Northern Rock(1)

8/18/2019 Northern Rock(1)

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Université Paris Dauphine - Régis LOWE PRM PREPARATION - EXAM IV 1


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EVENTSIn 1997, Northern Rock converted to bank status, with a:

Central securitisation strategy

Funding predominantly on secured wholesale and other

capital market funding

During the summer of 2007,

It was a victim of the general market turbulence and lack

of confidence triggered by worsening developments in

the US sub-prime mortgage market



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EVENTSIn the summer of 2007,

Notwithstanding unprecedented UK government support,

depositors withdrew funds on a large scale

In September 2007,

Northern Rock was forced to seek massive financial

assistance from the BOE, and eventually reverted to UK

government ownership



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STRATEGY “Originate and distribute model” as the core business

strategy



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STRATEGY

Funding mainly from the wholesale markets, rather thanfrom retail deposits.

The proportion of

the retail deposits

and funds declined

from 62.7% in late

1997 to 22.4% at the

end of 2006



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STRATEGY

That strategy exposed to the following problems:

An unexpected downturn in the securitization market

would have a high impact on the bank.

Overreliance on wholesale funding and short term

financing left the bank very vulnerable to a LPHI

event :

Northern Rock was the only major UK bank to

have securitisation as its core strategy.



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STRATEGY

During the 2007 turmoil, The bank or its conduits were unable to roll-over

maturing funding

The liquidity squeeze raised the cost of wholesale

funding

As liquidity dried up, Northern Rock could not finance its

off-balance-sheet vehicle and was :

Forced to take assets back on to the balance sheet or

hold on to assets it was planning to securitize.



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THE COLLAPSE



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SOLVENCY & LIQUIDITY

During the crisis NR remained legally solvent (its equitywas greater than zero)

If the BOE didn’t provide the funding NR needed, it

would have been forced into insolvency to pay outdepositors

NR was business insolvent as the borrowing rate was

greater than interest on assets



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THE RESCUE

The government rescued NR by arbitrarily guaranteeing

all deposits held which was contrary to the well-

established deposit protection scheme.

Creating serious moral hazard issues with respect to

depositor protection and the role of the BOE’s money

market operations.



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RISKS INCURRED Portfolio and Capital Funding Risk - Excessive

dependency on one sector ((Handbook Volume III,

Chapter 10)

Operational and Reputational Risk – A sharp decline inconfidence can lead counterparties in the wholesale

markets and retail depositors to suddenly withdraw

funding from a suspect bank, driving the institution into a

funding liquidity crisis. (Handbook Volume III, Chapter 13)



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STRESS AND SCENARIO TESTING FAILURE Absence of stress testing the business model for the

multi-dimensional LPHI covariance incidences

Neither the bank nor the FSA had incorporated a stress

test scenario of liquidity squeeze on various market-based funding sources upon which it relied heavily.

Simulations carried out jointly by the FSA, the Bank of

England and the Treasury failed to involve banks

themselves as players



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MITIGATIONS & LESSONS LEARNED

Identification and measurement of the full range ofliquidity risks

Design and use of severe stress test scenarios

LPHI risks need to be more explicitly considered and

managed

Corporate governance



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MITIGATIONS & LESSONS LEARNED

A business model which emphasises short term wholesalefunding and securitisation for matching long-termliabilities with short term funding is a recipe for disaster.

Shareholders can still lose everything even when a bank isbailed out.

Maintenance of an adequate level of liquidity, including

through a cushion of liquid assets

Necessity of allocating liquidity costs, benefits and risks toall significant business activities


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Northern Rock(1)