A MONTH after Northern Rock made shocking headlines around the world, the full story of Britain's first bank run in 140 years has yet to be told. People were little the wiser this week, after Adam Applegarth, the mortgage bank's chief executive, and Matt Ridley, its chairman, tried to convince a sceptical parliamentary committee investigating the fiasco that they had been struck down by a bolt from the blue. The business model of Britain's fastest-growing mortgage bank—which funded its loan book mainly from the wholesale markets, rather than from retail deposits—had been prudence itself, they explained, derailed only by sloppy lending in America that caused those markets to seize up in August.
But their Northern Rock is now a busted flush. None of the three groups who talk of buying it at a knock-down price—a consortium led by Sir Richard Branson's Virgin Group and two private-equity outfits, Cerberus and J.C. Flowers—wants to keep its name. The bank, kept afloat at present by £13 billion ($26 billion) of public money, does not rule out going back to the Bank of England for more. And just as Northern Rock's bosses deny imprudence, so the central bank's governor, the head of the Financial Services Authority and the chancellor of the exchequer stoutly maintain that they were not responsible for the mess either.
Yet the story needs to be pieced together, for the debacle has had three important and unpleasant consequences. A financial institution that underpinned for years the economy and self-image of one of England's poorest regions, the north-east, has been destroyed. The reputation of a broadly good central-bank governor has been tarnished. And an admired regulatory system that helped to make London the world's biggest international financial centre has fallen into disrepute. What went wrong? What signals were missed? And what lessons should bankers and regulators both learn?
The faster they come
The year that Northern Rock fell from grace could hardly have started more promisingly. In January the bank announced record pre-tax profits of £627m for 2006, 27% higher than the previous year's. This marked a decade of success since its conversion in 1997 from a building society—a residential mortgage lender owned by its savers and borrowers—into a bank quoted on the stockmarket. Year after year its assets had grown by a fifth, even though it had few branches—128 when it converted and 76 this year. A small local lender had become Britain's fifth-biggest mortgage provider, ambitious to become its third-biggest before long.
The trick Northern Rock pulled off was to rely on wholesale markets rather than on retail deposits to finance most of its lending. More than any other big British lender, it relied on “securitising” its mortgages. The bank bundled its loans together and packaged them into bonds that it sold to investors around the world. In January 2007 it raised £6.1 billion that way; a second securitisation in May brought the first-half total to £10.7 billion and made Northern Rock the top securitiser among British banks (see chart 1). With money swirling around the world's capital markets, securitisation worked a treat. By tapping global wholesale markets, Northern Rock was able to raise money more cheaply than its home-bound rivals, price its mortgage offers more keenly and carry on its hectic expansion.
More securitisations were planned for later in the year. Northern Rock needed the money because it was growing even faster than before. In the first six months of 2007 its lending was 31% up on the same period in 2006; net of redemptions, lending soared by 47%. As HBOS, Britain's biggest mortgage lender, put on the brakes, Northern Rock's share of the net new-lending market jumped to 19%, an extraordinarily high share for a bank that had had just 7% of outstanding loans at the end of 2006.
Yet the bank's share price had been sliding (see chart 2). As the Bank of England pushed interest rates up sharply, the City was starting to worry about the prospects for mortgage lenders. Northern Rock appeared to have a good loan book: at the end of June, repayment arrears were just half the industry average (though mortgages seldom curdle immediately, and a third of fast-growing Northern Rock's were less than two years old). The bank suffered along with other mortgage lenders as financial folk pondered how far the fallout from America's excessive subprime (ie, high-risk) lending might spread.
Worries intensified in June when Northern Rock trimmed the year's expected profits growth from 17% to 15%. At a time when monetary policy was tightening faster than expected, the bank had agreed to issue a tranche of mortgages at interest rates that were lower than those it eventually had to pay in the markets to finance them. The episode highlighted the fact that its reliance on wholesale funding made it vulnerable.
An unknown unknown?
