Northern Rock: Risk Management

Northern Rock plc Risk Management Home Assignment Northern Rock plc Risk Management Home Assignment Authors: Serghei Leahu Alexandru Mangir Mihail Mavrin Seminar leader: Herbert Windsor Authors: Serghei Leahu Alexandru Mangir Mihail Mavrin Seminar leader: Herbert Windsor Table of Contents Executive summary2 Economic and financial environment description3 Causes and circumstances of incurred losses5 Errors by the organisation8 Errors by internal and external supervising authorities10 The internal authorities10 The external authorities10 Effects on other commercial organisations12 Conclusions14

References15 Executive summary According to the House of Common’s Treasury Committee’s Fifth Report of Session 2007-08 “The run on the Rock”, on the evening of Thursday 13 September 2007 at 8. 30 PM the BBC announced that Northern Rock plc had asked for and received emergency financial support from the Bank of England. The terms of the funding facility were finalised in the early hours of Friday 14 September and announced at 7. 00 AM that day. That day, long queues began to form outside some of Northern Rock’s branches; later, its website collapsed and its phone lines were reported to be jammed.

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The first bank run in the United Kingdom since Victorian times was underway. The purpose of this home assignment is to critically discuss the Northern Rock plc bank run from a faulty risk management perspective. We seek to examine what were the causes of the collapse of Britain’s fifth largest mortgage lender, associated consequences for both the bank and other financial institutions (both domestic and international), the way authorities coped with this event and possible lessons to be drawn about proper and improper risk management. Economic and financial environment description

For a better understanding of the details of risk management problems that engulfed Northern Rock plc, it is of vital importance to first and foremost take a look at the financial environment during the period of the loss. Real GDP growth projections as of 4 April 2007 Country/Region| 2006| 2007| 2008| United States| 3,25| 2,25| 2,5| Western Europe| 2,75| 2,5| 2,25| United Kingdom| 2,75| 2,75| 2,5| Other West Europe| 3,75| 3| 2,75| Euro area| 2,75| 2,5| 2| Emerging markets| 7,25| 6,5| 6,25| World(WEO weights)| 5,25| 4,25| 4,25| In August of 2007, the UK found itself affected by global financial chaos.

Citing bank Credit Europe (2007), the liquidity crisis originated from the US subprime mortgage market. In mainland Europe, the crisis is believed to have been triggered when French based bank BNP Paribas suspended three of its investment funds that were exposed to the US markets that traded ‘toxic’ assets, as reported by BBC News on 9 August 2007. As a result, share prices plummeted and banks would not continue lending to each other. So, all major central banks around the world started injecting liquidity into their domestic markets in similar attempts.

The European Central Bank sought to calm the tide by reportedly pumping $130 billion in the European banking system. It sought to satisfy Eurozone liquidity demands as fast as possible, unlike the Bank of England who left UK banks’ claims for liquidity unsettled. The Bank of England did not follow suit and took no contingency measures in order to protect against moral hazard. Their rationalisation was that an injection would induce banks to take on more liquidity risk, resting sound knowing that the Bank of England would find a way to save them.

Injecting money into economy to prevent crisis have two major risks, first one is slowing growth too much in case of trying to avoid issuing new money, and second one is that inflation pressures will rise in case of issuing too much , at the end even with a greater slowdown. Due to these risks, the bank of England did not inject money into the UK financial system. Also, behind the economic environment a large effect on any business has the political environment. Its effects are even greater during a period of critical time in financial systems where trust and confidence is very significant.

In the UK for example, the financial system is regulated by the Tripartite system: the Bank of England, the Financial Services Authority and the Treasury. According to Aldrick (2007), although their roles are clear, there was no overarching authority when the crisis struck, which meant that everyone was pointing fingers around, but nobody was able to take the large chunk of responsibility for reactionary measures. In retrospect, how come Northern Rock, out of all of the UK’s financial institutions, proved to be the weakest link?

