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

their exposure to the weakened US mortgage market. This was due to a belief that numerous banks had invested in comparable securities, resulting in a cessation of lending on the inter-bank market. Northern Rock was hit harder than other banks because its business model focused on residential mortgage lending, which was significantly affected by the lack of credit in global institutional debt markets. In the first half of 2007, Northern Rock accounted for up to 19% of all new mortgage policies sold in the UK as it was the biggest residential mortgage provider at that time.

Despite having a smaller deposit base, Northern Rock relied heavily on wholesale money markets for funding, with only 25% coming from retail sources. Similar to other banks, Northern Rock packaged mortgage assets into special purpose companies and issued asset-backed securities to raise funds in the wholesale market. However, this structure made the bank susceptible to liquidity risk and changes in the wholesale money market. When inter-bank lending collapsed in August, the bank was unable to fund its loans and mortgages. This crisis also revealed the maturity mismatch that many banks, particularly specialist mortgage lenders, must manage.

The majority of funding, whether wholesale or retail, typically has a short-term duration and can be withdrawn by investors within a few months. In contrast, mortgage lending involves long-term loans lasting up to 25 years. This discrepancy enables the institution to increase its profits as short-term borrowing is usually less expensive for the bank than long-term borrowing. Nonetheless, it also results in a higher liquidity risk in times of scarcity of short-term funds.

The failure of Northern Rock was caused by its

inability to fund its assets, rather than any concerns about their credit quality. Banks have a unique aspect in their balance sheets, where assets are made up of illiquid term loans and liabilities are mostly short-term deposits. This imbalance makes them more vulnerable to bank runs during financial crises. In addition, banks often cannot sell their assets easily, which may result in otherwise solvent banks being forced to sell their assets at low prices during bank runs. Banking economics is affected by these factors.

The provision of liquidity to a financial institution by the central bank could result in a potential welfare loss to the public. This loss justifies public sector intervention. The Bank of England's emergency funding for Northern Rock was criticized by many for the perceived leniency of the BOE as the lender of last resort. The role of the central bank as the LOLR is generally pertinent for two reasons. Firstly, a halt in inter-bank lending during a crisis could cause solvent banks to become susceptible to deposit withdrawals due to informational asymmetry.

Intervention by the central bank may be necessary to prevent negative consequences for the stakeholders of a financial institution. The authorities may be better equipped to evaluate a bank's financial position than the inter-bank market due to access to supervisory information. In situations where the failure of a solvent bank could threaten the stability of the entire financial system, the central bank may also act as the LOLR. However, some critics disagreed with the Liquidity Support Facility provided to Northern Rock since it indicated that the troubled bank was not punished for its risky business model. This could potentially encourage

other banks and financial institutions to take on greater risks, assured of an eventual guarantee.

The Financial Stability Review (1999, p. 159) cites Bagehot's assertion that assisting a struggling bank only ensures the absence of a successful bank in the future. The presence of moral hazard presents concerns, as the central bank may not have swift access to reliable data when an institution experiences abrupt liquidity issues and determining the solvency of the bank may prove challenging. Nevertheless, the Bank of England defended its backing of Northern Rock as a strategy to prevent any impact on the overall financial system in the United Kingdom.

When deciding to utilize the lender-of-last-resort function to provide assistance to banks, it is necessary to evaluate the current and potential expenses of this aid compared to the expenses that financial instability would cause throughout the economy. It is foreseeable that these expenses would be proportionally greater for larger banks in comparison to smaller ones, such as in the case of Northern Rock, for which the Bank of England has presently issued a loan of about ? 5 billion. Although the assistance provided by the Bank of England can be argued as justified, there are queries concerning whether more low-key aid could have averted a run by depositors on Northern Rock. In August 2007, the German government arranged a rescue plan worth €3.5 billion for IKB Deutsche Industriebank AG, which had also been affected by the US sub-prime market crisis.

The handling of IKB's situation was done with great caution, without giving any clear indication of the extent of their troubles to the public. The reason for this secrecy was explained by Eddie George,

Governor of the Bank of England in 1994. He stated that when widespread panic has yet to occur, it is best to keep the fact that systemic support is being provided a secret. Revealing this could lead people to question how far the support would extend and ultimately result in the underwriting of all banking system liabilities (Financial Stability Review, 1999, p. 160).

Implementing a reliable deposit insurance system could have helped avoid the problematic situation that led to the run on Northern Rock. The availability of deposit insurance significantly minimizes the possibility of a widespread crisis, as depositors will not feel the need to withdraw their money if they are confident in its security. At the time of the run, the Financial Services Compensation Scheme ensured one hundred percent recovery on savings under ? 2,000 and 90 percent recovery on up to ? 33,000. However, only when Alistair Darling, the Chancellor of the Exchequer, declared that all deposits from Northern Rock account holders were guaranteed by the government did the run come to an end.

According to a statement by Darling reported by the Financial Times on September 17th, arrangements will be put in place by both Darling and the Bank of England to guarantee existing deposit agreements if necessary. The lack of an effective deposit insurance system prior to the central bank's emergency funding announcement for Northern Rock may have increased the likelihood of a bank panic. After the Northern Rock incident, however, the government announced plans to review and reform deposit insurance in the longer term. From a regulatory perspective, the failure of Northern Rock indicates a flaw in the current regulatory regime, as

many members of the general public believe that allowing a business model like Northern Rock's to exist demonstrates such a flaw. Authorities did not fully appreciate the risks associated with the bank's funding model, and it ultimately made them overly vulnerable to wholesale money market volatility.

During the Northern Rock crisis, the Tripartite arrangement between the Bank of England, Financial Services Authority (FSA), and Treasury posed some challenges to effective crisis management. The arrangement was established by Gordon Brown in 1997 and divided responsibilities among the institutions: the Bank had financial resources for bailouts, FSA received information from regulation and monitoring of individual banks, and Treasury confirmed fund release from the Bank. However, conflicting reactions from these independent bodies caused delays and a lack of coordination during decision-making as they faced global credit crunch pressures in UK's financial market. In contrast to prompt action taken by Federal Reserve and European Central Bank through injecting liquidity into their banking systems to address credit concerns, initial hesitance shown by conservative approach of Bank of England towards providing support to Northern Rock was partly due to dissuading irresponsible risk-taking and potential inflation caused by cash injection into system.

As a lender of last resort, the Bank of England offered emergency financial assistance to Northern Rock on September 14th, 2007. The crisis could have caused less damage to public trust in the bank if they had responded more quickly. Furthermore, alterations to liquidity regulations may have prevented other banks from facing runs (Weale, M. (2007) Northern Rock: Solutions and Problems. Sage Publications).

Encouraging liquidity insurance policies could have forced other banks to lend to Northern Rock for longer periods if the bank

had chosen to insure themselves with these other banks. This would have effectively recycled the deposits from other banks to Northern Rock, preventing a panic and the subsequent run. If banks were unable to lend to each other during inter-bank market dry-ups, liquidity insurance would take over by compelling banks through insurance contracts to provide necessary funds to those in need. As of now, the ultimate fate of Northern Rock remains undecided; however, a consortium led by Virgin Group is currently the bank's preferred bidder.

Virgin plans to re-brand Northern Rock under its Virgin Money business and proposes the repayment of ?11 billion from the ?25 billion loan received from the Bank of England. While some argue for nationalisation to safeguard saver deposits and offer affordable mortgages, attention is directed towards legislative and regulatory changes that require attention. With interdependence in today's global financial system, one institution's unwise risk can negatively impact any country's economy. This type of risk should be avoided.