Economic Meltdown: the Failure of Northern Rock - Essay Example

Introduction The current financial meltdown and subsequent decline in economic activity is considered as one of the worst periods in modern economic history of developed world. During the period starting from late 2007 to 2009, financial institutions failed in dozens and governments of various countries had to intervene in order to bail out these institutions so that whole financial system can be saved from complete collapse. The overall collapse of the financial system started with the busting of subprime mortgage bubble which started to have an impact on other sectors of the economy also. Financial institutions with significantly larger subprime mortgage portfolios therefore faced difficult situations in managing the losses and consequently went out of business owing to large losses sustained as a result of mass scale defaults by subprime borrowers. There are various reasons as to why financial institutions failed and consensus have now emerged that it was the failure of financial regulatory system of developed countries that resulted into the excessive risk taking by financial institutions. This excess risk taking therefore resulted into the failure of some financial institutions. What is also critical is the fact that systematic failure of financial institutions created negative impact on the economy and system as a whole experienced bank runs also. Northern Rock was one of the glaring examples of the failure of financial institution resulted due to imprudent risk management policies and practices. This paper will therefore provide an in-depth overview of the failure of Northern Rock and whether it was due to failure of regulatory agencies? Financial Crisis and Economic Meltdown To discuss the failure of Northern Rock, it is important to provide a critical discussion of the current financial crisis and resulting economic meltdown. It is generally believed that the financial crisis started as a result of subprime borrowers who failed to pay on their obligations when they became due. Subprime borrowers are those borrowers who normally do not fall into the acceptable category of borrowers due to their poor credit history. However, subprime borrowers also offer an opportunity to financial institutions to earn higher returns because of their high risk and most of the financial institutions jumped on this opportunity and started to lend in subprime market extensively. Most financial institutions however, also securitized their mortgage portfolios including subprime portfolios in order to recoup their liquidity drained as a result of lending to subprime borrowers. Most of financial institutions however, found themselves in trapped in this complex web as their repayment capacity against mortgage baked securities was directly dependent upon cash flows received from subprime borrowers. When subprime borrowers failed to pay off their liabilities, financial institutions have to divert their own funds to pay off their obligations against mortgage backed securities and faced liquidity crunch. What is also critical to note that this liquidity crunch resulted into credit crunch because bank funds could not be diverted into those areas where banks can earn i.e. giving loans to the firms. Thus credit crunch started to affect other sectors of the economy also as lack of credit to manufacturing and services firms started to result into decline in productive capacity of these firms. Some Notable Failures Some of the notable failures of financial institutions during this crisis include institutions like Lehman Brothers, Royal Bank of Scotland as well as Northern Rock. Though this paper will exclusively discuss the failure of Northern Rock however, it is important that a background to the failure of other notable failure is also presented. Lehman Brothers filed for Chapter 11 Bankruptcy during the month September 2008 and is considered as one of the most spectacular failure of financial institutions. It was also the largest bankruptcy filed in the modern history of America as Lehman Brothers, at the time of filing its Bankruptcy, was managing assets over $600 Billion. Failure of such a large firm therefore created significant doubts over the ability of modern financial institutions to bear the adverse market shocks and also created a strong debate over the ability of existing financial regulators to properly regulate financial markets. The failure of Royal Bank of Scotland was also one of the most critical corporate failures in the history of UK. RBS was the second largest bank of UK with a balance sheet footing of £1900 Bn and was 10th largest bank in the world. (Aldrick). RBS was rescued by Bank of England by pumping in new funds to ensure that its failure does not lead into the failure of the whole system. Northern Rock Northern Rock was probably the only bank which suffered a bank run in 150 years of history of Modern Banking. The run occurred after it asked for a loan facility from Bank of England to bail it out from the trouble which could have resulted into its complete collapse. Founded as a Building society during 1965, Northern Rock started to become a full fledged bank after demutualizing itself during 1990s in order to expand its range of services. Over the period of time, it became one of the leading financial institutions in issuing mortgage lending product. Along with issuing mortgage loans, bank also started to offer saving account facilities and insurance products to its customers. During 2006, Northern Rock entered into one of its worst business deals when it teamed up with Lehman Brothers to start selling subprime mortgages duly underwritten by Lehman Brothers. (Bruni and Llewellyn) The business model of bank was based on heavily borrowing from international and local markets and lending the same to the mortgage borrowers with an aim to earn higher profitability. Since bank started as a building society therefore it was confident that it will be able to serve the market better while at the same time earning handsome returns for its shareholders. It floated its shared on London Stock Exchange as a minor bank with the expectations that it will be bought by larger bank however, it remained independent till its nationalization. At the time of floatation of the new shares, Northern Rock also offered shares to those who held its mortgages or had saving account with it. Failure of Northern Rock Run