Why had the credit crunch affected it in such drastic fashion? Was it a victim of its own doing or were other external forces involved in the bank run? We aim to answer these questions under following headings. Causes and circumstances of incurred losses According to ex-Unilever, British Gas and KPMG manager Mike Barnato, risk is the antagonist of opportunity. No ships would ever leave port if captains wanted to avoid risks associated with sea travel. Therefore, risk must be managed in order to achieve objectives at all levels: private, corporate, state.

However, the old-fashioned approach to risk management such as detect risk, measure probability, gauge effect, and identify reactions, habitually disregards broader people and strategic matters. As stated by the Financial Services Authority, liquidity risk is defined as “the risk that a firm, although balance-sheet solvent, cannot maintain or generate sufficient cash resources to meet its payment obligations in full as they fall due, or can only do so at materially disadvantageous terms. ”

Originally established as a building society, Northern Rock demutualised in October of 1997 and became a plc. The bank’s consolidated balance sheet grew no less than sixfold, as a result of a complete overhaul in its corporate strategy. According to the Treasury Committee Report (2008), CEO Mr Adam Applegarth claimed that Northern Rock’s assets “increase by 20% plus or minus 5% for the last 17 years”. Sustainability for the high growth of assets was to come from a restructuring of its liabilities.

The year 1999 marked the beginning of the so-called “originate and distribute model”, which involved originating or purchasing loans and transferring them to SPVs (Special Purpose Vehicle), which in turn package these loans into collateralised debt obligations (CDOs) to sell to third party investors. Approximately 50% of Northern Rock’s funding (coming from securitised notes) was provided by SPV “Granite”, registered in Jersey.

The constantly growing funding need was due to be met by means of securitising bonds using a LLP (Limited Liability Partnership), which allowed the bank to continue holding its assets and issue asset-backed securities on their basis. This was a lucrative and quite secure deal for investors. As wholesale funding dramatically increased, the proportion of retail deposits as means of funding gradually decreased, by 2006 totalling 22. 4% of total equity and liabilities as opposed to no less than 62% in 1997. It is a widely acclaimed fact that the Northern Rock crisis was caused by an verly aggressive business model, which relied mainly on wholesale market funding, rather than its own deposits. Rapid growth was understandable, because funding from deposits would nowhere near be as potentially high as wholesale funding. Nevertheless, this reliance exposed the bank to an imminent liquidity risk. UK money markets were bound to be hit by a liquidity crisis, following tension in the US as the Fed’s interest rate was all over the place. The first half of 2007 saw mortgage lending go up by 31% compared to the same period of 2006.

Northern Rock’s loan book quality was a clear sight for sore eyes, as lending quality drastically decreased. The bank was giving away mortgages left and right to customers whose credit worthiness was shady to say the least. It is no surprise that many similarities can be drawn between Northern Rock’s business model and the business model of US mortgage lenders. However, surprising is the fact that Northern Rock’s management apparently did not attempt to manage the obvious liquidity and operational risks having examples of mortgage lenders over the Atlantic that were clearly pushing the envelope.

According to the Treasury Committee Report (2008), on 9 August 2007 it became crystal clear that Northern Rock would face severe problems if the money markets continued to be frozen as they were. It was on that day that the bank’s traders noted a “dislocation in the market” for its funding. This was the effect of a global financial system shock triggered by the US subprime mortgage market. While this shock was originally credit based and it did not directly expose Northern Rock to the dreaded liquidity risk, its effects questioned the value of asset-backed securities and related products held by large financial institutions around the world.

Overall market liquidity was very shaky due to the fact that holders of asset-backed securities did not have information regarding loan quality and default rates, to which originators of these securities did have access, so the funding of these financial instruments became problematic. As Northern Rock was running low on cash since its last securitisation in May and another one was due in September at the earliest, the liquidity freeze hit the bank with disastrously poor timing. Even so, better timing would not have saved it from trouble, due to the prolonged duration of this drying up of money markets.

