Northern Rock: A Case in Low Frequency High Impact Event

In 2007 Northern Rock experienced a bank run, the first since 1886 by its depositors. The bank saw a withdrawal of 3 billion pounds which constituted about 11% of Northern Rock’s retail assets. It had to ask the Bank of England to intervene to save it. It eventually was taken over by Bank of England and later Virgin money.

Northern Rock was originally a mutual building society. It became a bank in 1997. Northern Rock could therefore move into all areas of banking. It chose to however focus on the residential mortgage business. Its strategy revolved around securitization and funding, and it used mortgage backed securities, extensively.

Problems in the MBS market in the US, resulted in a loss of faith by depositors. Despite assurances from The Bank of England, the UK’s Financial Services Authority (FSA) and Treasury (the UK government’s finance office) that Northern Rock was indeed solvent, the run could not be contained.

It may be considered irrational that depositors decided to do this, but global developments in this market make it less so.

Northern Rock used securitization quite extensively. This involved the bank collating its loans such as mortgages into one package. This portfolio was then sold to the capital market. The mortgage portfolio is usually bought by other financial institutions or Special Purpose Vehicles, Structured Investment Vehicles (SIVs), or Conduits of Northern rock. The buyers then sold them as securities, rated according to the mortgage underlying them. In this way Northern Rock passed on the loan to other agencies through SPVs extending them a line of credit in the event that they fell short of money to renew the securities.

The subprime market in the US was growing rapidly, with mortgage loans being combined with Collateralized Debt obligations (CDOs). The rating agencies usually gave CDOs high rating on account of the low number of low risk loans within it. Buyers of MBS and CDO’s included hedge funds, banks the world over or conduits established by banks or special purpose vehicles (SPV).

When housing prices started to crash, these buyers were affected. These banks, including Northern Rock started facing liquidity constraints. Further, a rise in the cost of funding meant it became increasingly difficult to roll-over short-term debt issues. Liquidity in the inter-bank market became worse resulting in a tier based interest rate system.

Banks with exposures to the MBS market started to feel the pinch. Most of their capital was tied up with mortgage assets and it looked unlikely that they could offload it to the MBS market. The liquidity crunch also meant that they could not continue to give credit to their SPVs. The market uncertainity resulted in some of the following issues:

  • a sharp fall in asset classes
  • uncertainty as to the risk exposure of banks
  • drying up of the  credit markets, particularly MBS securities
  • Poor to nil liquidity in MBSs and CDOs markets

Concerns about the real value of these instruments started setting in and investors were looking away from them. This was true globally. This resulted in conduits facing a serious liquidity crisis. These conduits were funding long-term mortgages (and other loans) by issuing short-term debt instruments. The lack of liquidity meant banks could not finance off-balance-sheet vehicles and had to take assets back on to the balance sheet or hold on to assets they were planning to securitize. This process was known as re-intermediation. Northern Rock went through this process.

Northern Rock with its central strategy of securitization relied heavily on short term money market funding. It had to keep several of its mortgage assets on the balance sheet. The interest rates or cost of money increased sharply to a point that the yields on its mortgage assets were lower than the borrowing cost. The final nail on the coffin was the bank run, with depositors clamoring for their money.

At this juncture the bank had to turn to the Bank of England (BoE) for assistance. BoE was the lender of last resort (LLR). Assistance was given in return for high quality assets and a penalty rate of interest. The timeline of this assistance looked like this:

  • September 14th 2007: The BOE’s role of LLR was activated on 2007 at a penalty interest rate of 1.5 pp above Bank Rate
  • The government further offers to guarantee all existing NR deposits.
  • NR was given an additional unlimited facility at the BOE secured on the collateral of all NR assets.
  • October 9th 2007: the government applies the guarantee not only to existing deposits but to all new retail deposits
  • Guarantee applies to not only retail deposits but to most other creditors

The bank run stopped only when BoE provided guarantee to all deposits.

What happened with Northern Rock was an instance of low probability but high impact or LPHI. If a bank is in this situation it is also the toughest to get out of as Northern Rock learned. If this instance were to happen it would mean the sale of the bank, and to maintain reserves for such an event may not be realistic. Therefore risk analysts within the bank and supervisors tend to gloss over these instances. Mitigation of such an instance though can be factored into its risk strategy.

Northern Rock’s heavy dependency on securitization and short-term wholesale market funding meant such an event was in the offing. The bank had not anticipated a bank run in addition to a drying up of liquidity whereby not only would it not be in a position to fulfill its obligation, but lead to the collapse of the bank itself. Northern Rock had not taken the precaution of taking lines of credit from other banks should such a LPHI event occur. The bank and supervisors ignored liquidity warnings a phenomenon that is referred to as disaster myopia. At the time of its bank run Northern Rock had 62% of wholesale funding as against the average of other UK banks of 45%.

The government’s role in this is worth scrutiny. The government stepped in and provided a full guarantee on depositor’s money. This was applicable for new customers and their depositors as well albeit with an interest penalty. This meant the tax payer was paying for this guarantee. Any fall in prices of housing meant in case the bank went insolvent they would find the price of the mortgaged houses would be cheaper than the value of the defaulted mortgage. This difference would be borne by the tax payer. By guaranteeing depositors money and protecting Northern Rock during the bank run, the importance of the Debt Protection Scheme (DPS) was brought into question. It was intended to protect financial stability rather than individual users. This gave the impression that the government would step in and protect consumer rights, superseding the conditions laid by DPS.

In the end Northern Rock teaches us the importance of not having a portfolio of assets leaning heavily into a market. A diversified portfolio is far better. Secondly, no scenario is impossible. It may be impractical to maintain reserves for such a scenario, but solutions must be discussed. The impact of financial scenarios is no longer local but glocal, Northern Rock experiencing the impact of the sub-prime mortgage crisis in the US, despite having no investments there. Its strategy of being largely in the securitization and MBS market raised fears in its depositors’ minds though. The importance of greater transparency in instruments and risk procedures as well as their subsidiaries can be seen in the Northern Rock example.

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