In august 2007 the UK experienced its first bank run in over 140 years. This bank was Northern Rock, the 7th bank in term of assets. In 3 days around 3 billion of deposits were withdrawn.
Ten years earlier it had converted from a mutual building society a retail deposit and mortgage bank. In 1997 it was converted to a bank and acquired full powers to conduct a range of different banking business. It decided to focus on the residential mortgage market.
Since inception, its strategy was based on secured wholesale money (by issuing mortgage-backed securities). So, in the first half of 2007, the mortgage lending accounted for ΒΌ of the total in the UK and obviously exceeded the growth of retail deposits.
The government after the failure to find a private buyer decided to nationalise the bank which is now a fully state-owned bank.
This crisis was, in some aspects, predictable. Both the Bank of England and the Financial Service Authority (FSA) warned financial operators about the risks of evolving trends in the market, especially in relation to the new credit derivatives such as CDO and CDS. Moreover, the bank commitment to the wholesale market funding and a certain institutional weakness in the regulatory system enhanced the effects.
As appeared evident during the crisis, the UK regulatory scheme had a fundamental defect in the deposit protection scheme, there were no special bankruptcy regimes for banks nor resolution regimes for troubled banks.
But what are the main causes of such crisis?
Northern Rock had a unique business model based on securitizations and reliance on short-term market funding
The high dependence on short-term funding exposed the bank to the so-called low-probability-high-impact risk.
The financial crisis of 2007 increased the LPHI risk associated to the NR business model by drying up liquidity in the financial market.
A general and multi-dimensional problem associated to the regulatory system, involving the Bank of England and the FSA, with a fault-line in the separation of powers .
THE EXTERNAL CONTEXT
The Northern Rock crisis emerged in a period of international financial market turbulence. As stated by the Bank of England, this was mainly due to the creation of complex financial instruments with a high embedded leverage. Two major financial instruments are at the centre of the crisis: securitizations and CDO.
Securitization was supposed to transfer the risk, but two major problems arose during the crisis: risk was not shifted as much as foreseen and the shifting often came at the expense of boosting the counterparty risk, which might result in a solvency risk.
Moreover, financial markets closed and issuing banks faced both a liquidity constraint and a rise in the cost of funding as it became increasingly difficult to front short-term debits. Liquidity in the inter-bank markets also weakened and the interest rates became to grow.
As liquidity diminished, banks could not finance their off-balance vehicles and were forced to change their assets. This led to a huge demand for liquidity, since banks were concerned about their and their counterparty liquidity risks.
A MULTI-DIMENSIONAL PROBLEM
Seven different aspects can be identified in the Northern Rock failure, concerning both financial problems and regulatory/political aspects.
Low Probability/High Impact risk: This risk was related to NR business model, since it was low-probability risk (liquidity should have dried in the inter-bank and financial market) but it involved a high-impact effect (failure to continue to fund its business operations).
Incomplete credit risk shifting: The new financial instruments were supposed to transfer credit risk from balance sheet to other subjects. Anyway, the 2007 crisis showed that the risk-shifting ability of these instruments was not complete. The potential liquidity problems attached to such instruments were underestimated or not estimated at all.
Solvency vs. Liquidity: Even if legally Northern Rock remained solvent, the term "solvent" is difficult to apply to a bank which is facing problems in funding money in the open market, depends on the support of Bank of England and the cost of funding exceeds the average interest rate. Given the low equity capital owned by Northern Rock, the liquidity problems were enough to move it into legal insolvency
Deposit protection: The British deposit protection scheme (called Financial Services Compensation Scheme) revealed itself to be inadequate to protect depositors. It states that the first £ 2000 of deposits were fully protected, and then only 90% of the deposit up to a limit of £ 33000. This was the major liability of the system
Structural weakness: In addition to a defective deposit protection scheme, UK lacked a special bank insolvency scheme nor a resolution model in case of failing banks.
Institutional structure of supervision: The supervision of banks is not a job for the Bank of England. In 2000 the regulation and supervision process was vested in the Financial Service Authority, while the provision of market liquidity remained with the national bank.
