TITLE: An Investigation into the effect of Liquidity Risk Management on UK Banking sector. A case study of Northern Rock Bank.
INTRODUCTION
In finance Liquidity Risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss or to make required profit. The impact of financial crises caused by subprime mortgage sets an example of improper implementation of Liquidity risk management and its application (North cott and zelmer, 2009). It is now important to apply proper and effective Risk management by financial institutions to avoid the effects of great financial depression due to result of subprime mortgage crises and other financial uncertainities.The present research is aimed at assessing the effective methods of Liquidity risk management and applying the same for proper and smooth functioning of northern rock bank. Northern rock bank has been remembered for the worst affected during the financial crisis (Mc cruise and von peter, 2006). It is also remembered as the poor financial strategic management which failed to access the upcoming financial crisis followed by deep depression. Liquidity risk management has been the most important factor when it comes to manage financial sector specially the banking sector which rules the country's economy. It becomes the most important tool for an organisation to assess its liabilities, explore and exploit the opportunities (Duttwaler, 2009). Plan activities to avoid threat and apply its strategy in a way that could prevent the organisation from potential threat like great depression which was due to inadequateliquidity risk management.
RESEARCH AIMS AND OBJECTIVES:
Liquidity Risk Management and its proper use keeps financial institutions safe from financial crises and other debt obligations, therefore there is a need to research in detail about liquidity risk management, its various components. Northern Rock Bank suffered huge loss due to the financial crises. Economist and financial experts failed to control the situation; this makes Liquidity risk management a vital tool in controlling the financial risk in the financial institution. Key Research objective includes the following:
RESEARCH QUESTIONS
With changing financial situation and frequent ups and downs in the economy it become very important to assess, evaluate some methods which can help banks and financial institutions to understand the market situation and act accordingly. To come up with any possible answer or solution or resolution or remedy, it is important to know the basic purpose of doing research and objective for the same. The research question will guide researcher to focus in a specific direction rather than entering in a broad and a complex way. Research questions should be sufficient enough to give a clear picture of how, where and what research is aimed at and should be able to get answers which should be clear enough to provide the basic purpose of research.
Question1. What are the strategies applied by Northern Rock Bank to overcome the deficiencies in its liquidity risk management?
Question2. To examine the signalling qualities of different financial instruments.
Question3. How does Northern Rock Bank prevent any financial losses by using effective liquidity risk management?
Rationale for the Research:-
Rationale for research requires long term prospective as it deals with the most important part of banking sector also it is detached from day to day fire fighting and conference calls that are currently consuming the days of most treasures. The sudden collapse of northern rock bank and bear Stearns proved that profitability and capital are no longer considered to be defence against liquidity risk. Both the organisations made good profit before they disappeared due to financial crisis. Both were also well capitalised business and yet due to their inability to sense the threat and analyse the liquidity risk issues they got wiped out from the market. Northern rock bank and bear Stearns were not only the banks which got affected. Till this time nobody realised the importance of liquidity risk management and its impact on banking sector ( Evan off and wall, 2009). In the meantime the regulatory bodies continuously monitored banks and their concerned management issues, but they rarely seem to understand the serious challenge. As a result liquidity was largely an invisible risk and threat for many financial firms it always remains unidentified threat and was avoided either due to its improper usage, improper knowledge and its importance in presenting such serious threats. Liquidity risk management is typically split into category such as liquidity risk, credit risk, market risk, and operational risk each of which is observed as a separate and distinct. Recent events have proved that how different types of risk can influence and impact on each other. During the time of financial crisis risk have shown a tendency to transform and convert from one type to another and with varying and breathe taking speed. It has been clear and seen for example how mistrust of asset value due to default credit risk can develop and initiate liquidity risk (J Econ Geoger, 2011). So moving ahead banks will need to emphasize more on developing and well integrated view of risk across all types of existing risks. Asset and liquidity committees (ALCOS) are set to play a pivotal role. Nationalization of northern rock bank underlined the need of proper liquidity risk management system to be utilized in the system and use its components to avoid threats.
