Introduction
Crisis is of the most dangerous in financial operation. There are some financial crises in Asia crisis in 1997 and America crisis in 2008 then that spreads in all over the world. Over the past 15 years crisis has been an observation of economists. There are many economists have investigated the root cause of crisis and have showed many solutions to deal with this problem. In this essay will focus on LPHI (Low Probability High Impact) risks tend to induce disaster myopia so that such risks discounted altogether and the probability is assumed to be zero. This one will divide into four parts which shows the overview of banking and banking structure, the concept of LPHI risks, effect of LPHI risks to bank operation, the roll of central bank and government. This essay is also being used evidences from Northern Rock.
First of all this essay will be overview the meaning of banking. According to Heffernan:
"The provision of deposit and loan products normally distinguishes banks from other types of financial firms. Deposits are liabilities of banks which must be managed if the bank is to maximize profit. Likewise loans are assets of banks which are given borrowers. Thus, the core activity as to act as intermediaries between depositors and borrowers" (Heffernan 1)
Therefore, from that stand point of view bank is an intermediary between people have unused money and people need money. Thus, the roll of bank is very important in business operation. The management of asset and liability are also necessary and this shows on the balance sheet of the bank. This balance sheet also shows the activity of bank and the result of operation.
As a result, bank likes an intermediary finance; hence structure of bank in England has been built to follow the core activity of bank. According to Heffernan:
"The structure of banking varies widely from country to country. Often, a country's banking structure is a consequence of the regulatory regime; the different banking structures do not alter the core functions of banks, the provision of intermediation and liquidity, and, indirectly, a payment service, which are the defining feature of banks." (Heffernan 15)
Moreover according to Bank of England:
"The bank is organized into four main operational areas- Monetary Analysis and Statistics, Markets, Financial Stability and Banking Services, supported by a Central Services area." (Bank of England)
Therefore, the activity of Northern Rock is affected by structure and regulation of banking in England. As a result, this influences to the form Balance Sheet of Bank. According to Hempel bank's balance sheet could be understood that:
"Bank's balance sheet is data of bank that observes the result of generalize results on particular day. There are two main parts. One part is bank's asset show how the bank used the funds it has attracted. The other part is bank's liabilities and net worth itemize the specific sources of fund" (Hempel 35)
As a result, also according to Hempel "the net worth or equity capital is the value of the bank's assets minus the value of its liabilities". Consequence, when the liabilities are too high and the assets is low these could lead to risk. Bank Risks always exist around firm operation. Risk leads to no effect to company, which is the cause of losing especially bankrupt. According to Damodaran:
"Risk refers to likelihood that we will receive a return on an investment that is different from the return we expect to make. Thus, risk includes not only the bad outcomes (returns that are lower than expected), but also good outcomes (returns that are higher than expected). In fact, we can refer to the former as sown side risk and the latter as upside risk, but we consider both when measuring risk." (Damodaran 60)
Also according to Akkizidis:
"Operational risk is the risk that deficiencies in information systems or internal controls will result in unexpected loss. The risk is associated with human error, systems failure and inadequate procedures or controls" (Akkizidis 9
Consequence
Consequence, risk influences to firm operation especially this essay focuses on bank operation. For this reason, risk management is one of the most important things to maintain the business of banking. Otherwise, bank cannot manage the risk that effects to bank operation, the faith of depositors, liquidity capital. That could show on bank balance sheet furthermore that could lead to imbalance in bank management, moreover that could lead to crisis. According to Matthews:
"The business of banking involves risk. Banks make profit by taking risk and managing risk. The traditional focus of risk management in banks has typically arisen out of its main business of intermediation - the process of making loans and taking in deposits" (Matthews 183)
Risk is a nightmare of firm especially in the bank operation. There are many types of risk such as credit risk, liquidity risk and interest rate risk. If firm cannot control risk that will directly influence to the firm. Especially bank attaches special importance to risk management. Despite attention to risk nevertheless bank cannot avoid risk such as LPHI risks. According to Llewenllyn:
"An inherent property of this business model was that it exposed the bank to a low-probability-high-impact (LPHI) risk. The bank became heavily dependent on short term funding in the money and capital markets, while no-one can predicted that liquidity in the markets would suddenly evaporate on a large-scale. This was the nature of the LPHI risk." (Llewenllyn 2)
Liquidity can be understood as the ability to buy or sell of firm in a short period time. In this case liquidity is ability of bank to obtain deposits or give loans of customers in a short period time. Furthermore, Liquidity is credit-worthiness of bank. Therefore, if the business of banking has problem with liquidity, this will reduce the payment ability of bank. Business of banking is becoming more difficult when depositors of lenders want to withdraw funds from bank. Amount of money had been withdrawn over the ability of bank, in that case, that could lead to illiquidity of bank. As a result, bank has to face on liquidity risk. Account for that "Depositors of a big British mortgage lender, Northern Rock, rushed to withdraw money on Friday…" (Pfanner) and "…customers stood in line to withdraw their deposits, rose 29.75 pence, or 46 percent, to 94.25 pence in London on Monday…" (Werdigier). According to Matthews:
"Liquidity risk is the possibility that a bank will unable to meet its liquid liabilities because of unexpected withdrawals of deposits. An unexpected liquidity shortage means that the bank is not only unable to meet its liability obligations but also unable to fund its illiquid asset" (Matthews 185)
Moreover, Northern Rock is a mid-size the United Kingdom (UK) mortgage lender in 2006, captures 20 percent of UK new mortgages (Mainelli). Therefore, the core business of Northern Rock is mortgage. Consequence, when mortgage market crises could influence bank operation. To show that, seller (people have houses) cannot sell houses and that people do not have enough money to return the loan for bank. As a result, bank has problem with finance especially is money. That effects to liquidity and this lead to risk. The lack of "high imbalance of wholesale funding in the case of Northern Rock (62 per cent) compared with the average of 45 per cent for the other banks in the sample" (Llewellyn 6) also effects to asset of bank. When risk happening that imbalance of wholesale funding could lead to risk in asset side. That leads to liquidity risk management which would dry-up liquidity in the business banking. From that stand point, if supervisors did not take action in the case of Northern Rock, which would lead to disaster myopia.
In the risky business environment Northern Rock has securitizations of mortgages as a part of business strategy. "Low probability high impact risks are the most difficult to manage, and the history of banking crises around the world indicates that a high promotion occur when a bank finds itself operating in this area of the matrix. This is partly because it tends to induce disaster myopia where low probability risks are discounted altogether and behaviour is implicitly based on the assumption that the probability is zero" (Llewellyn 6)
The rolls of Bank of England and Government are necessary in bank operation. Government likes a visible hand to control the economy in this case is bank operation. By laws and policiesBank of England
Conclusion
This essay has shown the lack of model of Northern Rock bank and the effluences of this to bank operation. Risk also had focused on business of banking especially LPHI risks LPHI risks are the most difficult to manage, that risks tend to induce disaster myopia so that such risks discounted altogether and the probability is assumed to be zero
