Northern Rock Term Paper

Topics: Subprime mortgage crisis, Asset, Bank run Pages: 20 (6704 words) Published: September 25, 2011
The Case of Northern Rock

Table of Contents
1 Scope of Study3
2 Introduction to the Northern Rock Debacle3
2.1 Introduction to Northern Rock’s Business Model4
3 Internal Analysis7
3.1 Analysis of Northern Rock’s Balance Sheet 20067
3.1.1 Northern Rock’s Sources of Funding7
3.1.2 Asset and Liability Maturity Mismatch 20068
3.1.3 Peer Group Ratio Comparison to Assess Northern Rock Liquidity Risk 20069
3.2 Exposure to Low Probability High Impact (LPHI) Risk10
4 Analysis of Market Condition10
4.1 U.S Sub-prime Mortgage Market Crisis10
4.2 Consequences of U.S. Sub-prime Mortgage Market Crisis11
4.3 Impact on Northern Rock12
5 The Collapse of Northern Rock13
5.1 Bank Run13
5.2 Nationalization of Northern Rock14
5.3 Insufficient Due Diligence14
5.4 Inaccurate Business Forecasts15
6 Ineffective Depository Insurance Scheme15
7 Regulators’ Role in Northern Rock’s Failure15
7.1 Financial Services Authority (FSA)16
7.2 Bank of England (BoE)16
7.3 Basel II Liquidity Framework17
8 Aftermath of the Crisis17
8.1 Restructuring of Northern Rock into Two Entities17
8.2 Introduction of Basel III18
9 Lessons Learnt18
9.1 For Regulators19
9.1.1 Instilling Market Discipline19
9.1.2 Closer scrutiny for systemically important banks19
9.1.3 Vigilance in pre-empting potential market developments and risks19
9.2 Bank Managers20
9.2.1 Awareness of business model and risks undertaken20
9.2.2 Effective Crisis Management Plans In Place20
9.2.3 Incentive Schemes to Discourage Excessive Risk Taking20
10 Conclusion21
11 Bibliography22

1 Scope of Study
On the 14th of September 2007, Northern Rock became the first United Kingdom bank to experience a bank run in 150 years(British Broadcasting Corporation, 2007). This study seeks to investigate the reasons behind the bank run and the ensuing aftermath of the Northern Rock debacle, with a specific focus on the liquidity risk faced by the bank due to its extreme business model. In addition, we look at the regulatory failure factors from the different governing bodies, which might have exacerbated the situation. Finally, we conclude with the lessons learnt from the Northern Rock debacle, which bank managers of today can take away to prevent a liquidity crisis of this scale from occurring again.

2 Introduction to the Northern Rock Debacle
Northern Rock became the first bank in U.K. to suffer a modern day bank run after approaching the Bank of England for emergency funding, to replace money market funds, during the recent credit crisis in 2007. The bank run, coupled with the deteriorating market conditions and Northern Rock’s extreme business model, led to the collapse and nationalization of the bank, with huge ramifications to the financial market.

The Northern Rock debacle happened in a few stages, commencing with Northern Rock’s business model, which was deemed very aggressive and extreme in nature, as they had a high wholesale funding ratio. However, it served Northern Rock well for 10 years between 1997 and 2006, propelling it from obscurity to prominence in a short span of time, a remarkable feat for a building society.

However, the US subprime crisis boiled over to the global financial markets which affect liquidity in the market resulting in a global credit freeze. This affected Northern Rock more than any other bank due to the nature of their business model which relied on short term wholesale funding. With uncertainty and cautiousness setting in, Northern Rock found difficulty in selling its new issue of mortgage securitizations which was suppose to bring in fresh funds for its long term obligations.

With the payment deadline creeping in, Northern Rock had no other choice but to approach the Bank of England for a loan facility to replace its money market funding. This resulted...
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