Northern Rock

8/3/2019 Northern Rock

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Term paper

Prepared For:

Prepared by:

ID

Muntazera Husain 081-442-030

Papia Nury 073-392-030

North South University

22nd

December, 2010


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Background of Northern Rock PLC:

Northern Rock is a British bank, best known for becoming the first bank in 150 years to suffer a

bank run after having had to approach the Bank of England for a loan facility, to replace money

market funding, during the credit crisis in 2007. Having failed to find a commercial buyer for

the business, it was taken into public ownership in 2008. It is based at Regent Centre in

Newcastle upon Tyne, United Kingdom. Formerly the Northern Rock Building Society, the bank

was formed in 1997 when the society floated on the London Stock Exchange. Northern Rock

converted from a mutual-form building society to a stock-form UK bank on 1 October 1997. At

the time of conversion it was a retail-funded lender, but from the second half of 1999 it

embarked on a growth strategy which was increasingly dependent on securitization and other

secured borrowing in a range of currencies and targeting investors in both UK and foreign capitalmarkets.

Northern Rock is an extreme case of mismanagement in the banking sector. Its spectacularly

imprudent business strategy caused the first run on a British bank in more than a century. The

Treasury was forced to rescue and then nationalize the bank to protect the wider financial

system.

On 12 September 2007, Northern Rock asked the Bank of England, as lender of last resort in the

United Kingdom, for a liquidity support facility due to problems in raising funds in the money

market to replace maturing money market borrowings. The problems arose from difficulties

banks faced over the summer of 2007 in raising funds in the money market. The bank's assets

were always sufficient to cover its liabilities, but it had a liquidity problem because institutional

lenders became nervous about lending to mortgage banks following the US sub-prime crisis.

Bank of England figures suggest that Northern Rock borrowed 3 billion from the Bank of

England in the first few days of this crisis.

Reasons of the failure of Northern rock:

Northern Rock had a unique business model in that securitization (originate-and-distribute) was a central part of the banks overall business strategy. While many banks


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securitized assets at the margin, the uniqueness of Northern Rock was that securitization,

and a reliance on short-term market funding, was the central feature of its business

model.

An inherent property of this business model was that it exposed the bank to a low-probability-high-impact (LPHI) risk. The bank became heavily dependent on short-term

funding in the money and capital markets, while no-one predicted that liquidity in the

markets would suddenly evaporate on a large scale. This was the nature of the LPHI risk.

While the business model was successful for some years, the LPHI risk eventuallyemerged in the context of global financial turbulence focused initially on sub-prime

mortgage lending in the US. As the Northern Rock had no part in this it might be claimed

that it became an innocent victim of this turbulence. However, the chosen business model

exposed the bank to a LPHI risk associated with a drying-up of liquidity in the London

financial markets.

The Northern Rock crisis was multi-dimensional and revealed several fault-lines withrespect to:

I. The implications of securitization and a consequent over-reliance on short-term marketinstruments,

II. The management of LPHI risks in banks,III. The deposit protection regime in the UK,IV. Money market operations of the Bank of England,V. The institutional structure of financial regulation and supervision,

VI.

Corporate governance arrangements in the bank,

VII. The arrangements for defining insolvency in banks,VIII. Resolution arrangements for failing banks.


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Background on DBBL

Dutch-Bangla Bank Limited (the Bank) is a scheduled commercial bank. The Bank was

established under the Bank Companies Act 1991 and incorporated as a public limited company

under the Companies Act 1994 in Bangladesh with the primary objective to carry on all kinds of

banking business in Bangladesh. The Bank is listed with Dhaka Stock Exchange Limited and

Chittagong Stock Exchange Limited. DBBL- a Bangladesh European private joint venture

scheduled commercial bank commenced formal operation from June 3, 1996.

After instability and frequent management changes in its initial years, DBBL overcame these

obstacles to establish rapid growth since the year 2000. The bank grew its reputation through

social work rather than profits. The bank's conservative nature, long-term strategies, hefty social

donations and technology investments have always led to modest but steady profits. DBBL hasbeen known to be overly conservative in its banking practices.

Despite being the largest corporate donor in Bangladesh, investor confidence was unhindered. In

March 2008, DBBL share prices reached Tk. 14325.80 in the Dhaka Stock Exchange, setting the

record for the highest stock price in the history of Bangladesh. It is also one of the few banks that

do not participate in merchant/investment banking (which can lead to sporadic growth).


