8/18/2019 Northern Rock(1)
1/15
Université Paris Dauphine - Régis LOWE PRM PREPARATION - EXAM IV 1
8/18/2019 Northern Rock(1)
2/15
Université Paris Dauphine - Régis LOWE PRM PREPARATION - EXAM IV 2
8/18/2019 Northern Rock(1)
3/15
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
Université Paris Dauphine - Régis LOWE PRM PREPARATION - EXAM IV 3
8/18/2019 Northern Rock(1)
4/15
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
Université Paris Dauphine - Régis LOWE PRM PREPARATION - EXAM IV 4
8/18/2019 Northern Rock(1)
5/15
STRATEGY “Originate and distribute model” as the core business
strategy
Université Paris Dauphine - Régis LOWE PRM PREPARATION - EXAM IV 5
8/18/2019 Northern Rock(1)
6/15
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
Université Paris Dauphine - Régis LOWE PRM PREPARATION - EXAM IV 6
8/18/2019 Northern Rock(1)
7/15
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.
Université Paris Dauphine - Régis LOWE PRM PREPARATION - EXAM IV 7
8/18/2019 Northern Rock(1)
8/15
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.
Université Paris Dauphine - Régis LOWE PRM PREPARATION - EXAM IV 8
8/18/2019 Northern Rock(1)
9/15
THE COLLAPSE
Université Paris Dauphine - Régis LOWE PRM PREPARATION - EXAM IV 9
8/18/2019 Northern Rock(1)
10/15
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
Université Paris Dauphine - Régis LOWE PRM PREPARATION - EXAM IV 10
8/18/2019 Northern Rock(1)
11/15
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.
Université Paris Dauphine - Régis LOWE PRM PREPARATION - EXAM IV 11
8/18/2019 Northern Rock(1)
12/15
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)
Université Paris Dauphine - Régis LOWE PRM PREPARATION - EXAM IV 12
8/18/2019 Northern Rock(1)
13/15
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
Université Paris Dauphine - Régis LOWE PRM PREPARATION - EXAM IV 13
8/18/2019 Northern Rock(1)
14/15
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
Université Paris Dauphine - Régis LOWE PRM PREPARATION - EXAM IV 14
8/18/2019 Northern Rock(1)
15/15
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
Université Paris Dauphine - Régis LOWE PRM PREPARATION - EXAM IV 15