Northern Rock's profit warning led to a further slip in its share price. But banks do not answer to their shareholders alone. They are subject to special supervision, because a problem at one bank can undermine confidence in the whole system and do immense economic damage. The Bank of England had long been in charge of overseeing banks, and its record, though not flawless, was widely reckoned a good one. In 1997, however, when Gordon Brown, then chancellor of the exchequer, freed the central bank to set interest rates, he decided to hand bank supervision to a new Financial Services Authority. The FSA was to look after individual banks while the Bank of England remained responsible for the stability of the financial system.
A falling share price, an explosive increase in market share and a profit warning: three reasons, one might think, for a newish banking supervisor to start sweating about one of its charges. Yet the FSA remained cool. Indeed, it chilled out even more on June 29th, giving Northern Rock a stamp of approval that let the mortgage lender, under new international banking rules, set aside less capital against its loans. Northern Rock promptly announced an increased dividend (even though it expected profits to fall). At around the same time, bizarrely, the FSA was urging the lender to toughen its “stress tests”.
The FSA's apparent insouciance was even stranger given Northern Rock's specific history. In 2004, after short-term interest rates shot up, the bank was caught off-guard, and profits suffered. It promised investors that half its loans would be matched by retail deposits—a pledge it promptly ignored once rates moderated. By the time it hit trouble this year, just under a quarter of Northern Rock's funding came from retail customers.
But there were good reasons to doubt the wisdom of relying so heavily on the capital markets. Though retail deposits cost a lot to acquire, many banks still prefer them, for they are generally a more steadfast source of finance than wholesale funding. A former chief risk officer at one of Britain's biggest banks says that Northern Rock's operating model was very risky: “To say that nobody could have envisaged what happened doesn't wash at all.”
As long as five years ago Tommaso Padoa-Schioppa, now Italy's finance minister but then on the board of the European Central Bank (ECB), pointed out that the liquidity of financial markets had grown in importance. He gave a prescient warning: “The deepening of the markets has improved the ability of banks to access funds in normal times, but liquidity may be more prone to dry up when it is most needed.” In 2006 Moody's, a rating agency, cautioned that some British banks were exposed to the risk of disruption in wholesale markets because they were increasing their loans faster than they could gather the deposits to back them. More recently, the Bank of England itself highlighted in April the danger of liquidity risk in its Financial Stability Report.
Yet both Northern Rock and the FSA assert that the event that felled the bank—the complete failure of the various market-based funding sources upon which it had become reliant—could not have been foreseen. Mr Applegarth has stressed the speed, duration and global nature of the liquidity freeze that started on August 9th. “I didn't see this coming, I have yet to find someone who did,” he said. The FSA has played a similar card: in parliamentary testimony on October 9th, Sir Callum McCarthy, the regulator's chairman, insisted that the seizing-up of the money markets was unprecedented.
So neither the bank nor the FSA had incorporated such a scenario into stress tests of the bank's resilience. Indeed, the simulations carried out jointly by the FSA, the Bank of England and the Treasury to gauge the financial system's ability to withstand potential upsets (one of which, ironically, posited problems at Northern Rock) failed to involve banks themselves as players, and thus were unable to predict their likely behaviour in a crisis of this sort.
The timing of the liquidity freeze was, it is true, disastrous for Northern Rock, which was low on cash because its last securitisation had been in May and it was planning another in September. But even if the timing had been better, its strategy for dealing with a liquidity crisis proved to be little more than wishful thinking.
The bank had sought to diversify its funding sources around the world; but markets dried up globally. It had hoped for a flight to a quality loan book such as its own if investors became alarmed about subprime mortgages; instead, investors shunned anything to do with mortgages. Unlike Countrywide, an American mortgage lender that also got into trouble, Northern Rock had nailed down little money—only $3 billion, it emerged this week—in committed credit lines from banks that it could call upon in an emergency. And it had failed to take steps to increase its access to central-bank liquidity in a crunch. About 150 banks, some of them British, were able to tap the ECB through their branches in the euro zone. Northern Rock could perhaps have put mechanisms in place to use its outlet in Ireland. But the paperwork would have taken a few months; and by the time the bank thought of it, the moment had gone.
