Discussion of the North Rock Company - Coursework Example

Discussion of the North Rock Case Study Northern Rock is considered as one of the largest retail bank in United Kingdom. The is also known as the largest financial institution in the northeast region. Among the country’s retail banks, Northern Rock is ranked at 15th number. One of the core products or services the bank provides to its clients is concerned with the mortgage landing. Concerning the home mortgages on the other hand, the bank ranks on top of the UK banks by grabbing a share of 10% of the total market in home mortgage industry. The cost-efficient structure adopted by the staff of the institution has caught the admiration of a larger audience across the country. Since the last 20 years, the uncertainties in the global financial system have affected a large number of financial institutions among which the Northern Rock is also included. The institution has been bearing the losses since the last 4 years, where another reason for that could be the global recession that has veiled the whole Europe. Also the debacle of the home mortgage industry since the 1990s is another factor for the debacle of the business of Northern Rock. The purpose of this report is to establish an authentic critique on the case study of Northern Rock retail bank. The key aims adopted in the critique will deal with those indicators that have made NR a victim of debacle in the financial system. The report will critically analyze those aspects that have led NR to keep losing in the financial business race. The role of the credit crunch and its direct effect on NR financial performance will be discussed. The effects of the modern models of banking will be explained in the light of which an analysis about NR will be made that will explain the outcomes of the institutions in case of adopting new business banking models. The role of the credit rating agencies has also been critical in terms of financial collapse of the NR and that will also be discussed. Another important dimension of NR consistent failure of bringing back its old legacy will be presented in this critique in which the role key policies and regulations adopted by UK financial system and more importantly Northern Rock will be explained and their spillover effects would also be explained. The current crisis inside the business of the NR will best be understood by the consultation of the liberalization of financial markets in UK in 1986. The financial institutions and production markets then were allowed to compete with each in a free market as well as to offer as many services or products as they wanted. The decision made by NR officials was to follow this policy and hence they started expanding their business by offering more services to the clients to catch more number of consumers to get subscribed with their services. When needed, the bank borrowed money from other financial institutions as loans for meeting their own objectives. The economy at the local scale grew by leaps and bounds through these reforms, and the benefits enjoyed by the NR as well as its customers were immense too. The overall financial system had been exposed to many new policies that liberalized the economy. The mortgage market also expanded in the early 90s and this was the only field in NR had been specialized to deal. The potential credit market then had lowered down the risks as well and that is the kind of behavior that is still demonstrated by the consumers and the officials of the banks, especially NR, i.e. the lowered risk factor. The environment was stable then and therefore people were willing to take more risks than ever before, as so were the policies made by Northern Rock. NR believed to expand their market in the same way, so as to grab more market share by liberalizing their policies and take more risks in the financial system. The latter period showed these reforms and policies quite illusive and many financial analysts and economists considered them as short-term and predicted immense financial losses bore by financial institutions as well as the consumers involved in this gambling. They also predicted that the financial institutions such as NR that were directly as well as deeply involved in the home mortgage industry will be indebted once this short-term era of credit lending is over. One of the factors that led the Northern Rock to bear losses and collapse in their financial standing was the massive defaulting of the US mortgage market. The final argument that can be deduced from this whole discussion of credit crunch, would be the extreme business model adopted by the Northern Rock, which gradually confirmed its debacle in financial standings. NR believed on growing it business to new horizons in terms of mortgage business, but it ultimately led to its privatization due to extremist business policies in 1997. Then it became a public limited company. The upcoming company’s strategies were experiencing a radical change. For example, from the end of 1997 till the beginning of 2006, the financial balance sheet of the company increased to more than six times the credit that the company had in pre-1997 period. The then bank’s CEO said in 2008 that the bank’s assets had increased to more than 25% since the last 17 years, which he considered a great achievement for the institution. Then, the bank completed adopted a new approach in terms of changing the structure of its liabilities so that they could sustain higher growth in their assets. The initiation of ‘originate and distribute model’ in 