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Comparison between Northern Rock bank and Bank Asia

Net Profit after tax:

Net profit after tax shows whether the organization is making profit or not. This is an item that

many people use to make assumptions about the profitability of the organization. Net profit after

tax of Northern rock and Dabbles as follows:

Fig: NET PROFIT AFTER TAX

According to the graph, the net profit after tax for northern rock and DBBL was quite similar till

the year 2006. After that there was a Sharpe fall of the net profit of the northern rock. The profit

of the company was decreasing at a decreasing rate. Here the company actually incurred a huge

amount of loss as it was generated negative amount of profit for consecutive two years. This

actually reveal financial crisis for the company. In case of DBBL the net profit was quite stable

till 2008. After 2007 the profit started to increase but it actually increased by a very stable rate. If

we compare the net profit after tax of these two companies we can say that the trends of these

two company for net profit after tax is not similar.

-1500

-1000

-500

0

500

1000

2004 2005 2006 2007 2008

Northern rock

DBBL

NET PROFIT AFTER TAX


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Impairment losses on loans and advances for Northern rock plc:

The Group named impairment losses on loans and advances assess periodically and at each

balance sheet date whether there is objective evidence that a financial asset or group of financial

assets is impaired. In case of northern rock, the company suffered from impairment losses on

loans and advances from 2005. Since then the company has been suffering from this serious

problem. Till 2007 this damage was not that much serious but in 2008 it took a worst shape and

the company lost almost 894.4 million. At the same time the company has suffered from

impaired charges on unsecured investment loans. This situation occurred from year 2007. The

impairment charges on unsecured investment loan are less than the impaired losses on loans and

advances. These types of damage can affect a company at a high extend. As the bank was not

able to collect the loan amount back so it faces huge illiquidity. This is one of the main reasons

for the financial crisis faced by northern rock.

In case of DBBL, the bank has reported small amount or charges on loan losses during the year

2007 and 2008. The amount was 4. 4% and 5.8% of their total revenue. So we can say that thetrends practiced by Northern rock and DBBL is not Similar. In terms of this variable DBBL has

less likely to face financial crisis.

-900

-800

-700

-600

-500

-400

-300

-200

-100

0

2004 2005 2006 2007 2008

Impairment losses on loans and

advances

Impairment charges on unsecured

investment loans


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Comparison of asset and liabilities of northern rock and DBBL:

Northern Rock PLC:

FIG: Total asset of Northern rock plc

In the nine years from June 1998 to June 2007, Northern Rocks total assets grew from 17.4

billion pounds to 113.5 billion pounds. This growth in assets corresponds to a constant

equivalent annual growth rate of 23.2%, a very rapid rate of growth by any standards. After the

crisis, in the year 2008 the total asset of the bank started to fall down. In order to sustain high

growth in the banks asset, the bank changed the structure of its liabilities. In 1999, the bank

adopted an originate and distribute model whereby the bank originates loans orpurchase them

from specialized brokers and transfer them to special purpose vehicle which then package them

into collateralized debt obligation for sale to other investors.

In the year 2004 the bank turned to covered bond in order to meet its growth funding needs. Inthis financial method the bank holds its asset and issue the covered bond which are secured

against them.

At the same time the counterpart of the rapid and huge growth in the whole sale funding was

parallel decrease in the ratio retail deposit in its funding. Thus as a proportion of the total

-010%

000%

010%

020%

030%

040%

050%

060%

070%

080%

090%

100%

2004 2005 2006 2007 2008

Asset of northern rockCash and balances with central

banks

Derivative financial instruments

Loans and advances to banks

Loans and advances to customers

Fair value adjustments of

portfolio hedging

Available for sale securities

Debt securities

Equity shares

Intangible assets


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liabilities and equity, retail deposits and funds declined from 62.7% in late 1997 to 22.4% at the

end of 2006.