If Northern Rock's excuses fail to pass muster, so do those of the FSA. Hector Sants, who took over the job of chief executive in July, admitted on October 9th that the regulator should have been more forceful in its dealings with the bank, and accepted that stress tests had not been “extreme” enough. But both he and Sir Callum continued to depict the event as an “unknown unknown”.
Equally guilty was the new system of banking and financial-market supervision put in place by Mr Brown. Fragmented among three institutions, and manned by people who were either unaware of what was going on or unable to communicate what they knew to one another, it failed its first big test. Sir John Gieve, the Bank of England's deputy governor in charge of financial stability and also a non-executive director of the FSA, gave evidence to the parliamentary committee on September 20th along with Mervyn King, his boss at the central bank. “I was concerned in a general way about the growth of wholesale lending,” he said. “Did I know the details of Northern Rock's position before this blew up? No, I did not.” This institutional deafness was to become an increasing problem as the government sought solutions to the bank's worsening plight.
How not to handle a crisis
On Monday August 13th, two working days after the markets dried up, Northern Rock told the FSA it was in trouble. The message was passed on to the Bank of England and the Treasury the next day. All three institutions were supposed to deal with crises under a “memorandum of understanding” setting out their respective roles. The Treasury, which chaired the committee, was involved in these “tripartite” arrangements because helping a bank often requires a bail-out from the taxpayer.
By August 16th the possibility that the Bank of England would have to act as a “lender of last resort” to Northern Rock had already been raised. All three agreed, however, that it would be better for a stronger bank to take over the mortgage lender. Northern Rock put itself up for sale and feelers were put out in all directions. Lloyds TSB, a British bank, emerged as a serious contender, but the deal foundered on September 10th. Lloyds was prepared to step into the breach only if it was given a loan of up to £30 billion by the Bank of England; but the tripartite authorities agreed it would be “inappropriate to help finance a bid by one bank for another”.
Of the three, the Bank of England had taken the hardest line since the crisis began. Whereas the world's two main central banks—America's Fed and the ECB—sought at once to relieve the liquidity drought by injecting extra cash into the money markets and accepting a wider range of collateral than usual, the Bank of England did neither until September. It wanted to send a message that if bankers took excessive risks they could not look to the central bank to rescue them from the consequences. So the central bank resisted pleas—not just from private banks but also from the FSA—to copy its American and European counterparts.
Mr King's critics say that in his fixation on future crises he failed to deal with the one at hand. Mr Sants pointed out that logically the only replacement for private-sector liquidity, once it dries up, is central-bank liquidity. According to DeAnne Julius, a former member of the Bank of England's monetary-policy committee, “The first duty of a central bank is to retain confidence in the banking system, especially at a time of illiquidity, and our central bank didn't do that.”
A telling indication of Mr King's priorities emerged last year, when a new version of the memorandum of understanding came out. In the original agreement, dating from October 1997, the bank was “responsible for the overall stability of the financial system”. In the new version, however, it merely “contributes to the maintenance of the stability of the financial system as a whole”.
This anaemic wording contrasts with the Fed's “key role in the prevention and mitigation of financial crises”, which Ben Bernanke, its chairman, emphasised in a speech in January. Some charge Mr King with neglecting the subject since becoming governor in 2003. An executive director for financial stability respected for his close City contacts was replaced in that role by one without them. The bank's widely followed, half-yearly Financial Stability Report was halved in size and published erratically. Others with City connections have left the bank, reducing its “eyes and ears” in the market.
Once the deal with Lloyds TSB fell through, only the Bank of England could rescue the beleaguered mortgage lender. Mr King wanted to do this behind the scenes, as happened as recently as the early 1990s. His desire for a covert operation was, he said, thwarted by a European-inspired law, the Market Abuse Directive, which came into force in Britain in 2005.
Charlie McCreevy, the Brussels commissioner responsible for the directive, denied at once that it prevented a secret intervention in an emergency. But even if the gold-plated British version of it did make things harder, the bank should not have taken so long to figure that out. “You don't wait for the cinema to catch fire before you check out whether the fire precautions are going to work,” says Richard Lambert, head of the Confederation of British Industry and a former member of the MPC.
