Northern Rock

Introduction

As Britain's fifth largest mortgage bank, Northern Rock faced funding and management difficulties which is led by increased pressure among banks to sell, pushed down prices, and impacted the market for interbank loans due to the global market liquidity squeeze for securities happened in 2007. Hence, Northern Rock's difficulties arose on account of its inability to manage its credit risk and liquidity risk. This report will present an analysis relations between investment and commercial activities of Northern Rock and interest in bank operation strategies, rely on analyzing the problems about inability in managing its credit risk and liquidity risk. It will also outline its rescue and reforms by the UK Government and financial authorities towards the end of the same year and the beginning of 2008 such as tripartite regulatory system, Treasure, the Financial Services Authority (FSA) and BoE operates.

Findings

1. Development Background

Northern Rock described itself as a "specialised lender, whose core business is the provision of UK residential mortgages funded in both retail and wholesale markets". Northern Rock's assets increased by 20% plus or minus 5% for the last 17 years. (Treasury Committee Report 2008)

To sustain high grow in assets, it changes the structure of liabilities to originate loans or purchases them from specialized brokers adopting an "originate-to-distribute" model(appendix 1) of funding and transfers them to Special Purpose Vehicle and package into collateralized debt obligations to other investors, a process known as "securitisation". Thus a new entity was called Granite, which was their securitisation vehicle. Besides, to meet funding needs, in 2004 Northern Rock turned to covered bonds as a new funding strategy by using Limited Liability Partnership to fund assets and transfer risks so as to be a more secure investment to investors. Hence, investment and commercial activities of Northern Rock would have good effects on and motivate more interest in bank operation strategies.

However, the conflict between commercial activities and interest in bank operation strategies existed since the difficulties happened in 2007. In 2006, there is a parallel decrease in ratio of retail deposits in its wholesales funding, resulting that total liability and equity, retail deposits and funds decreased from 62.7% in 1997 to 22.4% in 2006 (appendix 2). The pressure of squeeze in global market liquidity for securities in 2007 has increased among banks to sell, make prices drop, and impacted the market for interbank loans, leading to a funding gap at Northern Rock. (Annual Report, 2007)

FSA stated that the entity was functioning normally. The overall funding of NR was comprised of: 50% securitisation with an average life of 3 ½ years; 10% was covered bonds with an average life of about 7 years; 25% wholesale borrowings, from which half had a duration no longer than one year and the other half less than one year. While the wholesale funding of NR grew, there was no corresponding growth in its retail funding. Retail deposits and funds fell significantly comparing to other banks that were previously building societies: from 62.7% at end-1997 to 22.4% at end-2006. (Annual Report, 2007)

2. Reasons of failure in Northern Rock

Theoretically, the model of originate and distribute allows bank to save capital, increase lending portfolios and sustain profitability. While securitization can reduce incentives to monitoring borrows. (appendix 3)

The failure of Northern Rock, while a failure of its own Board, was also a failure of its regulators.

The debacle in Northern Rock is due to extreme business model of a mortgage bank, which is funding loan books on wholesales market，identified by the Treasury Select Committee, resulting at markets' liquidity squeeze with strong vulnerability.

Besides, fast growth lending funded in securitization. The loan book became concerned as the increase of 31% in lending from 2006 to 2007. It is similar with American subprime lenders.

FSA did not supervise Northern Rock properly. It did not allocate sufficient resources or time to monitoring a bank whose business model is an outlier. FSA remained passive in this situation that share prices fall by aggressive and risky strategy of expanding market share due to despite warning signals on the vulnerability. (appendix 4)

the systemic risk support operation have not be prepared adequately by the Tripartite authorities. The Tripartite arrangements need clear leadership structures or strategies for effective communication with the public. (appendix 5)

Therefore, Northern Rock is a self-designated victim of subprime crisis and has uncertainty subprime rise that caused illiquidity. Uncertainty, which is due to inherent structure of securitization, causes market illiquidity in financial instruments and funding illiquidity .

3. Strategy for rescue of Northern Rock

When there is not sufficient funding from the wholesale markets, it can seek emergency liquidity assistance from the Bank of England (BoE). The authorities have funding arrangements to take strategic decisions about firm's future.

Besides, there is a three-fold strategy taken by Northern Rock and the Tripartite authorities to salvage from difficulties which are as below.

Take measures by own in short-term money markets and by securitizing its debt to resolve its liquidity crisis which was pursued until abandoned on 10 September.

Find a takeover by a major retail bank. There are two types of proposals: 1) invest in the company through an injection of assets and new capital; 2) acquire parts of the business or assets. However, the conflicts inhibited the solution which is from Northern Rock and the Tripartite of the support facility requested by the potential bidder.

Receiving guarantees from government such as a support facility from the BoE and Northern Rock's deposits halted the momentum of the runwhich was raised on 16 August and extended to cover accounts re-opened in the future by those who closed them on crisis. On 18 December the Government granted a further extension of the earlier guarantee arrangements covering nearly all the wholesale deposits.

Taking advantage of the collateral requirements and willingness to adjust the timing of its credit supply to access European Central Bank (ECB) funding, which is more generous than BoE's. Northern Rock should make use of this liquidity via its operation in Ireland. (ECB)

Take a covert support operation by the BoE