Why Northern Rock Fell During the Financial
Crisis and How the Government Prevented a Contagion Effect
1. Factors which led to the financial crisis of
2007/2008
The financial crisis in 2008 is one of the
worst economic meltdown in history. There are many factors which caused the
financial crisis and these factors are interlinked and interconnected to one
another. It is very difficult to pinpoint the root of all problems as these
factors had manifested upon one another into a web across the whole financial
sector. Fundamentally, the 2008 financial crisis is a result of the failure of
banking system due to the subprime mortgage crisis.
Financial innovation is one of the more glaring
reasons that resulted the financial crisis. A mortgage is a debt instrument to
facilitate the repayment of debts, plus interest, that is secured by the
collateral of a specified housing property. Traditionally, it is not easy to
get a mortgage if a person has a bad credit rating or do not have a steady job
as lenders are not willing to take the risk that the borrower might default on
the loan. With financial innovation, banks and financial institutions were able
to create mortgage-backed securities and sell them to other parties. Market sentiments
for these new mortgage-backed securities are high and demand for these
securities increased. To meet derived demand for mortgages. Lenders, such as
banks and financial institutions, start to loosen their standards for borrowers
and accepted more people who have poor credit rating. From Figure 1, we can see
that the percentage
Figure 1: Percentage increase of housing
prices over the years
increase of housing prices have increased
year over year and that housing prices have skyrocket over a few years,
especially in the United States. The housing prices have peaked in around
2002, exceeding a 25% growth rate.
The new lax lending requirements drove housing
prices higher and higher, which made mortgage-backed securities seem like an
even better investment. With the rising real estate prices, people presumed
that selling the house for money would be the worst-case scenario in the event
that borrowers defaulted. However, when increasing number of borrowers started
defaulting on their loans, more and more houses went back into the market for
sale. There were no buyers and supply greatly exceeds the demand for housing
and eventually the housing price fell. This fall in housing price resulted in
mortgages that far exceeds the value of the house at that point in time.
Credit rating agencies, such as Moody’s
Investors Service and Standard & Poor’s (S&P), and the government
played a role in exacerbating the process which led to the financial crisis.
The new financial mortgage-backed securities were rated AAA ratings as the
credit rating agencies failed to identify the inherent moral hazard problem
behind this new financial innovation. Mortgages were safe traditionally but
when lax lending requirements are left unchecked, people are under the illusion
that they are buying safe investments when they are in fact paying for very
risky assets.
The financial
innovation also created unregulated over the counter derivatives such as credit
default swaps. These credit default swaps act as insurance against the mortgage-backed
securities. Financial institutions, such as American International Group (AIG),
sold billions of dollars of insurance without money to back them up. To make
matter worse, these default swaps were also turned into other derivatives.
Financial innovation has allowed institutions and banks to pass on the risk to
the next person. This passing of risk from one to another has created a web,
entangling everything in the financial system. This compounding effect ultimately
accelerates the whole financial crisis.
Another factor that led
to the financial crisis is the “too big to fall” attitude where companies know
that there are safety nets set in by the government to help them if a crisis
were to happen. This has resulted in large banks and financial institution to
take up more risks than they should. When the subprime mortgage crisis sets in
and the safety nets were unable to save everyone, banks will go bust. The
bankruptcy of Lehman Brothers has brought about a contagion effect (Kilic, Chelikani, & Coe, 2014) and a series of bank runs which cripples and banking
sector and resulted in the financial crisis.
2. How these factors impacted upon Northern Rock
and the reasons for the nationalisation.
Northern Rock was a British bank and was the first bank to go bust
during the 2008 financial crisis. Although all banks are met with various
challenges and illiquidity problems during the crisis, Northern Rock suffered
the most when the crisis came as it adopts a very risky and ambitious business
model relative to its counterparts. Banks and financial institutions usually
follow a borrowing short and lending long business model, where the interest
paid to short-term depositors are lower than the rate of interest collected
from lending out money to other long-term borrowers. Banks and financial
institutions profit from this spread in interest rate. However, unlike other
banks, Northern Rock had over-dependency on wholesale markets rather than from
retail deposits on its loan book. Retail deposits generally cost much more than
wholesale markets to acquire but traditional banks still prefer them as they
have higher liquidity.
Figure 1: Top five banks by securitisation issues
Northern Rock’s business model used mortgage-backed securities
and collateralized debt obligations, which offered higher interest rates than
government securities and retail deposits, to finance their loans. In January
2006, Northern Rock had a record pre-tax profits of £627 million, which was a
staggering growth of 27% compared to its previous year. From Figure 1, we can
see that Northern Rock relied the most on securitised mortgages among British
banks.
