The Failure of Northern Rock in the Light of Banking Economics and Regulation

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The Failure of Northern Rock in the Light of Banking Economics and Regulation

Increasing global connectivity and integration in today’s world ensures that almost any serious problem has worldwide ramifications. The global financial system can serve as a key example of this phenomenon. Very recently, Britain’s fifth-largest mortgage lender Northern Rock was rescued by emergency funding from the Bank of England. This made the Newcastle-based firm the highest profile UK victim of the global credit crunch that had been triggered by the sub-prime mortgage crisis in the US. The bank run on Northern Rock that followed was unprecedented in recent UK monetary history. The Overend Guerney crash of 1866 was the last recorded bank run in the UK, before Northern Rock lost over £2 billion, starting on the 14th of September 2007.

The run on Northern Rock can be considered as the most vivid indication of the contagion that consumed the financial markets around the world. The company did no overseas lending. Nevertheless, the spill-over effects of the failing US mortgage market sealed the fate of the company when the money markets that Northern Rock had depended on for years crashed at the start of August 2007.

The sub-prime mortgage market crisis started in the United States in the fall of 2006 and took hold as a global financial crisis by July 2007. Due to innovations in securitization, the risks from these sub-prime mortgages had to be shared more broadly with investors which essentially led to the ripple effects in the world-wide economy. The mortgages are generally repackaged into a variety of complex investment securities which are bought by institutions to diversify their portfolios. In the case of the US sub-prime mortgages, European banks bought the securities that were based on these mortgages, without any real understanding of the risks they were running. The crisis broke in August when French bank BNP Paribas suspended three of its investment funds with exposures to the troubled US sub-prime market. Since it was believed that many banks had invested in similar securities, many banks felt that they did not know enough about the solvency of the banks to which they may lend to and how much losses they had suffered as a result of their exposures in the impaired US mortgage market. Subsequently, the lending on the inter-bank market came to a halt.

Northern Rock’s Business Model
Although all banks were facing greater than normal difficulties in acquiring funds given the lack of credit that was available on the global institutional debt markets, Northern Rock was hit harder than most. Its core business was, and still is, residential mortgage lending. Northern Rock was the biggest provider of mortgages in the UK in the first half of 2007. It sold up to 19% of all new mortgage policies during that time. However, it had a comparatively smaller deposit base meaning that most of its funding came from sources besides deposits from ordinary retail customers. Famously, seventy-five percent of its funding came from the wholesale money markets and just twenty-five percent from retail funding. Additionally, like many other banks, Northern Rock extensively engaged in packaging many of its mortgage assets into special purpose companies and raised funds in the wholesale market by issuing asset-backed securities. This business structure of Northern Rock’s made it particularly more vulnerable to liquidity risk and to changes in the wholesale money market conditions. The near collapse of inter-bank lending in August effectively starved the bank of funds and Northern Rock found itself unable to fund its loans and mortgages.

The liquidity crisis also exposed the maturity mismatch that most banks have to manage, especially those who are specialist mortgage lenders. Most of the funding- be it wholesale or retail- is short-term in nature and matures, or can be withdrawn by investors, within a few months time....
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