Background For The Study
As northern rock bank collapsed due to various factors driven by global credit crisis. This bank suffered a huge loss of 585.4 million in first six months, during a year it become shocking and most surprised outcome in the finance sector most of its losses came from the charges of mortgage borrowers who were not willing to pay back during 2007, after failing to find a white knight, to take over its business northern rock bank has no option but to turn back to bank of England for saving its life and have liquidity life line support. Bank of England provided necessary financial support, but it failed to equal the financial price and manifested itself in first fully blown nationwide deposit run on UK bank for over 140 years. This panic situation in UK economy spread like fire and crippled the whole economy and paralyzed the flow of money within it. It made the government to intervene the situation and pour additional liquidity support into the economy, but this attempt of government was inadequate to boost the economy and normalize the situation. Widespread of this financial crisis hit hard all stock markets trading process (FTSE, NIFTI, and LSE etc.). This made a fear in investors mind which made them reluctant to invest in the new project, all the corporate investors and large financial institutions were worst affected and this had gradual impact on whole economy leading to low consumer spending power and this affected small scale, large scale industries and forced industries to take crucial steps like cutting down the jobs, cost reduction, low investment in all the sectors. The purpose of this paper is to unfold all the reasons and causes behind such serious financial crisis and to explore and identify the tools which can be utilized to prevent such reputation. It created a need to identify importance of liquidity risk management and apply to review the situation and plan the strategies accordingly. Credit default and payment related to it has been cause of concern, excessive leverage and liquidity with improper assessment of market leads to such crisis, the research work will consider all the factors and analyse the situation with a view to find effective tools and financial signalling qualities which can unfold the reasons for such cause and protect banking sectors from such liquidity crisis.
LITERATURE REVIEW
In last few decades, financial institutions have been working in an environment which is more characterised by financial instability and unavoidable credit crunches. This situation was influenced by many factors such as interest rate, lack of liquidity, growing competition in offering the financial services. These factors contributed and had a gradual impact on growing national economy which was clear indication that banks are important pillar of economy, which drives the economy and leads to its success. Liquidity crisis specially in banking system leads to its failure is eventually made business environment more and more risky having subsequent impact on ability of commercial and non-commercial bank, to work in synergy to move the economy towards growth. Therefore, it became an important issue of adopting efficient and effective risk management in banking to make it possible to do continuous reviews to analyse any untoward financial incident. We can broadly classify the risk involved in banking sector in three main categories. Financial risk faced by commercial bank in the process of managing its assets and liabilities comprising of following type of risks, liquidity risk insolvency risk, credit risk. Operating risk which characterise sphere of banking services, commonly known as operational risk, technological risk, strategic risk. Environmental risk that is generated by competitive business environment within any bank is expected to properly function. They involve fraud risk, business risk, and competitive risk, political and legal risk. Studies conducted on exposure to risk identifies two different types of risk namely pure risk, these kind of risks are generated by banking activities and process with potential to produce events that would result in losses such as physical risk (destruction, accidents, breakdown). Financial risk which are generated due to traditional banking operations, criminal and fraudulent risk (fraud, theft, embezzlement), responsibility risk not complying with banking standards and speculative risks (risk generated by trying to obtain maximum profit). Authors like (Greuning H and Brata Novic) provide detailed overview of topic which deals with assessment, analysis, and management of financial risk in banking. Risks management principles that were the key players in corporate governance process were held accountable for different dimensions of financial risks. The basic approach of author was to provide framework for identifying the key players, which were involved into risk management process. Research methods in banking techniques underlined the importance of systematic risk. Here the approach is focusing on banking and its associated risk such as credit risk, price risk, interest rate risk, operating or legal risk. The above treatment give insight into modern risk management and hedging techniques, it also allows practical guidance on role of banks, board and executive management and coordination of risk management. Opritescu M provided description of banking risk which is considered to be the benchmark of recent research in the field. He makes a clear distinction between general risk and specific risk in the bank and conducted the multidimensional description and banking of their risk. He also describes the nature of banking institutions its, characteristics, exposure involved, transfer rate on bank result, bank to customer relationship and other elements involved in market risks and active banking activities reflected in balance sheet. Prunea P has presented the issue of banking risk faced by the bank and categories to be the most specialised during the banking activity namely as financial risk. This category represents the risk faced by bank in managing its assets and liabilities and involves other related risk. If we look at the other studies, these are oriented to study particular