Northern Rock: balance sheet growth and liability structureJune 1998-June 2007

DBBL:

Fig: Assets of DBBL

In case of DBBL the average growth for total asset is 25.95% which is high. The total asset of

the bank is increasing at an increasing rate. In order to sustain the growth of asset, the liability

structure used by BDDL is quite secured than the structure used by northern rock. DBBL mostly

use term deposit to finance their assets. At the same time they use current deposit and saving

bank deposit to finance their liabilities. These sources of funding are less risky. Comparing the

000%

010%

020%

030%

040%

050%

060%

070%

080%

2004 2005 2006 2007 2008

Asset of DBBLCash In hand

Balance with Bangladesh Bank

Total Balance with other banks

Total with other banks and financial

institutionsMoney at call and short notice

Total Investments

Total Loans and advances

Lease receivables

Other assets


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liability source of these banks we can say that the trends of these two companies are not similar.

As DBBL has no securitized bond or they do not borrow any money from the money market so

its visible that DBBL is less likely to face financial crisis.

Northern rocks liability:

Northern rock plc used to heavily rely on the retail deposit. During 1998 60% of its liability was

retail funding but gradually it decreased. Northern rock then mostly use non retail fund. By the

summer of 2007, only 23 percent of its liabilities were in the form of retail deposits. The rest of

its funding came from short-term borrowing in the capital markets, or through securitized notes

and other longer-term funding sources. The dating of the beginning of the credit crisis can be

seen below in figure 1, which charts the weekly series on the outstanding amounts of asset

backed commercial paper (ABCP), obtained from the Federal Reserves website. Asset backed

commercial paper was the favored means for off-balance sheet vehicles to fund their holdings of

long-dated mortgage-related assets, and as such served as the barometer for the appetite for

short-term lending against mortgage assets. The weekly series shows a sharp break between the

August 8th and August 15th.


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DBBL liabilities:

Fig: DBBLs liabilities from 2004-2008

In case of DBBL we can see that the firm mostly uses term deposit for funding. Term deposit is a

deposit which held at a financial institution that has a fixed term. These are generally short-term

with maturities ranging anywhere from a month to a few years. Term deposits are an extremely

safe investment and are therefore very appealing to conservative, low-risk investors. By having

the money tied up you'll generally get a higher rate with a term deposit compared with a demand

deposit. Almost 60% of DBBL liabilities are term deposit. At the same time the bank is

increasingly using saving bank deposit, current deposit and other deposit for funding. These are

000%

010%

020%

030%

040%

050%

060%

070%

20042005

20062007

2008

Borrowings from other banks,

financial institutions

Current deposits

Bills payable

Savings bank deposits

Term deposits

Other liabilites

Long term liability

Subordinated debt


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very secure source of funding so DBBL is less likely to face a financial crisis like northern rock.

At the same time we can say that the trends of these two banks are not similar.

Investment of DBBL:

DBBL mostly invest in government securities. DBBL invest in both Treasury bill and bonds.

They invest in several government bonds with different maturity period. At the same time DBBL

uses REPO with other bank and financial institution. At the same DBBL also invest in some

debenture. They actually invest a very small amount in other investment instrument. We know

that the risk associated with government securities is very small and most of the time these risks

can be avoided. So investing in government securities actually minimize the business risk and at

the same time firm specific risk is also eliminated. According to the graph we can see that

DBBLs investment in government securities is not stable. From the year 2004 the investment of

DBBL was increasing. The highest investment of DBBL was made in the year 2006 which is

almost 13% of their total assets. After that the investment in government securities is decreasing

very slowly. DBBLs investment in other securities is very small that the risk associated with

these types of investment is actually very insignificant. So it is assumed that DBBL is not likely

to face any financial crisis because of the structure of their investment which is mostly consists

of government securities

000%

002%004%

006%

008%

010%

012%

014%

2004 2005 2006 2007 2008

Investment of DBBL

Government Others


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Derivative financial instruments of Northern rock

Derivative financial instrument is a security whose price is dependent upon or derived from one

or more underlying assets. The derivative itself is merely a contract between two or more parties.

Its value is determined by fluctuations in the underlying asset. The most common underlying

assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most

derivatives are characterized by high leverage. Northern rock uses the derivative instruments for

the purpose of supporting the strategic and operational business activities of the Group and

reducing the risk of loss arising from changes in interest rates and exchange rates. All use of

derivative instruments within the Group is to hedge risk exposure, and the Group takes no

trading positions in derivatives. From 2005 to 2007 the company has almost 2% derivative

financial instrument of their asset. In the year 2008 there was a Sharpe increase of using this

instrument which was almost 12% of their total assets. The objective of using derivative

instrument is to ensure that the risk to reward profile of any transaction is optimized. The

intention is to only use derivatives to create economically effective hedges. DBBL does not use

any derivative financial instrument in order to hedge their operational and business activities.

