure of Northern Rock was the fact its business model was unique and relied heavily on the capital markets for securing funds to make the lending. However, as the world’s capital markets started to shrink owing to credit crisis in US, the same effect was carried over to the capital markets of the UK too. Thus depositors started to withdraw their money from their accounts in Northern Rock- according to one estimate more than one billion pounds were withdrawn- creating serious funding problems for the bank to continue to remain solvent in foreseeable future. (International Herald Tribune, 2007). A brief look at the history of Northern Rock would indicate that it has successfully transformed itself from a mere building society to a fully listed bank and as such capitalized on its aggressive pricing strategies as well as serving more risky markets. This strategy seems to have paid the results as Northern Rock became one of the largest mortgage lenders in the country with amazing presence in the market. (Keasey & Vernoesi,2008). Keasey & Vernoesi (2008) are also of the view that the lending policies of Northern Rock were many aggressive given the fact that major chunk of its financing was coming from capital markets. Such high reliance on external sources of financing not only increased the overall risk profile of the bank but also put the role of financial regulators under question as they failed to realize the potential after effects of such a business strategy. These strategies of Northern Rock finally put a lot of pressure on the short term liquidity of the company as it failed to honor its short term commitments due to financing constraints placed due to constrained capital markets as well as the run from the depositors. It was because of this region that earlier an emergency loan was granted to it by the Bank of England and finally the bank was nationalized under the efforts by the British government to save the financial system from a complete collapse as one run could have led to other. This request was first in the form of an emergency loan request from the Bank of England which was provided to it because BoE, being the lender of the last resort, carries the responsibility of assisting banks when they require it. However, this may not seem to have worked too as Northern Rock was formally nationalized by British Government. The Bank was formally nationalized in Feb 2008 after British Government rejected the takeover bids from different bidders wanted to buy the bank. (Laurent, 2008). Conclusion Current Credit crunch is considered as one of the most significant downturns in the modern history of the developed world. What started from US soon spread over the world including UK as the after effects of this crunch were severely felt by the UK’s economy. The future projections suggest negative growth from UK at least in this year however; this decline is considered as the result of multiple failures of the government, financial regulators as well as private organizations in regulating themselves responsibly. Northern Rock was the victim of its own policies which it pursued in order to achieve rapid growth as it went on to become fifth largest mortgage lenders in the country. Run on Northern Rock was first of its kind in UK in almost a century however, it left behind a trail of events which clearly points out towards the failure of modern finance to regulate itself into more prudent and conservative way so that the interests of all the stakeholders could have been saved. References 1. http://www.riskglossary.com. (2009). Securitization. Available: http://www.riskglossary.com/link/securitization.htm. Last accessed 08 March 2009. 2. Campbell. Andrew (2008). The run on the Rock and its consequences. Journal of Banking Regulation. 9 (0), 61-64. 3. Gangopadhyay. Dr Partha (2005). UWS economist reveals the role of globalization in the current financial meltdown. Available: http://pubapps.uws.edu.au/news/index.php?act=view&story_id=2344. Last accessed March 7, 2009. 4. Gentle, Chris. (2008). How the credit crunch has its roots in the lack of integrated governance and control systems. The Journal of Risk Finance. 9 (2), pp: 206-210. 5. McIlroy. David Halliday (2008). Regulating risk: A measured response to the banking crisis. Journal of Banking Regulation. 9 (4), 284–292. 6. Mainelli, Michael. (2009). The religion of regulation: too big to succeed. The Journal of Risk Finance. 9 (4), 2. 7. Keasey, Kevin & Veronesi, Gianluca. (2008). Lessons from the Northern Rock affair. Journal of Financial Regulation and Compliance. 16 (1), pp: 8-18. 8. International Herald Tribune. (2007). Crisis deepens for Northern Rock. Available: http://www.iht.com/articles/2007/09/17/asia/17northern.php. Last accessed 07 March 2009. 9. Atkinson, Paul, Blundell-Wignall, Adrian, and Lee. Se Hoon (2008). The Current Financial Crisis: Causes and Policy Issues. Available: www.oecd.org/dataoecd/47/26/41942872.pdf. Last accessed 8 March 2009. 10. Laurent. Lionel. (2008). Northern Rock Nationalized. Available: http://www.forbes.com/2008/02/17/northern-nationalize-bank-markets-cx_ll_0217northernrock.html. Last accessed 09 March 2009. Read More