Northern Rock’s business model was unique in the sense that the central part of its business strategy was securitisation. The bank relied heavily on short-term funds, while as most banks opt for marginal securitisation of assets. In addition, a property of this aggressive model is that it exposes a bank to the so-called LPHI risk (low probability-high impact). In essence, the low probability is derived from the fact that the drying up of money and capital markets on a large scale is improbable. The high impact relates to the almost exclusive reliance on high liquidity for the bank to be able to fund its operations.

According to David Llewellyn, citing his work “The Northern Rock Crisis: A Multi-dimensional Problem”, in the context of Northern Rock, the LPHI risk is composed of three micro risks: a) the risk of the bank being unable to re-receive funds that reached maturity, (b) the risk of being unable to securitise the planned mortgages, (c) the cost of funding would rise relative to the mortgage loans it kept on its balance sheet. A pivotal role in the subsequent events linked to Northern Rock’s failure was the run on deposits which equalled about ? billion, dubbed “The run on the Rock” by the media, which took place from Friday 14 September to Monday 17 September. Once the run had begun, two factors kept its momentum: a) depositors were becoming more and more aware of the fact that Northern Rock would cease to be a going concern, were the run to continue; (b) deposits above ? 2,000 were not guaranteed in full to customers, which dramatically increased the awareness of a large amount of depositors that previously were not in touch with the shocking scale of their potential losses.

As a result, the Bank of England had to implement an immediate emergency facility programme for the bank, which was previously considered as a “backstop”, rather than a reactionary safety net. Naturally, customers acted completely rationally and logically seeking to save their deposits by joining in on the run having heard about the distress of their bank on the news. This psychological factor shifted the issue from being one of the Northern Rock customers to a rather large scale crisis that affected any person’s belief in the banking system.

As a result, the following months saw the Government discussing takeover offers from various companies, notably Virgin Group, Olivant, JC Flowers, Lloyds TSB. However, according to an announcement by Northern Rock, all the bids were rejected, because they were “materially below” the previous trading value. As such, according to Elliot, Seager and Inman (2007), the Government arranged an emergency legislation to nationalise the bank, in the event that takeover bids fail.

On 17 February 2008, following unsuccessful bids to take over Northern Rock, Mr Alistair Darling, the Chancellor of the Exchequer, announced that the bank was to be nationalised, as mentioned by BBC (2008). Errors by the organisation “Northern Rock’s risk management framework is designed to maintain and continually improve the established processes and tools for the identification, assessment, control and monitoring of existing and future risks. Northern Rock’s approach provides a mechanism for the active identification, assessment and communication of risks throughout the business”.

Northern Rock Community Report (2006) We will soon come to prove that the above statement is completely false. First and foremost, it must be noted that the Board and management team of Northern Rock rightfully took a large chunk of blame for their irresponsible and incompetent actions. In the chase for rapid growth and profits through securitisation, they clearly missed out on a basic principle of risk management which is the diversification (spreading) of risk.

While Northern Rock’s management and Board clearly placed all of their eggs in one basket, it was obvious that should an improbable (although completely unavoidable) liquidity shock hit the UK markets, they’d be in head spinning trouble. The bank had a proper approach to risk management. It covered liquidity, credit, operational and market risk, which were described in detail in its filing for the US Securities and Exchange Commission. Northern Rock’s assets were looking strong, therefore credit risk was insignificant.

In terms of market risk, FOREX and interest rate fluctuation exposures were managed properly Nonetheless, its management clearly did not take into consideration the fact that if the access to short-term funding was impeded, it would end up facing a huge liquidity crisis. Therefore, as the US sub-prime mortgage crisis (mortgage backed securities were the meat of Northern Rock’s funding) unravelled, the bank became exposed to liquidity risk. In addition, the management apparently did not have a plan “B” to funds its activities in case the money markets dried up – an operational risk.

The Tripartite authorities might be frowned up as being short-sighted in respect to the Northern Rock case. However, the bank’s CEO, Mr Applegarth, and his Board are the ones responsible of failure to identify the risks associated with their aggressive and reckless business model, or for being foolish enough to indeed identify the risks, but deciding to ignore them, in hopes that bad luck would strike elsewhere. The need to balance risk appetite and return is a basic business principle, however risk must be managed consciously, continuously and actively.