000%

002%

004%

006%

008%

010%

012%014%

2004 2005 2006 2007 2008

Derivative financial instruments of northern rock

Derivative financial instruments


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FIG: Loans and advances of Northern Rock and DBBL

The amount of loan and advances to customer of northern rock is higher than the DBBL.

According to the graph we can see that total loan and advances to customers of northern bank

was very high from 2004 to 2007 which is almost 90% of the total asset of the bank. Then in the

year 2008 after the financial crisis the amount of loan and advances to customer decreased which

was almost 70% of the total asset of Northern Rock. These loans and advances include Advances

secured on residential property, Commercial secured advances, unsecured loans, and unsecured

investment loans etc which are mostly mortgages. These all loans and advances are not securedand some of them are not backed by any asset. So the risk of those is high.

000%

020%

040%

060%

080%

100%

2004 2005 2006 2007 2008


Total Loans and advances

of DBBL

loans and advances of

northern rock plc

,000

10000,000

20000,000

30000,000

40000,000

50000,000

2004 2005 2006 2007 2008

Debt securities of Northern bank

Securitised notes

Covered bonds

Other


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Northern rock used various methods to raise funds for mortgages. These include using the

money held in deposit accounts, borrowing from the wholesale markets, where banks lend to

each other, and selling existing mortgage debts on to other institutions to raise funds for new

home loansthis is a process known as securitization. In this situation the financial crisis of US

mortgage market take place. This actually decrease the Demand for mortgage-backed securities

also pretty much evaporated because of worries that other borrowers, and not just those in the

US, would slip into arrears. This affected northern rock very badly. Northern Rock, had a

business plan which involved borrowing heavily in the UK and international money markets,

extending mortgages to customers based on this funding, and then to re-sell these mortgages on

international capital markets, a process known as securitization. When the global demand from

investors for securitized mortgages dropped in August 2007, Northern Rock became unable to

repay loans from the money market with money which should have been raised from

securitization. The problems were anticipated by the financial markets which made the issue

more public. On 14 September 2007, the bank sought and received a liquidity support facility

from the Bank of England, to replace funds it was unable to raise from the money market. This

led to panic among individual depositors fearing that their savings might not be available. This

led to a bank run and the bank faced a huge financial crisis.

In case of DBBL they make fewer amounts of loan and advances to their customers comparing to

Northern bank. On an average the loan and advances to customers of DBBL is 65% of their total

asset. In Bangladesh their loans and advance to customers included secured overdraft, cash

credit, export cans credit, transport loan, house building loan, loan against trust receipt, term loan

industrial, staff loan etc. most of the loans and advances to customers of DBBL are secured

against asset. So theses are less risky. At the same time DBBL mostly use current deposit, bills

payable, saving bank deposit and term deposit to raise the fund to make loans and advances to

customers. These funds are less risky compare to those of northern rock. In this case it is easy to

conclude that practices for loans and advances to customers of DBBL and Northern rock aredifferent. At the same time it can be noticed that DBBL is less likely to face financial crisis like

Northern Rock.


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Ratio Analysis for Northern Rock:

1,044372791 1,0350808721,061126185

1,030363699

0,892859759

2004 2005 2006 2007 2008

Current Ratio

Ratios: 2004 2005 2006 2007 20

1.Current Ratio: (Current Assets/ Current

Liabilities)

1.044373 1.035081 1.061126 1.030364 0.892

2. Total Debt/ Total Asset 0.976301 0.968426 0.968215 0.975308 0.9939

3. Times Interest Earned (EBIT/Interest expense) 0.274895 0.149558 0.151994 -0.02727 -0.239

4. Return on Equity(Net Income/Total Owner's

Equity)

19.91% 13.38% 13.80% -7.37% -206.71

5.Net profit Margin(Net Profit/ Sales) 41.89% 42.34% 43.57% -27.55% -514.82


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As we can see from the above diagram that the current ratio of Northern Rock has considerably gone

down after the year 2007. It had become only 0.89 times higher than their current liability which is

obviously due to the financial crisis it had to face during the end of 2007.

The total debt to total equity ratio has also gone up between the years 2006 to 2008.

