Northern Rock Bank and Financial Instability

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Table of Contents

Introduction
Lender of last resort
Northern rock and the FSA
Failure of prudential supervision
Conclusion
References

Introduction

Northern Rock is a bank operating under the umbrella of Virgin Money in the United Kingdom. It was established in 1965 and 30 years down the line, it had acquired approximately 53 building societies in England.

Over the years this bank was being considered as one of the top lenders in the UK, especially in relation to mortgages. Prior to 2007, Northern rock had an investment plan which was to result in securitization.

This according to Milne & Wood involved “borrowing heavily in the UK and international money markets, extending mortgages to customers based on this funding and then re-selling these mortgages on international capital markets” (518).

This, however, failed in 2007, when, owing to the global financial crisis, the demand for credit facilities from investors went down and Northern Rock was unable to pay back the credit it had obtained from the money markets.

Lender of last resort

This is a facility that allows banks to survive a financial crisis. It is mostly offered by the central bank. When Northern Rock was faced with the liquidity crisis in 2007, it looked up to the Bank of England for emergency support but this was not possible since it could not provide the facility.

Many scholars, including Vesala (2006), Herring (2007), and Shin (2009) blame the situation in Northern Rock to the inability of the Bank of England to act promptly indicating that had it performed its role as a lender of last resort, the bank run would have been avoided.

In fact, Shin indicates that “in its role as a lender of last resort, the Bank of England had been able to exert significant moral suasion over the banking sector, and the discount office was able to obtain information from banks on a purely informal basis” (2009,p.103).

Other scholars believe that the Bank of England failed to act because Northern Bank had not provided it with sufficient information concerning its discount facilities. They also argue that the management of Northern Rock failed to heed to liquidity warnings and this acted as a hindrance when they needed assistance.

These claims are, however, refuted by Freixas et al (2009). He asserts that a central bank is expected to perform its role irrespective of the actions of the other party (151). He states that “even when the central bank does not have the formal statutory responsibility for banking supervision, it can still obtain the information it needs to act as lender of last resort” (2009,p.152).

Kane (2008) believes that the Northern rock issues exposed the faults in the government with regard to dealing with financial crisis. These faults include “the workings of emergency liquidity assistance, some others the workings of deposit insurance and some others the insolvency and pre-insolvency arrangements” (2008, p.50).

All these boil down to the functions of the Central bank as a lender of last resort. Financial crises in banks are one of the greatest challenges in most economies, since failure of banks spells out a failure in the entire economy. Liquidity lending is therefore considered to be an important factor since it is usually the solution to most banks going through a crisis.

Some of the instruments available to governments dealing with financial crises include “the central bank’s role as a lender of last resort, deposit insurance schemes, government’s policies to shield depositors’ insolvency laws, among other preventive measures” (FSA internal Audit division, 2008, p. 39).

Despite all the other actions, the lender of last resort factor is the most effective since it provides the banks with the credit facilities to continue with their operations promptly.

Prior to the crisis, Northern Rock was a successful institution though not influential to the point of thinking its failure would affect the economy in any way. This issue however attracted the attention of many financial analysts since it brought out the weaknesses of the Bank of England in dealing with crises faced by the banks.

Due to this exposure, the government made a commitment to offer the required liquidity, and this worked since the bank run in Northern Rock stopped instantly. House of Commons (2008) therefore made a conclusion from this issue that the run would have been avoided all together, if all parties had been playing their roles effectively.

This can, however, not be blamed on the Bank of England since it had not dealt with such an issue in the recent past. The activities in relation to acting as a lender of last resort were rarely carried out, hence the policies were outdated. This explains why the situation caught all relevant bodies including Northern Rock itself by surprise (House of Commons, 2008, p. 23).

Northern rock and the FSA

In the view of financial analysts, the crisis that hit Northern Rock in 2007 was predictable and some even argue that the crisis was not related to the activities of Northern bank per se. It is believed that the Financial Services Authority (FSA) played a major role in this.

An article by Bank of England (2007) made an observation that FSA had given Northern Rock warnings concerning “the evolving trends in the market which included; sharp asset growth, systemic underpricing of risk, and the risk shifting characteristics of new financial instruments which would not be as water tight as they appeared to be” (2007,p. 2).