Steve Boyle, in his article “Avoiding the next Northern Rock” goes so say that it is important to note that although the contemporary business model (coupled with legal frameworks and regulators) encourages companies to ignore inconvenient truths, ultimately the companies themselves are to blame for their failure to handle their risk appetite. It is surprising to find out that CEO Mr Applegarth did not respond to the Bank of England’s interest rate increase in any reasonable way.

Liquidity conditions were tightening up on a global scale for a fair amount of time and although these were not drastic enough to raise a panic, the bare minimum questions “How are we prepared for this? Are we at all prepared? ” should have been raised. Despite obvious indicators of an unstable interest rate environment, Northern Rock continued giving out mortgages for 125% of house valuation, paying little to no respect to risk management. Did Mr Adam Applegarth even want to see the impending funding shrinkage?

Probably, by sitting down and giving it an objective though he would spot the effect of rising interest rates on the UK financial markets. As stated in the Treasury Committee Report (2008), “Northern Rock’s continued expansionary lending policy required the continued success of its funding strategy at a time when there were indications of potential problems on the funding side. ” Although the Bank of England was keen to identify the potential risk of wholesale funding for banks should the money markets lose its liquidity, the managers at Northern Rock did not heed this warning.

The reliance on short and medium term funding was not met with any kind of standby facility, leaving liquidity risk completely uninsured. This high risk, reckless strategy was formulated by the Board and overseen by long serving directors. Yet, it was not met with any kind of restraining from the Chairman of the Board, Chairman of the Risk Committee, internal audit staff, which is at the very least surprising. In reality, the Board and management kept ploughing at their reckless business model, believing that standby facilities are a waste of money.

Errors by internal and external supervising authorities The internal authorities One cannot detach internal control from corporate governance, because it is the Board’s responsibility to monitor significant risks and to ensure that internal controls are effectively involved in their proper evaluation and handling, but most importantly the Board must always induce internal controls to be cautious while dealing with risk because of their ever elusive nature.

It is quite a possibility that Northern Rock’s internal controls were not up to par and were giving out the rest of the company completely the wrong message. As stated in an article on cimaglobal. com, Northern Rock’s filings to the SEC give the impression that its main concern was regulatory conformance, rather than its overall control environment. According to the Treasury Committee Report (2008), part of the oversight of the liquidity strategy of Northern Rock was conducted by its Risk Committee, chaired at the time by Sir Derek Wanless, a non-executive member of the Board of Northern Rock.

Sir Derek Wanless is reported to have said that the Risk Committee “looked at the issues of [their] funding strategy and what the risks were”. He went on to defend the role of the Board and the Risk Committee, telling the Treasury Committee that “The Risk Committee and the Board did [their] job, in my view, properly through this period. ” The external authorities The external regulation of Northern Rock plc was conducted by the Financial Services Authority spanning from 2005 to 2007.

Its handling of the events of August-September 2007 received wide criticism. In the following paragraphs we aim to describe the poor regulation of Northern Rock that went hand in hand with mismanagement that ultimately led to its collapse. Citing the Treasury Committee Report (2008) on Northern Rock’s failure entitled “The run on the Rock”, London School of Economics Professor Willem H. Buiter was found stating that “The FSA did not properly supervise Northern Rock. It failed to recognise the risk attached to Northern Rock’s funding model.

Stress testing was inadequate. ” According to an IMF working paper, a ‘stress test’ is termed as the revaluation of a portfolio using different sets of assumptions, the goal of which is to assess the sensitivity of the portfolio to changes in various risk factors. It is curious to find out that while the FSA had been highly unsatisfied with Northern Rock’s stress testing procedures; it did not notify the bank’s management team to immediately adjust these procedures.

