Northern Rock was also running a large interest rate risk. More specifically, the mortgages issued by the Northern Rock were linked to the base rate whereas the funds it obtained were linked to the 3-month London Interbank Offered Rate (LIBOR) (Shin, 2009). But LIBOR rose faster than the base rate, resulting an increase in its refinancing costs and decrease in its profitability (ibid).
In addition, the bank’s management failed to consider in its stress testing the possibility of a system-wide liquidity crisis, as the bank claimed that is was an unforeseeable event, and thus, has not taken any liquidity risk insurance (Marshall et al., 2011). The press then pointed it out as an operational failure, blaming Northern Rock for its poor contingency plan to cover the liquidity shortage (Cimaglobal, 2017).
CONSEQUENCES
As market conditions continued to deteriorate, Northern Rock could not securitise the mortgages that it has prepared to execute in September 2007, and was therefore, stuck with mortgages worth several billions of pounds (Docherty and Viort, 2014). When all sources of its funding dried up, Northern Rock was forced to seek the BoE’s liquidity support. However, the news that the BoE is providing an emergency liquidity support to Northern Rock was leaked by the media before it was officially announced and caused the retail depositors to queue outside its branches (Docherty and Viort, 2014 and Shin 2009). In just 3 days the depositors withdrew around £3 billion, which accounted for 11% of the total retail deposits (Llewellyn, 2009). As a consequence, the BoE was forced to exercise its safety net by acting as a Lender of Last Resort (LLR) and guaranteeing deposits (Eisenbeis and Kaufman, 2009). Additionally, the BoE injected £10 billion into the money markets and widened the range of assets it accepted as a collateral for its discount loans to banks (BBC News, 2008).
Following that, the share price of Northern Rock plunged in value by more than 90% and was valued at nil in the end (Docherty and Viort, 2014). On top of that, it suffered from reputational loss, downgrade in its credit rating and made thousands of its employees redundant (BBC News, 2008 and Cimaglobal, 2017). Moreover, it reported a loss of £1.4 billion in 2008 as a result of massive mortgage loan (which occupied around 90% of its total assets) write-offs associated with its “Together” mortgage, which allowed borrowers to borrow up to 125% of their home value (Onado, 2009 and BBC News, 2009). The BoE eventually nationalised Northern Rock in 2008, split it into a ‘good’ and ‘bad’ bank in 2010, and sold the good‘ bank to Virgin Money in 2012 (Docherty and Viort, 2014).
The most immediate result following the failure of Northern Rock was that it has become more difficult to get mortgages as other banks increased their risk-averseness by reducing their mortgage lending and Loan-to-Value (LTV) limit (Eley et al., 2017).
LESSONS TO BE LEARNED
Northern Rock was one the several banks to fail as the wholesale liquidity market froze and the demise of Northern Rock exposed major flaws of its business model and internal operations, and revealed the weaknesses of the traditional banking regulation and the way regulators act in times of market turmoil. In particular, the failure of Northern Rock taught us several lessons of which briefly outlined below.
Firstly, it seems that the collapse of Northern Rock was partly due to the negligent supervision and over-delegation of the work by the Financial Services Authority (FSA) to fully review the risky business profile, inadequate liquidity and weak stress testing of Northern Rock since they were busy focusing on other matter such as the implementation of Basel II. Such misconduct by the FSA allowed Northern Rock to misreport its financials and therefore attract more funds from investors who believed in its reports (BBC News, 2010). Moreover, despite the Moody’s warning of potential risks related with wholesale market disruptions of which some British banks were exposed to and falling profits of Northern Rock, the FSA not only did not halt Northern Rock from announcing increased dividends or restrain its excessive asset growth, but also ignored its breach of required minimum capital in early 2007 (Onado, 2009; The Economist, 2017; Docherty and Viort, 2014; and Eisenbeis and Kaufman, 2009).
Secondly, when the market liquidity gets squeezed, the only type of funding that is available to banks is the central bank’s liquidity support, and thus, it is the duty of the central bank to step in promptly, provide an emergency lending and restore the confidence in the banking system but the BoE failed to take actions in a timely manner as it was concerned with the moral hazard problem that could result in if obtaining an emergency funding is seen as easy. It stepped in only after the news broke out in September and depositors started to run. If the regulators had acted within short time periods and taken prudential steps well before, especially when Northern Rock reported to the FSA and BoE of its funding problems in early August, the damage could have been less.
Thirdly, at the time of the run, the UK had a partial-insurance scheme for bank deposits – it guaranteed 100% of the first £2,000 but only 90% of the next £35,000 (Eisenbeis and Kaufman, 2009). Hence, the incentive of depositors to withdraw their money was strong because they did not really feel the full protection of it. Given this partial insurance model and the reaction of depositors to it, the Northern Rock’s episode shows that unless all depositors are fully insured there will always be some depositors who are expected to incur losses and therefore run on the bank should their bank get into a trouble. Had the depositors believed that they would neither incur losses nor lose access to their deposits, the probabilities of them running could have been smaller. Hence, the deposit insurance scheme needed to be designed in a way such that all depositors are fully covered, have full access to their deposits and are paid out quickly.
Finally, before the onset of the financial crisis, it was evident that regulators focused too much on capital adequacy to the point that the liquidity regulation was left behind. But, liquidity is as important as capital for the long-term viability of the bank as illiquidity can turn a solvent bank into an insolvent one once depositors start to run. Clearly, the run on Northern Rock at the time of the crisis has proved the absence of liquidity requirements in Basel II framework as detrimental. Furthermore, the fact that Northern Rock funded its long-term assets using short-term and non-retail borrowings made it extremely vulnerable to a liquidity shock. Even when Northern Rock sought to diversify its funding base globally, the fact that the market liquidity had evaporated all around the world suggests the need for banks to rely more on long-term and retail borrowings, invest in more liquid asset holdings; and for regulators to put more emphasis and supervision over banks’ adequacy of liquidity.