Times Interest Earned Ratio:

Times Interest Earned ratio has fallen drastically over the years, especially after the year 2007 because,

the interest expense has risen over the years. And after the year 2008 the Earnings before interest and

taxes in a negative figure which gave a negative result for the times interest earned ration. It indicates the

worsening ability of Northern Rock to afford loans.

0,976301192

0,968426462 0,968215217

0,975308495

0,993927894

2004 2005 2006 2007 2008

Total Debt to Total Asset Ratio

-0,3

-0,2

-0,1

0

0,1

0,2

0,3

2004 2005 2006 2007 2008


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The return on Equity for Northern Rock has also fallen after the year 2007. The most probable cause is

the negative profit after taxes in the year 2007 and following.

The net Profit margin also shows a negative figure after the year 2007. Even the income from interest and

other sources could not cover the negative net income figure.

For the ratio calculations, we considered the following:

Current assets

Cash and balances with central banks

Loans and advances to banks

-250%

-200%

-150%

-100%

-050%

000%

050%

2004 2005 2006 2007 2008

Return on Equity

-600%

-500%

-400%

-300%

-200%

-100%

000%

100%

2004 2005 2006 2007 2008

Net Profit Margin


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Debt securities

Prepayments and accrued income

Current tax asset

Available for sale securities

Current Liabilities considered:

Loans from central bank

Deposits by banks

Customer accounts

Debt securities issued: (Securitized notes, Covered bonds, other)

Current taxation liabilities

Accruals and deferred income

Retirement benefit obligations

Deferred income tax liability

Provisions for liabilities and charges

Historical Prices for DUTCH BANGLA BANK LIMITED:

The prices were at its highest during the year 2008.

0

2000

4000

6000

8000

10000

12000

14000

16000

time

average daily price of DBBL

shares 2005-2010 February


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Historical Price of Northern Rock

As we can see from the graph above that the share prices of Northern Rock fell drastically after

reaching its peak in mid or before mid 2007. However, Northern Rocks Share price crashed by 30% on

September 14th

2007 as the mortgage bank sought emergency funds from the Bank of England due to the

credit freeze in the interbank money market which Northern Rock heavily relies upon. Panic gripped

savers forming long lines outside Northern Rock Branches throughout the UK to withdraw funds.

Investors dumping the stock on the market open where even unsubstantiated rumors of takeovers and

white knights failed to halt the crash in the banks share price.


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References:

http://www.economist.com/node/9832838?story_id=9832838 http://en.wikipedia.org/wiki/Northern_rock#Subprime_mortgage_crisis_and_nationalisati

on

http://books.global-investor.com www.bankofengland.co.uk www.britannica.com http://www.thisismoney.co.uk www.dutchbanglabank.com www.wikipedia.com
http://www.economist.com/node/9832838?story_id=9832838http://www.economist.com/node/9832838?story_id=9832838http://en.wikipedia.org/wiki/Northern_rock#Subprime_mortgage_crisis_and_nationalisationhttp://en.wikipedia.org/wiki/Northern_rock#Subprime_mortgage_crisis_and_nationalisationhttp://en.wikipedia.org/wiki/Northern_rock#Subprime_mortgage_crisis_and_nationalisationhttp://en.wikipedia.org/wiki/Northern_rock#Subprime_mortgage_crisis_and_nationalisationhttp://en.wikipedia.org/wiki/Northern_rock#Subprime_mortgage_crisis_and_nationalisationhttp://books.global-investor.com/http://books.global-investor.com/http://www.bankofengland.co.uk/http://www.bankofengland.co.uk/http://www.britannica.com/http://www.britannica.com/http://www.thisismoney.co.uk/http://www.thisismoney.co.uk/http://www.dutchbanglabank.com/http://www.dutchbanglabank.com/http://www.wikipedia.com/http://www.wikipedia.com/http://www.wikipedia.com/http://www.dutchbanglabank.com/http://www.thisismoney.co.uk/http://www.britannica.com/http://www.bankofengland.co.uk/http://books.global-investor.com/http://en.wikipedia.org/wiki/Northern_rock#Subprime_mortgage_crisis_and_nationalisationhttp://en.wikipedia.org/wiki/Northern_rock#Subprime_mortgage_crisis_and_nationalisationhttp://www.economist.com/node/9832838?story_id=9832838

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Northern Rock