type of banking risk for example liquidity risks. Here author develops liquidity analysis from NBR regulations, when dealing with liquidity risks. Here the liquidity indicators are analysed on the example of commercial bank by assessing its liabilities and assets, in terms of residual maturity and influence of certain factors on liquidity indicators. Financial crisis which erupted in USA from higher number of risk is a part of corporate life which became the essence of banking activities. Liquidity remained one of the main drivers for credit crisis. Liquidity ability to fund increase in assets and meet obligations as they become due is crucial to on-going liability for any organisation. But at the same time important of liquidity short ell at a single organisation can have systematic repercussions management of liquidity therefore become the most important activity conducted at bank over the period of time it is seen that there is reducing ability to rely on core deposit and increase reliance on wholesale funding. Also the newer technological and financial innovation has provided the banks either new ways of funding their activities and managing their liquidity. But the recent global financial markets have post new challenges for liquidity management. In sufficient funds occurred as a result of non performing credits, can effect banks capacity of fulfilling obligation towards depositors major financial risk may appear commonly known as ill liquidity risk. Such type of risk is associated with deposits and it is caused by uncertainties that exist concerning the way depositors may withdraw the invested funds liquidity is an important on going viability of any banking organisation. Banks capital positioning can effect on their ability to obtain liquidity, especially during crisis. Every bank must have adequate system for measuring, monitoring and controlling the liquidity risk. Financial institute should evaluate, adequacy of capital given their own liquidity profile and the market in which they operate. Liquidity risk management implies in three different stages. One is liquidity risk identification second is liquidity risk measuring and third is liquidity risk monitoring and control. during 2007 northern rock bank announced that it has started arranging funds from major government banks that is bank of England in a view to protect insolvency this happened for the first time in 130 years in the history of UK economy an taken as a shock in the economy where a government. Bank has to pour in the money to save bank which was going through bad financial crisis. After facing such terrifying event in economy it become necessary to investigate the risk signal in qualities of investor in modern financial market primary research aims to analyse whether market investor did signal the upcoming problem at northern rock. Financial innovation in the form of new market instrument such as credit default swaps and rapid rise in 15 years in U.K credit institution. this paper also aims to analyse individual signal in qualities of number of market instrument and using the marketing data to supervise banks. The objectives and questions in the studies aims to assess suitability of northern rock bank in market examination, study also aims to explain data and research basis and methodology used in study. Banking sector teams and individual supervising team did receive simple analysis and collation of bank result and share price movement. The situation, there was no clear mechanism which could have been used to dissolve the situation. Various studies conducted can northern rock bank aims to examine the potential methodology and financial signalling qualities which could have deployed to warn investors in advance before this crisis actually happened.
Did market investors sense the risk at northern rock bank in advance of requiring emergency assistance from bank of England?
What we can learn from northern rock bank experience in relation with use of market signalling qualities.
Study of northern rock bank is particularly in addressing these questions and explores the signalling qualities in market which we are supposed to be used as tools to avoid such bank failures (Krasner and Lopez 2004) It shows clear indication of individual bank failure it became now necessary for many researchers to study in deep the methodology and various tools which can be used in future to thoroughly review and end the market situations and investment policies, high interest rates, defaults rate, credit risk and other banking issues on the large. A certain lack of liquidity for a bank can arise from variety of structural correlations in order to avoid such risks. Banks specially establish optimal forces between the nature and maturity of the resources. Liquidity risks basically arise from banking activities in the management of asset position. It includes risk of being enable to fund due to severe shortage of liquidity. Banks strive hard to maintain a balance of granting a loan and maintaining the balance between liquidity through the use of liabilities and different range of maturities. Liquidity always remains a crucial viability of banking sector. Each bank must have adequate system of monitoring, measuring and controlling the liquidity risk. Banks should evaluate the adequacy of capital given to their own liquid profile and liquidity of market on which they operate. Liquidity risk is basically a condition where bank is unable to meet all its payment requirements. When obligations are in due the banks only maintain liquidity with the purpose to meet its basic requirement of operating.
In order to measure liquidity risk of any bank it is necessary to study the details about the bank, its operation, its activities, its total liquidity, using a system of indicators the bank can be assessed on its negative features and the degree of liquidity, quality of bank can be assessed. One has to study in detail the available capital to invest in mortgage sector and the maximum risk the bank can afford and also in relation with the economic situation in the country where bank is situated. There are lot of factors which can contribute in piling up situation for such liquidity crisis and severe collapse of banks.
