The Failure of Northern Rock - A Multidimensional Case Study

In August 2007 the United Kingdom experienced its first bank run in over 140 years. Although Northern Rock was not a particularly large bank (it was at the time ranked 7th in terms of assets) it was nevertheless a significant retail bank and a substantial mortgage lender. In fact, ten years earlier it had converted from a mutual building society whose activities were limited by regulation largely to retail deposits and mortgages. Graphic television news pictures showed very long queues outside the bank as depositors rushed to withdraw their deposits. There was always a fear that this could spark a systemic run on bank deposits. After failed attempts to secure a buyer in the private sector, the government nationalised the bank and, for the first time, in effect socialised the credit risk of the bank. It is now a fully state-owned bank. Since then, another British bank (Bradford and Bingley ? which was also a converted building society) has also been nationalised. Furthermore, the government has since taken substantial equity stakes in several other British banks as part of a general re-capitalisation programme. Of course, since Northern Rock failed the world has experienced what is arguably its most serious financial crisis ever and in the US much larger and more significant banks have failed. On the face of it, therefore, the Northern Rock crisis pales into insignificance within the global context. Nevertheless, the Northern Rock is particularly significant because it represents in a single case study virtually everything that can go wrong with a bank. As we argue in the first essay in this compendium, it was a multi-dimensional problem. For this, and other reasons, it will surely become a much-analysed case study in bank failure. It is also for this reason that the Editorial Board of SUERF decided to invite a selected group of eminent scholars to write short essays on what they judge to be some of the significant issues raised in the Northern Rock case study. We were anxious to ensure that the authors would not be exclusively from the United Kingdom and of the thirteen contributors, six are from outside the country including perspectives from the United States and Italy. All of the authors were given a completely free hand to select their own focus and no attempt has been made to coordinate or edit the contributions. In the first contribution, David T. Llewellyn offers an overview of the multi-dimensional nature of the Northern Rock case study in order to set the perspective for those who may not be fully familiar with the many different strands of the episode. We also consider the business model of the bank and how, in particular, it exposed the bank to a low-probability-high-impact risk. This contribution also briefly considers some of the reform measures that have subsequently been initiated by the government as a result of the Northern Rock failure. In particular, the crisis revealed a number of fault-lines in the institutional architecture in the United Kingdom and most especially with regard to insolvency arrangements for banks and the resolution arrangements for failed banks. In their overview of the Northern Rock crisis, Mayes and Wood argue that it provides an ?almost ideal test? of the effectiveness of safety-net arrangements in a wide range of countries. They suggest that the crisis should induce governments and regulatory authorities to consider the lessons from this particular crisis. They indicate their own interpretation of the lessons to be learned. In particular, they focus on six key issues: (i) deposit insurance, (ii) the ?too-big-to-fail? concept, (iii) the role of the lender-of-last-resort facility, (iv) the need for early intervention and the merits of Structured Early Intervention and Resolution and the Prompt Corrective Action models, (v) the need for a special resolution regime for banks, and (vi) responsibility and coordination between agencies. They also consider the potential information value of movements in a bank?s share price. Paul Hamalainen considers the important issue of the implications of the Northern Rock episode for the role of market discipline and, in the process, reviews two key requirements for market discipline to work effectively: incentive structures and bank transparency. He emphasises the importance of market discipline in giving market signals that emanate from risk monitors. In the following contribution, Eisenbeis and Kaufman give a powerful perspective from the United States by comparing the failure of Northern Rock with that of Countrywide and IndyMac in the US. They argue that there are three common features: serious weaknesses in the structure of deposit guarantee arrangements, supervisory failures, and weaknesses in the legal structure governing bank failures. They argue that the main lessons from the three failures focus on the design of deposit insurance, the need for an institutional architecture that reduces the negative externalities of bank failures and, in particular, a special bankruptcy procedure for handling troubled financial institutions, the importance of timely and accurate accounting and reporting, and the necessity of improving the incentives and Preface 9 accountability for bank regulators. They also point to the weak role played by market discipline in the case of Northern Rock. There is a danger of regarding the Northern Rock crisis as one exclusive to the United Kingdom. Marco Onado rightly moves us away from this focus and argues that the problems revealed in the Northern Rock case study are far from temporary and that at the core was the business model of the bank and that this model was common to many other banks in many other countries. This provides a useful link to the global financial crisis. In particular, he argues that ?while there is no doubt that Northern Rock?s business model was extreme, one can argue that its underlying philosophy was shared by many other banks.? He emphasises the combination of aggressive asset growth, minimisation of capital, and funding risks designed to maximise rates of return on equity as a common denominator. He also argues that the business model of Northern Rock ?stretched to the maximum extent the opportunities for regulatory arbitrage induced by Basel 1 and which led to dramatically overlooking the fundamental role of capital in banking?. The central conclusion is that the