1999 was a crucial step undertaken by the bank, as it started giving loans or purchasing shares from the specialized brokers. The bank then used to transfer the capital to the SVPs which used to package them into the CDOs for selling them to the other investors. ‘Granite’ was the vehicle initiated by Northern Rock and 50% of its funding was provided by NR for the purpose of securitizing notes. The bank also initiated a new funding strategy in 2004 in which it used the covered bonds to meet its growing growth funding needs. Limited Liability Partnerships (LLP) were employed to meet this kind of securitization plan, whereas the old funding sources were shattered. The LLP method is still being used by the bank to date and the main benefit they are getting from LLP is their holding of the assets as well as their authority to issue the covered bonds to other lenders that are secured against them. The officials of NR consider this highly secure approach in terms of investment as they are seeking the main advantage of such financial gains in terms of their linkage with the LLP that will be only coming into force when the bank has become defaulted. On the one hand, the bank once again was experiencing a rapid growth in its finance in terms of wholesale funding but on the same track and in parallel grounds, the officials and investors in the bank were experiencing a decrease in the overall ratio of retail deposits. Therefore, the total retail deposits actually declined to 22.4% in 2006 which were basically 62.7% in 1997, considered on the overall proportion of the total equity and liabilities. The main advantage of ‘originate and distribute’ model that the bank established was its capability to save the capital, enhancing its lending portfolios, as well as sustain its profitability, and all these benefits gained in agreement to the following the capital regulation of the bank. At the same time on the other end, the method of securitization reduced the authority of the bank’s officials to monitor the borrowers. Therefore, securitization led to spread the risk as well as tended it to rise. Theoretically speaking, a bank loses its reputation and standing by first transferring loans that are not included in the balance sheet, and then failing to check and monitor the loans granter to different borrowers. The bank will also assume a loss to its reputation if is consistently overstating their quality and credibility to return money. The debacle of Northern Rock is therefore mainly due to the adoption of extreme business models of mortgage banking. The mortgage banking mainly funded its loans through the wholesale market rather than from retail deposits. As a result of that, it forced the market to liquidate and to make it to come into a vulnerable position. Additionally, the Northern Rock Securitization plan funded a very fast growth lending. In 2007 year’s first half, the money lending had increased up to 31% as compared to the first half of 2006 year. This developed many doubts in the quality of lending pursued by NR. The reasonable doubts were in terms of the quality of lending that strengthened a huge growth in early period of 2007. Another main reason of the collapse of Northern bank might be the similarity in the business models adopted by NR and other subprime leaders in America and Europe. NR was considered as the victim of its own policies that led to drag the institution into the subprime crisis, as well as the consequent upheaval in the uncertain situation due to which the liquidity period was extended. But the US banks experienced a credit shock and not the liquidity issues when they were facing the subprime crisis. The event of the subprime crisis swiftly brought up the issue of asset-backed securities as well as other structured-credit products which were seized by a large number of financial institutions around the world. NR case represents the exact flow of the policy ‘originate and distribute’ that was adopted by many financial institutions in the world. Other banks, however, escaped before getting defaulted, but NR dragged this model through the end. The extreme case of Northern Rock in this regard presents many repercussions that were expected from the model. Lending three pounds, and asking for one pound for collecting that into deposits, NR was strongly opposed for this approach and was later exposed to the risk of the dire disturbances into the wholesale market. In terms of the traditional banking, the ‘originate and hold’ model was comparatively a successful approach which was also adopted by the NR before ‘originate and distribute’ model. According to the former, the banks used to transform money, extend its maturity, and then used to create its liquidity value. In return, the liabilities for the banks were short term and they only comprised of the deposits that were actually repayable whenever the lenders were demanding, and also the assets owned by the banks were hold for a long term period. The last characteristic was directly associated with the private and secret information and contents the bank held for loans compared to the market financing. This was the reason that the bank assets were considered more secure and safe compared to the many non-financial institutions. Normally, we do not see much of the difference in the balance sheets of banking and non-banking institutions, but whenever the bank experiences a weakened confidence in its ability to make the payments, it has the authority to withdraw funds from the deposits and therefore can survive from the