FSA also indicated that the strategies being used by Northern Rock were unstable since they were depending on large scale market funding; hence, placing the institution in a risky liquidity position.

Besides this, FSA had also made an observation in the government’s regulatory system which it claims had a number of loopholes that exposed the financial institutions to issues similar to those of Northern Rock.

These, according to FSA (2008) included “a fundamental flaw in the depository protection scheme, lack of established special bankruptcy regime for banks, lack of predictable resolution regime for handling troubled banks and the existence of an institutional structure of financial supervision that separated responsibility for systemic stability and lender of last resort from prudential supervision of individual banks” (FSA, 2008, p. 33).

Owing to the financial stability that had been witnessed in the region over the years, these observations seemed not to be having any ground, until the real risk was witnessed in Northern Rock, and this acted as a wakeup call to FSA.

At the beginning of 2007, FSA considered Northern Rock as one of the best performing financial institutions in the UK. What it failed to realize at that time were the mortgage risks that it was exposed to owing to the fact that the institution dealt mostly with international investors.

This risk was brought about by the financial crisis that was being witnessed all over the world during that period. Observations made later on indicated that “by mid-September, it had become apparent to Northern Rock that longer term funding markets were closed to it.

Rollovers were largely continuing but at shorter and shorter maturities and Northern Rock lacked the option to draw on sufficient prearranged contingency liquidity lines of credit and did not benefit from a third party injection of capital” (FSA, 2008,p. 34).

Due to this, FSA made an endorsement indicating that the Bank of England was deemed to provide liquidity facilities to all the banks that needed this kind of support in the UK, including Northern Rock.

This crisis mainly focused on three institutions, the Bank of England, the treasury and FSA, owing to their joint responsibility of ensuring stability in the financial sector.

FSA is blamed for permitting Northern Rock to raise its dividends irrespective of the already messed up financial position.

An article by FSA Internal Audit Division (2008) supports these allegations by indicating that, “in in their own internal audits of the experience and compilation of the lessons learned from the Northern Rock failure contained a broad list of problems within FSA which included lack of rigor in the analyses conducted and failure to devote insufficient resources to monitoring what are regarded as high impact situations” (Audit Division, 2008, p. 42).

This report indicates that the major issues that led to this failure included organizational shortfalls, lack of sufficient skills in the supervisors, and poor methods of supervision, especially in large institutions operating at international levels.

From the discussion, it is clear that FSA was in a position to save Northern Rock from the downfall, had it acted on the early signs. In fact, financial researchers such as Milne & Wood (2008), Shin (2009) and Herring (2007) indicated that FSA devoted little time to the process of checking the level of stress tolerance in Northern Rock, hence ignoring many factors that eventually worked against the institution.

Shin (2009) specifically points out that “insufficient attention was given to the banks challenging governance programs and risk mitigation processes” (2009, p.110). Herring (2007) concurrently indicates that “FSA not only ignored numerous early warning signs of troubles with Northern Rock, but also ignored a breach of required minimum capital standards early in 2007” (p.10).

Besides these, it was also noted that the bank failed to inform its stakeholders of this failure, and FSA was aware of this, but failed to take action.

From this, a conclusion can be drawn that despite the fact that Northern Rock was responsible for its own peril, FSA also played a major role of not intervening where it would have been and also assuming the warning signs that were so loud and clear.

Failure of prudential supervision

In any financial setup, there are four aspects that need to be considered to come up with a stable financial system. The Bank of England (2007) indicates that “the first aspect is prudential regulation of financial firms, second is systemic stability, third is the lender of last resort role and finally the conduct of business regulation and supervision” (Bank of England,2007,p. 6).

The issue in question especially in relation to the Northern Rock problem is the institution responsible for prudential supervision, whether it is the bank of Europe, the treasury or FSA. Irrespective of the institution responsible, this type of supervision is mandatory in financial institutions, failure to which results in cases such as what was experienced in Northern Rock (Freixas et al, 2007, p. 12).

