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Author: Martin Upton

Northern Rock: a business model unravels

Updated Thursday, 8th November 2007

Martin Upton analyses the factors that led to the Northern Rock crisis.

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Financial institutions have to manage a cocktail of risks. Foreign exchange risk, interest rate risk, credit risk and operational risk can, if poorly managed, dent profits and attract adverse headlines in the press. But what is most feared is liquidity risk - the risk that a bank cannot adequately finance its lending activities.

In September Northern Rock - a bank formed by the conversion of the Northern Rock Building Society to banking status in 1997 - found out the realities of a liquidity crisis with their customers queuing to withdraw their savings. This followed news that the bank had been forced to go ‘cap-in-hand’ to the Bank of England, the ‘lender of the last resort’, for an emergency loan. This was the first ‘run’ on a UK bank by its depositors for more than 150 years. Northern Rock cash machine A Northern Rock cash machine

The immediate cause of the crisis was the drying up of liquidity in the global institutional debt markets - known as the ‘wholesale’ markets - following a rise in mortgage defaults in the US. These defaults were concentrated in ‘sub-prime’ mortgages - home loans to borrowers with a poor credit quality. These events made financial institutions reluctant to lend to each other since no-one was entirely sure how much exposure each had to the losses arising from the impaired US mortgage market. Inevitably with the shortage of liquidity the cost of money - interest rates - was driven upwards. In the UK, money market rates rose to close to 7% despite the fact that base rates were still at 5.75% (normally money market rates are very close to the prevailing level of base rates).

The reactions of the UK and US Central Banks were starkly contrasting. In the US, the Federal Reserve Bank pumped billions of dollars into the markets to restore liquidity. Additionally it prompted the Bank of America to take a stake in the troubled home loan company, Countrywide, thereby averting the risk of its collapse. In the UK the Bank of England was less interventionist and only offered limited support to the beleaguered markets.

But of all the financial institutions in the UK why did the Northern Rock turn out to be most vulnerable to the shortage of funds in the wholesale markets? Here we need to examine the underlying causes of the crisis.

Northern Rock was becoming more and more reliant on the wholesale markets

Recently the Northern Rock had been building up its mortgage portfolio very rapidly, with growth of 12% in the first half of 2007. Simultaneously it was becoming more and more reliant on the wholesale markets for finance, with 70% of its funding coming from this source. By contrast only 27% of its finance came in the form of ‘retail funds’ from personal savers. Additionally, like many other banks, the Northern Rock had been parcelling up their mortgage assets and placing them into ‘special-purpose’ companies. These companies raise funds in the wholesale markets to finance the mortgages by issuing ‘asset-backed securities’. By operating in this way banks are able to boost the amount of lending they are able to undertake. Northern Rock engaged extensively in this activity through its ‘Granite plc’ companies.

Building the mortgage portfolio using this approach is fine so long as the global financial markets are operating smoothly, with funds readily available, and the borrowing institution remains creditworthy. But with the drying up of liquidity in the wholesale markets the Northern Rock’s business model began to unravel.

Compare the Northern Rock’s position with that of the building societies who are legally unable to fund more than 50% of their business from the wholesale markets. The rest has to come from personal savers. Indeed the largest building society, the Nationwide, has a wholesale funding ratio of only around 30%. So as funds became scarcer in the wholesale markets the Northern Rock found itself in an exposed position and was unable to fund its mortgages and loans.

The crisis also exposed the maturity mismatch that banks and building societies have to manage. Most of their funding - be it retail or wholesale - is short term in nature and either matures or can be withdrawn by investors within months. By contrast mortgage advances are usually for long term periods of up to 25 years. This mismatch helps to generate profits since short term borrowing is cheaper for the banks than long term. But it comes with the risk of a liquidity crisis if those short term funds become scarce. Even with the store of liquidity that the Northern Rock was required to retain to accommodate possible outflows of savings, the high wholesale funding ratio and the subsequent ‘run on the bank’ by personal customers, when news of the emergency loan from the Bank of England materialised, were enough to send the Northern Rock into financial submission.

All this happened despite the fact that there is no evidence that the credit quality of the Northern Rock’s assets - its mortgages and loans - is in question. It currently has relatively low levels of both arrears and property repossessions. Despite some fears that house prices in the UK are currently overvalued, house price inflation remains close to 8% p.a. So what we are looking at here is not a credit crisis in respect of Northern Rock’s assets - rather an inability by the bank to fund those assets.

In response to the crisis the Chancellor of the Exchequer, Alistair Darling, announced that customers of the Northern Rock would have their savings guaranteed by the Government. This move effectively ended the ‘run’ on the bank. Subsequently he announced that the maximum investor protection for all UK savers would be raised from £31,700 to £35,000.

The whole episode has raised questions about the operations of the Bank of England. Critics say it moved too slowly to deal with the growing lack of liquidity in the financial markets. Would it also have been wiser not to disclose publicly the loan deal for the Northern Rock - since disclosure resulted in the collapse in the confidence amongst Northern Rock’s customers? The role of the Financial Services Authority (FSA) has also come under scrutiny. Did it fail to identify the scale of the financial risks being run by the Northern Rock with a business model that was so dependent on there being no disruption in the wholesale markets?

As for the Northern Rock, with its once respected brand in tatters, with the emergency Bank of England loan now totalling £16 billion, with its credit ratings cut and with its share price down by over 80% since the start of the year the bank is now prey to predators looking to make an acquisition.

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