In addition, while the Board did continue to conduct stress testing, their methods were inadequate and the Financial Services Authority failed in its duty to guide the Board towards ensuring that the bank was ready to handle a market shock. A prime indicator of running a big risk financial plan is rapid expansion. The FSA had acknowledged obvious red flags concerning the bank’s rapid market share expansion, as well as decreases in share price from February 2007 which translated into Northern Rock’s extremely risky business model.

Yet, the regulator merely underwent into a greater regulatory engagement, which pretty much failed to target the root weakness – the funding model. As mentioned by the Chancellor of the Exchequer quoted in the Treasury Committee Report (2008), the FSA did not deem liquidity regulation as important as solvency regulation. It brings up the question whether the FSA is actually competent of handling liquidity related shocks at all. We believe that this was a substantial failure in regulation, which eventually no less than fuelled the forthcoming chain of events.

An increase of 30. 3% of Northern Rock’s interim dividend was made public on 25 July 2007. This was the result of, as CEO Mr Adam Applegarth put it “when you get your Basel II approval, the relative risk weighting of certain assets in your balance sheet changes […] our risk weighting for residential mortgages came down from 50% to 15%, which clearly requires less capital behind it”, which explains the increased dividend. Unfortunately, we are of the same opinion as the Treasury Committee Report (2008), which notes that this approval came at the most untimely moments.

In doing so, the FSA allowed Northern Rock to singlehandedly weaken their own balance sheet at a time when the FSA was itself battling liquidity problems in the financial sector. The support operation announcement by the Tripartite authorities was apparently to be treated with great delicacy, because they were aware that it might have the complete opposite effect than calming the depositors. We, the authors, believe that the authorities acted extremely rashly in the whole process of stating the Government guarantee of supporting Northern Rock through its crisis.

They failed to plan the announcement prior to 16 September 2007. It is also worrisome that the announcement was not made before the markets opened the following day. This led to a delay in the guarantee until the evening of the fourth day after the run started, which made the bank run even more prolonged and severely damaged the already whimpering health of the bank. Yet another area of concern is that the Financial Services Authority completely overlooked the fact that Northern Rock’s CEO was not a qualified banker, albeit he possessed significant work experience.

Mr Adam Applegarth did not have any training qualification and as such, this absence ought to raise major question marks. To sum up, Northern Rock’s failure was not entirely the fault of its management; it was also the fault of its regulator, the Financial Services Authority. Evidently, sufficient resources were not assigned to the watching of a bank’s business model that was so obviously screaming “Look at me! ” Moreover, the FSA did not seem to give the air of confidence of a supervising authority that knew how to handle a particular financial institution rather than targeting an aggregate group.

Effects on other commercial organisations “It was on the 9th of August when the world changed. ” Adam Applegarth, Northern Rock plc CEO The effect of Northern Rock crisis spread shockwaves all around the financial markets and most importantly to the UK, adding an unexpected swing to an already unstable financial situation that could go from bad to worse in an instant. As said before, on 9 August 2007 money markets froze and the short-term funding that Northern Rock so heavily relied upon (it made up roughly 60% of the right side of its balance sheet) squeezed considerably.

The Northern Rock crisis was a signal which raised awareness of other banks with a similarly risky business model on upcoming problems and showed the need to concentrate on actively managing liquidity and operational risk. In the midst of the crisis, it was evident that banks became reluctant to ask the Bank of England for liquidity facilities, because it might have been treated as Northern Rock clones. Furthermore, such facilities were obviously not going to be offered in a confidential manner.

Even if the Bank of England did keep things hushed, word would spread anyway and a simple case of extra liquidity claim would cause devastating panic. The Newcastle-upon-Tyne based bank was the first of its kind, the first in a notable list of banks that were nationalised during the crisis that took the United Kingdom by storm. Next on the list came Bradford and Bingley, Heritable Bank and Kaupthing Edge which were all also nationalised. The nationalisation of Northern Rock increased national debt by an additional ? 00 billion, which was due to be settled by no later than June-July of 2010. In addition, The Bank of England pledged to pay off Northern Rock’s debts consisting of the following: * loans (approximately ? 25 billion ) * guarantees (approximately ? 30 billion) * value of company (approximately ? 1 billion) Another consequence of this failure was that Northern Rock was responsible for about one fifth of all mortgage business. With its collapse and also in ‘close cooperation’ with the overall mortgage crisis, it struck individuals at the heart of their fears – uncertainty.