INSTITUTIONAL STRUCTURE OF SUPERVISION
The new (1997) supervisory system revealed critical weaknesses the first time it was tested. The so-called Tripartite arrangement was too slow to activate. This was mainly due to the fact that FSA and Bank of England had different ideas about the actions to carry out for facing the crisis. Moreover, there were no clear definition about who should start the action and communication planning was undoubtedly problematic.
The Tripartite agreement is a formal memorandum between the Treasury, the Bank of England and FSA. It is based on 5 principles: clear division of responsibilities, appropriate accountability arrangements, avoidance of duplication of responsibilities, exchange of relevant information and mechanisms for crisis management.
THE RESOLUTION OF THE CRISIS
Initially, the UK government attempted to find a private buyer. Four conditions were set:
The government should share in any upside gain to the buyer
New capital was to be injected
Repayment of Bank of England loan was to be paid within 3 years
Bidders had to present a viable business plan
Later, the government proposed that Northern Rock could securitize some of its remaining mortgage assets with the securities being guaranteed by the government The funds would be used to repay the Bank of England's lend.
After a period the bank was posed in temporary public ownership. An independent commission would decide upon an appropriate price to be paid to shareholders though this was required to be made on the basis of excluding the effect of Bank of England support. This raised a problem since, while the bank's asset may have a certain value, the value of the equity could be zero.
None of the private bids was deemed acceptable: market conditions were uncertain and the demand to buy a mortgage bank was limited, the housing market in the UK was weaker than in the past years and was expected to fall again and there were uncertainty over the legal status of Granite (a Northern Rock vehicle for securitisation of the bank loans).
STRUCTURAL FLAWS IN THE UK REGIME
The deposit scheme was fundamentally flawed
The UK had no special insolvency arrangements for banks
There were no clearly defined ex ante Resolution procedures in the event of failing banks
The institutional structure of regulation proved to be an uncertain arrangement in time of crisis.
The major problem in the FSCS scheme was that it would not prevent bank runs because of its co-insurance principle. Secondly, there was no arrangement to ensure that, in the event of a bank failure, there would be arrangements to ensure there was only minimal disruption to customers in the conduct of their normal banking business. Thirdly, the arrangements for deposit protection could not guarantee that payments would be made promptly thus expositing bank deposits to a liquidity risk.
The new Special Resolution Regime (SRR) implies new powers and tools, and institutional structures and insolvency arrangements for banks. The SRR also gives powers to intervene before insolvency is reached.
The SRR outlines new tools available to authorities:
A private sector purchase of a failing bank
Transfer of the bank to a Bridge bank
A partial transfer of some parts of a bank's business by splitting the bank which would have the effect of disturbing property rights and creditor rankings
Temporary public ownership
THE NORTHERN ROCK CRISIS IN THE UK
DEPOSIT INSURANCE
The UK regulation about deposit insurance revealed itself as ineffective. It is not necessary that all the deposits have to be insured, but simply enough of them need to be protected so that the loss of the uninsured portions doesn't lead to a general loss of confidence versus the financial institutions.
The UK limit covers £ 35000, that is the 100% of the total 90% of all bank deposits. Anyway the so-called "co-insurance" scheme was set to protect only the 90% of the deposit after the first £ 2000 up to £ 35000. Thus, once the depositors felt something wrong in the bank, their only strategy was to run down the deposit to below £ 2000.
The co-insurance was intended to provide incentives for depositors to monitor the banks and put prudential pressure on the banks, who would know depositors were likely to exit.
Moreover, the UK (like the other EU countries) has an obligation to repay depositors within three months, extendable by a further three months in case of difficulty. The United States, e.g., the obligation is to restore deposits within a week. The UK structure is not credible by depositors, who will likely withdraw their money if a feeling of uncertainty is spreading over the country.
STANDING FACILITIES AND EMERGENCY LENDING
The Bank of England support for Northern Rock did not work as expected, on the contrary it helped precipitate a retail runner rather than stopping it. The FSA conviction that the bank was solvent and the lend by the Bank of England were not enough to convince depositors that the bank was solvent. Instead, the need to borrow from the central bank was interpreted as a signal of failure.
The penalty interest rate is sufficient to discourage banks from using the standing facilities as if they were a market solution, but it's not intended to be a difficult sign.