RESEARCH PARADIGM
Research Paradigm is a method of analysing or assessing phenomena, be it a social or non-social, be it natural or physical. Selector of research paradigm defines the way of understanding, analysing and explaining the situation which can be efficiently derived and confirming, Paradigm is generally based on the theory of hypothesis; it acts as a structure or a skeleton in which various theories can fit. But at the same time it differs that how you see the world. It determines your prospective and shape of understanding of how things are connected these kind of theories are broadly characterised into two categories one is positivism and phenomenological
Positivism
Positivism is associated with advance, scientific and experimental quantitative and deductive framework (Ticehurst and Veal) Positivism deals with objective evaluation of reality often employed by experts to test various theories and hypothesis for relevant acceptance, refutation or modification. It deals with actuality data which are measurable, quantifiable and are of crucial nature. The paradigm has its application in broad service. which are carried out to obtain quantifiable information. Also to pull primary and secondary data based on realistic sources.
Phenomenological
The purpose of phenomenological approach is to explore and identify and approach is to explore and identify and phenomena behind the process. it deep understanding the issue it translates gathering of core information having perception through inductive qualitative methods such as interviews, discussions/ participant observation. Epistemologically, phenomenological approaches are based on gaming personal knowledge and subjectivity and focus on personal prospective and interpretation. The research aims to understand the phenomena behind the liquidity crisis and gather realistic information so as to identify the deficiencies which were prominent during the crisis at northern rock bank; it will also include the methods to collect data useful for understanding the causes, reasons of this crisis.
Research Methodology
Research project will engage use of theory to understand the issues and justify the presentation of finding conclusion using deductive and inductive approach depends upon the level of clarity in which theory and hypothesis is developed. Hypothesis is basically judged on design research strategy or by inductive approach in which data is collected and theory is develops based on data analysis. Research approaches aims in different directions such as research philosophies, deduction aims towards positivism and induction aims towards interpretivisim.
Case study of Northern rock bank involves empirical investigation of particular contemporary phenomena within its real life context using multiple sources of proves and evidences. The information will be based on number of sources providing evidences and necessary data to understand a situation and the reasons behind the crisis.
Thematic Analysis
It will be used for analyzing the data in the form of qualitative information. Thematic analysis methods of all concern associated with qualitative research which can be understood and interpreted. Open questionnaires and interviews can be concluded with the help of thematic analysis. It is more beneficial in a case of semi structured interview and opens ended questionnaires. These kind of methods are flexible and it provides core skills that can be utilized for conducting qualitative analysis. Thus it can be effectively used to collect and interpret data and enquire about its reliability.
Analytic approach
The research methodology will utilize combination of methods under pragmatic and paradigm, such integrated approach will be utilized and prove suitable in terms of giving more explanatory facts which can drive the framework to find some crucial analysis. The present research aim to understand the perception of investors and capture data to analyze and assess the situation through best possible methods and also to collect data through different channels and methods. Primary data will include the basic answers for questionnaires and will also include survey information. Combination of qualitative and quantitative information will allow to provide the basic understanding behind the core issues in northern rock bank financial crisis.
RESEARCH METHODS
It generally involves data and collection approach through analysis of available data and internal reports to understand in deep to analyze the situation occurring during the financial crisis. The recent updates and journals related to this crisis outlines the specific reasons including internal and external reports giving clear idea about avoidance of marketing signal. Research methods will include interviews of northern rock bank staff and other financial experts to pull information useful for achieving the objective for study. We will also use other financial agencies and capture information through them to gather qualitative data.
Northern Rock plc board as of 8 April 2010:
Semi structured interview
It will give ideas based on personal experiences and evaluate in their own word, intention will always remain to cap late on array of prospects from comparatively small group of employees. The number of questions might differs and will focus towards gaining information on the said topic.
Survey Questionnaire
It refers to use of various data collection methodologies built around having pre set questions remaining standard and common for all the participants. Both interviews and questionnaire are widely used to collect data.
Ethical consideration
Ethical issues in research is a most important consideration in research because while doing any research one should not disclose any information related to individual or organisation and always conduct research in boundaries of ethical consideration. The key consideration includes:
CONCLUSION
With changing economic situation, bankers need to be cautious while stepping ahead in the strategic implications. As northern rock bank and its collapse showed the world the serious consequences of financial crisis and all the affected tools need to be analysed and studied briefly to protect crisis in future and research should conclude with positive findings and should explore the secrets of saving such crisis in future. The research also aims to develop some concrete method to analyse and tackle such situations and it should be effective enough so that it can be implemented. It should be adopted as an strategic method of framework by other banks to tackle such crisis in future.