At least 2,000 employees were dismissed as a result of the collapse, even if Alan Clarke, Chief Executive of the Development Agency stated that there was a demand in qualified Northern Rock bank workers and that there was a big chance of a slight increase in unemployment level. Also, hedge funds and investment banks were also affected, workers seeing their spending power reduced by lower bonuses, or even curtailed by job losses. Finally, the cuts are a blow for job prospects in north-east England where Northern Rock was one of the biggest employers.

Lloyds TSB was keen on helping Northern Rock reduce the size of its balance sheet, in a deal that would allow some Northern Rock customers to receive new mortgages at the end of their fixed-rates. A Forbes article (2008) mentions that customers would be exempt from the standard lender’s application fee and Lloyds would pay a commission fee to Northern Rock for every successful mortgage deal (the maximum loan-to-value ratio being 80%). As such, Lloyds took advantage of the Newcastle based bank’s troubles in a lucrative deal for more or less both parties.

The case of Northern Rock revealed a problem with the FSA’s handling of liquidity based crises. A new assembly of supervisors to review supervision of “high impact” firms such as Northern Rock was employed. In addition, staffing and training increased to not allow such incidents to affect public opinion so drastically, because a portion of it was clearly unsatisfied with the FSA’s role in the debacle. As suggested by internal auditors, high-impact firms would be reviewed annually and their performance checked every six months.

Furthermore, the Financial Services Authority would concentrate a larger part of its time and effort to be prepared to react to future liquidity shocks. On 24 May 2008 Legal ;amp; General, SRM Global, RAB Capital and the Shareholders Action Group (150,000 of the bank’s small investors) joined forces in the legal action against the Government after the nationalisation announcement. As written by Sean Farrell for the Independent (2008), shareholders believe that the Bank of England rigged the process for compensating Northern Rock’s investors, because a sovereign valuator must accept that the bank was not a going concern.

L;amp;G wished to see to that share valuation would be conducted on an impartial basis, without the dogmatic conventions enforced by the Treasury. According to Simon Evans (2008), at the end of July 2008 the valuation of Northern Rock would be delegated to 2 of 10 firms that applied, in spite of threats of legal repercussions. Monaco based hedge fund SRM Global stated that a negligence case of high stature would be opened on anyone that would partake in the role of valuing the poisoned chalice, considering that the hedge fund owned shares in value of 11% at Northern Rock before its nationalisation.

Unsurprisingly, few forms expressed their interest in the valuation process, because the Treasury had imposed a number of restrictions for potential valuators. Northern Rock was a just a drop in the ocean of the financial peril that followed. The difficulty for the financial markets and ordinary people was that at that point nobody knew where thunder would strike next and who would be its next victim. Conclusions At present, business at Northern Rock plc is looking quite optimistic.

It is known that the restructuring of the bank and the overhaul of the boardroom paved the road for a future re-entry into the commercial banking sector with a new formula for success. Also, a new debt reduction strategy was adopted, with the bank repaying its loans well ahead of maturity, with a little under ? 9 billion remaining to be paid as at 9 March 2009. Based on the above discussion, several key lessons can be learned such as that companies ought to move beyond box ticking by sacrificing performance for conformance.

Also, risk management is absolutely essential to undertake in today’s constantly changing financial environment where anything can happen at any time. As for the institutions delegated to supervise, we would like to stress a few recommendations: * liquidity assistance arrangements must be timely and inspire confidence * external supervisors such as the FSA must have a solid plan of corrective action * legal framework must exist in order to prevent the collapse of a bank that is enduring troubles with departments or functions of systemic importance

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