This conflict on the question of supervision mandate led the government to redefine the roles of the institutions in the financial sector. As a result of this, it was realized that supervision lies with FSA. The crisis in 2007 created the need to develop an official set of organizations and practices for assisting in the recovery of failing banks.

This led to the officiating of a memorandum of understanding between the three bodies, that is, treasury, FSA and the Bank of Europe.

A report by FSA internal audit division (2008) indicated that there were five basic standards that came with this agreement and these were “the existence of a clear division of responsibilities, appropriate accountability arrangements, the avoidance of duplication of responsibilities, exchange of relevant information and mechanisms for crisis management” (2008,p.50).

The causes behind the problem of Northern rock are interrelated to the extent that it is difficult to tell exactly what the main cause of this issue was. However, it was realized that prudential supervision of the banking institution was being conducted in a poor way and this is therefore deemed to be the greatest contributor to the whole problem.

According to the Bank of England (2007) “this institution had been a pioneer in risk based supervision; focusing attention where it is most important” (2007, p. 8). This credit was however withdrawn after the Northern Rock crisis which revealed the poor laid supervision strategies. Many financial analysts believe that FSA was in a position to foresee this situation, long before it occurred.

From this, it is evident that the Northern Rock crisis depicted a high level of failure in the prudential supervision of banking institutions.

These failures according to FSA (2008) include “reliance upon seriously deficient accounting and capital adequacy standards; failure to monitor institutions in a timely, effective, and on-going fashion; failure to intervene appropriately when problems were identified; and promoting the welfare of the regulated institutions and the regulatory agency rather than the insurance fund or the taxpayer” (FSA, 2008, p.43).

In fact, hearings in the House of Commons – a committee responsible for establishing the cause of the problems surrounding Northern Rock, indicated that FSA failed to perform effectively.

House of Commons alleged that this was by way of “failing to monitor the institution and allowing Northern Rock to increase its dividends despite its troubled financial position” (2008, p.23). The supervisory evaluations of Northern Rock conducted by FSA did not put much emphasis on liquidity issues.

Conclusion

From the above discussion of the issues surrounding the Northern Rock problems, it is evident that these problems could have been avoided if all the parties concerned, that is, Northern Rock bank itself, the Bank of Europe and FSA were responsible for the actions that were taken before 2007.

Northern Bank was responsible for the crisis in the sense that it did not perform a long term analysis of its actions. In its operations, it failed to consider the possibility of liquidity risks in the financial market.

Bank of Europe was responsible in the sense that it did not act promptly as a lender of last resort in providing the credit requested by Northern Bank when it started experiencing the liquidity challenges.

References

Bank of England 2007, Financial Stability Report. Web.

Freixas, X, Giannini, C, Hoggarth, G & Soussa, F 2009, ‘Lender of last Resort: a review of the literature’, Financial Stability Review, Vol. 7, pp. 151–167.

FSA (2008) ‘The supervision of Northern Rock: a lessons learned review’, Internal Audit, pp. 32 – 43

FSA Internal Audit Division 2008, ‘The Supervision of Northern Rock’ A Lessons Learned Review, pp. 37 – 56

Herring, R 2007, ‘Resolution Strategies: Challenges Posed by Systemically Important Banks’, lecture at Regional Seminar on Financial Crisis Management, pp. 5 – 16

House of Commons 2008, ‘The run on the Rock’, Treasury Committee, Vol. 1, pp. 23

Kane, E 2008, ‘Regulation and supervision: an ethical perspective’, Principles v Rules in Financial Regulation, Vol. 2 no. 5, pp. 48 – 56

Milne, A & Wood, G 2008, ‘Banking Crisis Solutions: Old and New’, Review (Federal Reserve Bank of St Louis), Vol. 1 no. 2, pp. 517–530.

Shin, H 2009 ‘Reflections on Northern Rock: The Bank Run that Heralded the Global Financial Crisis’, Journal of Economic Perspectives, Vol. 23, No. 1, pp. 101–119

Vesala, J 2006, ‘Which Model for Prudential Supervision in the EU’ Monetary Policy and Financial Market Stability, Vol. 10, No. 1, pp.99-105.

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