of Northern Rock was one of the most critical events in the banking history of UK as it was probably the only event that occurred in its long history. The bank run on Northern Rock was initially dubbed as an opening up of a volcano for banking industry of UK and many speculated about the potential fate of other UK banks during the peak of credit crisis. One of the critical reasons for the failure of Northern Rock was its unique business model which required heavy dependence on capital markets to generate funds to lend. (Brummer). Northern Rock borrowed heavily from Capital Markets and started to lend the same to the mortgage borrowers with the intentions to earn higher rate of return. Borrowing from capital markets inherently increased its cost of borrowing and to remain sustainable and competitive it had to charge higher premium to its borrowers. It was potentially because of this reason that Northern Rock started to tap into subprime mortgage market as it was not finding it competitive to lend to prime borrowers at rates which were not commercially feasible for it. Over the period of time, it relied heavily on its aggressive pricing strategies and its ability to manage highly risky assets. As discussed above, the main source of borrowing by Northern Rock was capital markets therefore in order to remain competitive it had to engage itself into aggressive pricing strategies. However, this aspect of its business model failed to attract the attention of regulators. It is also important to note that the reliance of firm on the borrowings from capital markets put in awkward situation when crisis started to emerge. Due to crisis, capital markets started to contract and investors were not willing to take higher risks. This change in the risk taking attitude of investors therefore placed critical funding constraints on Northern Rock which finally approached Bank of England for a formal loan request to overcome its funding restrictions. Though banks often borrow from their central banks and Northern Rock’s request may have been considered as a routine matter in good economic times however, its request for an emergency fund proved fatal for its survival. Its request for funds from central bank was perceived as a warning sign by the depositors and they started to withdraw their funds. This withdrawal of funds therefore resulted into serious funding problems for the bank which finally culminated into the fact that Bank seriously started to look for a new buyer to get out of this situation. Though Bank of England, acting as a lender of last resort, provided the emergency funding however, it failed to save the firm from collapse as general perception that emerged as a result of this request was negative. Northern Rock was already constrained by its funding restrictions due to chaos in capital markets and mass scale withdrawals of funds by the depositors proved as the last nail into it coffin as it was subsequently nationalized by British Government in a bid to save the system from collapsing. (Laurent) Failure of Regulations Failure of Northern Rock is also considered as the failure of regulatory bodies of UK. It is generally argued that regulatory authorities such as FSA failed to anticipate the results of the business practices adapted by Northern Rock. Reports indicate that though Regulatory Authorities have the feeling that Northern Rock may collapse due its business practices however, they relied heavily on the assumption that housing prices in UK will continue to rise or will decline to a very small scale. (Brummer). This assumption therefore led regulatory authorities to believe that even in case of the failure of borrowers to pay off their obligations; bank can easily fall back on healthy securities and can sell them off to recoup their losses. This assumption however was wrong as with the start of the crisis, housing prices also started to decline to their historic lows and even in the case of foreclosures, bank may not have been able to reduce their losses. It is also argued that the efforts to de-regulate the financial sector and minimize the role of Bank of England by Gordon Brown were the direct cause of the failure of banks like Northern Rock. The creation of FSA was therefore believed to be an error as FSA failed to successfully safeguard the country’s financial system from collapsing and lacked the necessary skills and aptitude to monitor the whole financial system. Conclusion Bank Run on Northern Rock was one of the most important events in the history of modern UK as it was the first Bank run in almost a century. The failure of the Bank to fulfill its commitment resulted into its Nationalization as Government took control of the organization after it failed to buy credible buyers for it. The failure of Northern Rock is often attributed to the way it used to manage its business. It relied heavily on capital markets as the main source of its funding therefore when capital markets started to panic in the beginning of crisis, Northern Rock almost lost its funding channels which resulted into its call for an emergency fund from Bank of England. Though Central Bank provided the needed funds however, this was viewed as a negative sign by the depositors and they started to withdraw their deposits from the bank. Failure of Northern Rock is also considered as the failure of regulatory authorities of UK also. Financial Services Authority completely failed to anticipate the potential impact of the business practices adapted by Northern Rock and failed to forecast the swings in the housing prices in the wake of financial crisis. Further, lending to high risk borrowers in a competitive environment where pricing was aggressive would have prompted financial regulators to start viewing the bank with suspicion however, this was not done and FSA continued to rely on wrong assumptions and estimates made by people who were probably not qualified enough to supervise the banks. Bibliography 1. Aldrick, Philip. "Royal Bank of Scotland: Why one of Britains biggest banks is trading like a penny stock ." 07 Oct 2008. Telegraph. 30 July 2010 . 2. Brummer, Alex. "A failure of regulation." 2007. New Statesman. 30 July 2010 . 3. Bruni, Franco and David T. Llewellyn. THE FAILURE OF NORTHERN ROCK:A MULTI-DIMENSIONAL CASE STUDY. Study. Vienna: SUERF – The European Money and Finance Forum, 2009. 4. Laurent, Lionel. "Northern Rock Nationalized." 2008. Forbes. 30 July 2010 . Read More