On September 13th Alistair Darling, the chancellor of the exchequer, had little choice but to agree that the central bank should provide emergency funding to Northern Rock. News of the impending rescue leaked out prematurely, and the government scrabbled to put out a public statement on September 14th.
To financial aficionados, the fact that Britain's central bank now stood squarely behind Northern Rock should have brought relief. But to ordinary people it sounded alarming, especially in its leaked version. Britain's flawed deposit-insurance scheme guaranteed fully only the first £2,000 of deposits, and then 90% of only the next £33,000 (though it has since been made more generous). Alerted to trouble, depositors raced to get their cash out before everyone else did. The bank run was stopped only on September 17th, when Mr Darling issued an unprecedented guarantee for all existing deposits at Northern Rock. Bafflingly, he extended this on October 9th to all new retail deposits as well.
Brickbats all round—and one lesson
No one emerges well from this tale. Northern Rock pushed an aggressive business model to the limit, crossing its fingers and hoping that liquidity would always be there. The FSA failed to spot the danger. The Bank of England worried too much about forgiving over-risky behaviour and too little about shoring up a stressed financial system. Mr Darling failed to reassure depositors when he eventually got round to it, then arguably reassured them too much when it no longer mattered.
But the biggest failure was the “tripartite” system, and its unreadiness in a crisis. Undoing the reform of 1997 that divested the central bank of supervision would be hugely disruptive; and other countries have divided central banks from banking supervision without seeing financial institutions go to the wall. But if Britain is to learn one lesson from the Northern Rock saga, it may be that a single outfit needs to be in overall charge of financial stability, the bedrock on which economies are built. Only a central bank can provide the liquidity needed in times of crisis. So whatever its failings this time, it is the Bank of England that should take responsibility and call the shots.
This article appeared in the Briefing section of the print edition
The Failure of Northern Rock - A Multidimensional Case Study
edited by Morten Balling, Franco Bruni and David T. Llewellyn, Vienna, 2009
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. 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.
The Northern Rock Crisis: a multi-dimensional Problem
David T. Llewellyn
The Northern Rock Crisis in the UK
David G Mayes and Geoffrey Wood
Fallout from the credit squeeze and Northern Rock crises: Incentives, transparency and implications for the role of Market discipline
Lessons from the Demise of the UK’s Northern Rock and the U.S.’s Countrywide and IndyMac
Robert A. Eisenbeis and George G. Kaufman
Northern Rock: Just the tip of the Iceberg
Blurring the Boundaries in Financial Stability
Michael W. Taylor
Northern Rock and banking law reform in the UK
Rosa M Lastra
The Regulatory Response to the Financial Crisis
Charles A E Goodhart
Can central bank provision of market liquidity create a problem of moral hazard?
The Northern Rock affair: an analysis of the ‘teaser rate’ strategy
Keywords: Northern Rock, retail banking, mortgages, nationalisation, bank failure, United Kingdom, LPHI risk, lender of last resort, deposit insurance, market discipline, Countrywide, IndyMac, United States, deposit guarantees, supervisory failure, bank regulation, return on equity, business model, securitisation, financial regulation, financial stability, crisis management, banking law, insolvency, emergency liquidity assistance, cross-border bank insolvency, moral hazard, penalty rates, teaser rates, capital-asset ratios, Basel I, Basel II
JEL Codes: D14, D18, D4, E21, E5, E51, E53, E58, G18, G2, G21, G28, G32, G33, G34, G38, K2, L1, L5, L51
ISBN No.: 978-3-902109-46-0
Authors: Tim Congdon; Charles A.E. Goodhart; Robert A. Eisenbeis and George G. Kaufman; Paul Hamalainen; Rosa M. Lastra; David T. Llewellyn; David G. Mayes and Geoffrey Wood; Alistair Milne; Marco Onado; Michael Taylor
Editors: Morten Balling, Franco Bruni and David T. Llewellyn