Northern Rock crisis was a crisis of securitisation and capital. Michael Taylor offers a different perspective by focussing upon institutional structure of regulation and supervision and in particular on the role of the central bank. He sets the context by explaining that, at the time reforms were made in the United Kingdom to the institutional structure of financial regulation and supervision about a decade before the Northern Rock crisis, little attention was given to crisis management arrangements. In particular, an attempt was made to draw a sharp boundary between bank regulation and supervision on the one hand, and the Bank of England?s role in promoting financial stability on the other. He argues in particular that the Northern Rock episode illustrated that ?the new boundary that was erected under the post-1997 arrangements is sub-optimal in crisis management?. He further argues that the Northern Rock case illustrates that monetary stability and financial stability are deeply intertwined and that the conduct of monetary policy must be informed by the central bank?s analysis of financial stability and the information flows it receives through its regular contact with financial markets and institutions. The issue of banking law reform following what was revealed through the Northern Rock crisis is considered in Rosa Lastra?s contribution. Her starting point is that the crisis exposed major deficiencies in the United Kingdom regime to deal with banks in distress. In particular, and in line with the contribution of Eisenbeis and Kaufman, she stresses the problems linked to deposit insurance arrangements and those for the insolvency of financial institutions. She also detects weaknesses in the workings of the emergency liquidity assistance arrangements. The main focus of the contribution is on bank insolvency and bank crisis management, and the reforms (most especially the Special Resolution Regime) that have been proposed by the government in the wake of the Northern Rock crisis. She also points out that there are international dimensions to many of these issues and discusses various issues related to cross-border bank insolvency. Charles Goodhart offers a tour d?horizon of the regulatory responses to the financial crisis albeit with a particular focus on the UK experience. The point is made that the retail depositors? run was specific to the UK which is another reason why the Northern Rock episode is an important case study. He considers seven key issues: the role and operation of deposit insurance, bank insolvency regimes and the PCA model, money market operations of the central bank, liquidity risk management, the procyclicality of capital requirements, the boundaries of regulation in the context of conduits and SIVs, and crisis management both with respect to individual countries and the cross-border dimension. With respect to the first-mentioned, Goodhart poses the question of what deposit insurance is designed to achieve and highlights the dilemma (raised in some of the other contributions) that there may be a conflict between the requirements of protecting individual depositors and the interests of systemic stability and preventing bank runs. Although, in the UK context, it was never intended to focus on systemic stability, the recent reform in the UK has focussed on this issue. He raises the issue of whether this might be premature in an increasingly cross-border banking system. He further argues that the moral hazard implication of the absence of co-insurance needs to be alleviated by a PCA policy. Regarding the insolvency regime, Goodhart argues that ?any bank insolvency regime must involve some expropriation of shareholder rights?. Regarding liquidity, Goodhart argues that we need incentives for banks to hold more liquid assets in good times so that they can be run down in bad times and argues that the current Basel 2 regime does not provide us with a contra-cyclical instrument for offsetting major fluctuations in liquidity conditions. More generally, he argues that ?the combination of more risk-sensitive methods of applying capital adequacy requirements and mark-to-market valuations are imparting a strong upwards ratchet to the procyclicality of our system?. At the time of the Northern Rock crisis there was discussion about the moral hazard implications of various forms of intervention, and controversy arose over the role adopted by the Bank of England. This issue is addressed in the contribution by Alistair Milne. A distinction is to be made between loans and support for individual institutions and the system as a whole. The scope of the essay is on the provision of liquidity to the market as a whole during a financial crisis and whether this has potential moral hazard implications. Milne argues that any moral hazard dangers arising from central bank liquidity assistance to individual institutions can be addressed by the central bank charging a penalty interest rate. On the other hand, such penalty rates are not required for central bank provision of system-wide liquidity because the potential moral hazard does not apply. In the final contribution, Tim Congdon addresses an entirely different issue and focuses upon how banks? loan margins are determined and the implications of what is termed a ?teaser rate? strategy given that Northern Rock?s margins were low by industry standards. The purpose of the essay is to set out an analytical framework for the determination of banks? interest margins. This framework encompasses cash and capital ratios. His model suggests that, the lower are the cash-assets and capital-assets ratios, the riskier are the banks? operations. On the other hand, the lower are these ratios the narrower are interest margins and hence the lower is the cost of finance to industry and household borrowers. Congdon argues that, because of this, banking ?suffers from an inevitable tension?. There may, he argues, be a conflict between the ?competitive, low-margin, and customer-orientated banking practiced by Northern Rock? and the interests of depositor safety. Two dominant themes emerge from these essays: that there are many strands to the Northern Rock crisis, and that many of the issues raised have relevance to all countries. The lessons to be learned are far from being exclusive to the United Kingdom. This is why the Editorial Board of SUERF has devoted this SUERF Study to this important episode in the history of bank failures.