The factors that resulted in the financial crisis has adverse
effects on Northern Rock. When the crisis hits, they became insolvent. As
Northern Rock adopts a business model that heavily depends on mortgage-backed
assets to finance its debt, their assets became illiquid. The crisis brought
about high default rates among the borrowers and Northern Rock was unable to
collect back the debts to finance its loans. Having illiquid assets put
Northern Rock in a very bad situation as no other financial institutions or
banks were willing to lend Northern Rock money to finance its loans. When a
bank is unable to borrow, it will have no money to give to people when they
withdraw and this has resulted Northern to go bust.
The creation of mortgage-backed assets, which
Northern Bank is so heavily dependent on, is merely a financial innovation that
shifts the risks away from the one individual or institution to another. Banks
were no longer offloading its risks when trading such securities; they were
buying more and more into the risky assets. The business model that Northern
Rock adopted had no true transfer of risk, instead, the risk began to feed on
itself, going around and round in the financial system and Northern Rock was
caught in the middle of all the mess.
They were unable to source for funding around
the world as investors immediately shunned anything related to mortgages. The
outcome of a major bank filing bankruptcy is pandemic and will cause widespread
of fear among the people, resulting in bank runs through contagion effect and
ultimately cause the financial system to crash and become obsolete. The only
way out of this crisis was for the government to step in and resolve the
problem before the contagion effect takes place and they had to nationalise the
Northern Rock.
There
were opposing views that Northern Rock should not have been nationalised as it
would have encouraged the “too big to fall” attitude among other banks.
However, the main purpose of the central bank was to ensure stability in the
financial system. If Northern Rock was left to sink, it would have set in a
domino effect of fear and negative market sentiments in the economy and the
bank runs would not have been able to be contained. The financial system would
have run out of cash and credits and within a short period of time,
unemployment and poverty will hit the society. If Northern Rock was not
nationalised, it could have potentially resulted in social unrest and outbreaks
of riots among the people.
3. Post nationalisation outcome and evaluation of
the net impact
During the 2008 financial crisis, Northern Rock
was the first bank in Europe to go bust as its business model of using
mortgage-backed assets collapsed together with the subprime mortgage crisis in
the United States. As Northern Rock was unable to raise money to finance its
loans and mortgages, the government had to step in to prevent a widespread of
bank run in the region from happening. Northern Rock was nationalised in
February 2008 by providing an emergency funding of £37 billion and all shareholders lost
their money as Northern Rock was “taken into temporary state ownership”.
In December 2009, the government made the
decision to divide Northern Rock into two parts: the “good” bank and the “bad”
bank, known as the new Northern Rock and Northern Rock Asset Management (NRAM)
respectively (Chibber,
2011). The
new Northern Rock continued to operate as a normal bank, holding on to all of
its existing savings accounts and the top-grade mortgages at that time, with a
total net worth of £29 billion. It did not have to deal with the bad mortgages
and the burden of £27 billion bailout loan in 2007 by the Bank of England.
However, the new Northern Rock still had a loss of £68.5m in the first half of 2011, down
from a loss of £142.6
million one year earlier. The bank was later taken over by Virgin Money
who employed 2500 people, down from 5500 when it was nationalised (Chibber, 2011). Although employment level has fallen after Northern Rock
was privatized again, nationalization still had a positive impact. The
nationalization of Northern Rock acted as a cushion during the financial
crisis, without which, they would have gone bankrupt and unemployment would
have been more severe (Curtis,
2011).
On the other hand, NRAM took over most of the
old Northern Rock’s mortgage book which amounts to about £50 billion. NRAM was closed to new
lending as the separation of the NRAM out of Northern Rock was to deal with all
the existing bad debts and to repay the government loan, which amounted to
£26.9 billion at the end of 2007. In contrast to the new Northern Rock, NRAM is
profiting, with a pre-tax profit of £291.5 million in the first half of 2011,
down from a profit of £349.7 million in the previous year (Chibber, 2011).
Although
nationalization of Northern Rock was effective to an extent, it should have
been implemented earlier. The tripartite system of banking regulation failed to
identify the problem and this is largely due to a breakdown in communication
between the three parties. The fragmented financial system also resulted in
inefficiency and ineffectiveness during the crisis (Hubbard, 2013). Regulations
and decisions were made very slowly which contributed to the fear amongst the
people.
Having said that, the
net impact of nationalizing Northern Rock remains largely positive. If Northern
Rock had been left alone to crumble during the financial crisis, it would have
set out a series of bank runs across the financial sector and the widespread of
fear will eventually put the financial system to a halt. Nationalizing Northern
Rock and separating it into two banks had mitigated the series of bank runs and
restore market confidence. Such is an essential move to prevent the meltdown of
the financial system. Although this decision had gravely affected the shareholders
and the taxpayers, the priority to prevent a meltdown in the economy far
outweighs that of the shareholders (Wilson, 2011).
4. Steps which have been taken to prevent the
repetition of a similar financial crisis
In light of the 2008 financial crisis, measures
have been taken to prevent similar financial crisis from happening in the
future. In 2010, the Obama administration passed one of the largest financial
legislation reform called the Dodd-Frank Wall Street Reform and Consumer
Protection Act. This act is to be implemented over a period of several years
and it aims to lower various risks that were in the financial system of the
United States.