liquidity problems they could face in another case. Another failure the Northern Rock experienced was the bank’s inability to face the liquidity problems with a proper solution, as the bank not only dried up in terms of market finance, but also its materialization as a bank run. The UK deposit insurance scheme helped the bank to recover its liquidity issues but the results were inadequate to solve out a big crisis with simple reforms. This might also blame the UK deposit insurance schemes to be not properly designed as they must have been specialized in reforming or forming the policies that could save a bank from going defaulted. Those schemes actually did not avert the establishment of the long queues of the NR branches. The failure of a bank is a completely different case compared to a company getting failed to operate. And there can be many aspects that can be organized for providing a justification of the exemptions of banks from the general corporate insolvency law as well as banks’ inability to administer the insolvency proceedings which must be under the control of the regulators. So the inability of these laws to make the banking institutions bound to follow them as well as to do their operations under some limits might prevent NR from first getting defaulted, and then getting privatized. The Northern Rock bank’s crisis is a continued series of liquidity events as well as flawed policies that led the institution to get privatized and then going under the control of public. The NR is a type of extreme school case that might be taught as an exceptional case study to the business students. The bank’s previous policies, decisions, and consistent failures lead to other banking regulators as well as many central banks to review their policies, especially those who are potential lenders. The case has also given rise to another economic characterization called banking disintermediation. The lessons that banks can draw from the NR debacle are not limited to just the banking institutions in UK rather they are equally applicable in US as well as in other countries where the mortgage business and finance is going on. Apart from the other failures, the NR collapse strongly highlights the inadequacies of most of the European financial analysts and directives whose predictions as well as the sufficient constraints on national level were disproved through the terrible experiences everyone saw in the financial world of UK. The whole European financial community must admit the failure of the financial collapse the Northern Rock faced, as the institutions might help NR in the reorganization of the NR through crediting the bank. Cross-border linkages of banks is also a concern that has to be discussed here, as NR is a leading bank in UK and there are several banks in European Union which had been running the same policies related to mortgage business and finance. The other countries’ financial institutions must have come up and assist the NR to come out of the crisis to avoid the complete and sheet debacle. The NR case teaches all of us the complexities one can face even in the financial issue, and such a case was difficult to handle, but for future reference, we can get help from this case about what solutions are more feasible and how the crisis can be worked out. Another issue that is worthy to be discussed is the future of the Northern Rock, i.e. what is going to happen next, and it is important to be discussed as the banking history of NR has always been controversial one. One lesson that this crisis can teach to the financial institutions is that what type of lending model or policy will now be adopted by the banks, i.e. either ‘originate and distribute’ or ‘originate and hold’. And also, what kind of consequences could be faced if again the former policy and model is adopted. The main concern that the NR management must think about is the approach that is going to be adopted for lending money in post 2007 period, as the bank has experienced the application of both the models and has been more successful in the latter one. But the last two years have seen the NR going back to the status quo financial position as the bank is again pursuing the same extremist policy as was the case in pre-1997 period. Finally, the focal lesson and implication of the crisis is the reflection of a set of changes in the western financial system as well as in the society. The impact of NR as a main stream money lender has not been quite the same as it was in the pre-1997 era. But still there are people who consider Northern Rock as the most established institution that can lend money to most number of borrowers. The main lesson other banks should also learn from the NR should be the reformation and re-establishment of the institution even after its sheer decline and that is a landmark achievement. References: Benston G. and Kaufman G. (1998), Deposit Insurance Reform in the FDIC Improvement Act : the experience to date, Federal Reserve Bank of Chicago, Economic Perspective. Boeri T. and Guiso L., 2007, Subprime crisis: Greenspan’s legacy http://www.voxeu.org/index.php?q=node/488 Calomiris Charles W., 2007, Not yet a ‘Minsky Moment’, http://www.voxeu.org/index.php?q=node/739 Eisenbeis and Kaufman, 2007, Why a run on Northern Rock but not Countrywide? http://blogs.wsj.com/economics/2007/10/18/why-a-run-on-northern-rock-but-not-countrywide/ Hüpkes E, 2003, Insolvency –why a special regime for banks”, Current Development in Monetary and Financial Law, vol 3, Washington D.C., International Monetary Fund. Read More