Through the Dodd-Frank Wall Street Reform Act,
companies that are identified to be “too big to fail” are closely monitored. As
from the 2008 financial crisis, large banks that become insolvent in the event
of a crisis will cause widespread panic and bank runs. This act requires banks
to increase their capital cushion and It empowers the
Federal Reserve to have the authority to split up large banks if they are
deemed to be “too big to fail”.
At the same time, it also eliminates loopholes for hedge
funds, derivatives and mortgage brokers. One key component of the
Dodd-Frank is the Volcker Rule that restricts the ways banks can invest,
banning them from owning hedge funds or using investors’ funds to do
speculative derivatives trading for their profit (Fontinelle, 2017).
In the fall of 2013, the Federal Reserve
has established new regulations that banks are required to have more liquid
assets in their portfolio management (Amadeo, 2017). Having more liquid assets, such as government
bonds and treasury, allow banks to be able to liquidate assets for cash easily
in a short period of time. This regulation is in place to prevent
insolvency problems like how some of the major banks such as Lehman Brothers
and Northern Rock faced during financial crisis.
Strict regulations were also imposed and
strengthened to address the moral hazard issue. As credit rating agencies were
accused of providing misleading information regarding the risk of the
mortgage-backed securities, office such as the Securities and Exchange
Commission were established to ensure accuracy and meaningful financial reports
and ratings. Whistle-blower programs were also expanded, discouraging predatory
lending schemes. Conflict of interests are also closely monitored. Close ties
between investment and commercial side of banking are frowned upon as it
creates conflict of interest, where depositors’ money is used for high risk
investments.
Last but not least, apart from government
regulations, education curriculums have also changed to better educate people
about the cause of financial crisis. There is a stronger emphasis being placed
on business and financial ethics and better management of risk. Students are
also made to study the causes and the scale of negative impacts financial
crisis bring about into the economy and society. Having a better understanding
of how financial crisis comes about will make such events less likely to occur
in the future.
5. Conclusion
There are many factors that led to the 2008
financial crisis. Most of these factors cannot be looked at and scrutinized
individually, but collectively where each of the factors interacted with one
another to result in a compounded effect which ultimately caused the financial
crisis. It is true that after surviving through the 2008 financial crisis,
people became smarter and are less delusional in the face of low risk high
return assets. Many of the factors that triggered the crisis were addressed and
responded with strict financial regulations after the crisis. Offices and
statuary boards are set up to monitor and audit companies with stricter
requirements to ensure that the companies do not bear too much risk. They also
make sure that the company’s business models are sound and are not too overly ambitious.
Government and central banks are also more proactive in screening for possible
systematic risks present in the financial system.
Although, the factors which triggered the
financial crisis have been addressed, they are all reactive measure to a
problem. Having all these regulations and acts in places does not, in anyway,
guarantee that there will never be another financial crisis again. The 2008
financial crisis started with the creation of mortgage-backed assets through
financial innovation. It was a new financial instrument which everyone failed
to fully understand the risks involved at that point in time. If there were to
be another financial innovation in the future, such as bitcoins and the block
chain technology, the regulations in placed to address the 2008 financial
crisis might very well not be effective in preventing the next financial crisis
of a different nature. The only way to prevent a financial crisis is for people
to be educated and stay vigilant, especially in face of a new financial product
that has low risk and high returns.
The rescue of Northern Rock by the government
by nationalising the bank was a good move. Northern Rock had become insolvent
due to the over reliance on mortgage backed securities. If Northern Rock were
to be allowed to go bust, it would have caused widespread panic across the
financial system. Depositors of other banks would have also gone to their banks
to withdraw money in fear that their life savings will vanish into thin air.
When everyone rushes to the banks to withdraw money, the financial system will
crash as more and more banks become insolvent. It would set about a contagion
effect and multiple bank runs will follow, crippling the whole economy.
There were other alternative solutions to
nationalisation of Northern Rock, such as allowing other banks to bail out
Northern Rock. However, having a bank or financial institution buying out
another bank would likely to be a profiteering move and might not alleviate the
crisis in the financial system. If the bank or financial institution that
bailed Northern Rock out could not contain the situation and damage, the
aftermath is definitely going to be pandemic. Having a meltdown in the
financial system is simply too big a risk for the government to take and their
priority should be restoring stability back into the financial system in times
of a financial crisis.
Although nationalisation of Northern Rock was
the correct move, the rescue came rather late and it should have been done
earlier. After the 2008 financial crisis, the tripartite system between the Financial
Services Authority (FSA), Bank of England and the Treasury, proved to be very
inefficient and ineffective in dealing with crisis. There were communication breakdowns
and it takes a long time before coming up with a decision.
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