Did the FSA Fail Northern Rock?

Topic: Banking
Words: 4985 Pages: 18

Executive Summary

In 2007, Northern Rock, a bank in the United Kingdom crashed. The reason behind northern bank crash was their reliance in securitisation. The steep interest rates in the United States made it hard for most homeowner to pay their mortgage loans. The problem of mortgage payment in the United States finally turned into a crisis and spread all over the world leading to a credit freeze. As a result of the global credit crisis, the wholesale markets virtually went dry. This in turn led to financial caution among financial institutions. Most financial institutions were scared of lending to other institution due to the uncertainty brought about by the global crisis (Ndong and Scialom, 2008). The crisis hit Northern Rock hard since they could not obtain funds from other banks. Therefore, circumstances forced Northern Rock to ask for a bailout from the Bank of England in order to meet its financial commitments. This move led to customers losing faith in the bank’s ability to stay afloat. Therefore, in 2007, the bank run in Britain occurred after a non-eventful century and a half.

Northern Rock had been warned of the forthcoming financial problems. However, the bank did not take heed of the warnings and continued to finance its activities using the wholesale markets. Therefore, when the bank finally failed the blame was laid on both the FSA and the management of Northern Rock. The case of Northern Rock acted as a revelation to the United Kingdom who decided to review some of their financial policies in order to prevent future crises. Moreover, after consultations, Europe finally managed to adopt the Basel II framework.

After the crisis of Northern Rock, the Financial Service Authority came up with a response to ensure that such a crisis never occurs again. The question that this paper asks is whether the financial service authority (FSA) actually contributed to the failure of Northern Rock. The answer to this question remains open in many respects and it up the readers of paper to determine the answer. Moreover, this article discusses some policies that the FSA may use in the future to ensure that crises similar to that of Northern Rock do not occur.

Introduction

The crisis that led to the run on of Northern rock was predictable from the initial stage. In fact, some analysts had predicted the occurrence of such a crisis even though they had not tied the occurrence to any particular bank. To begin with, the Bank of England had issued warnings on the changing financial trends in the market. On a lesser extent, the financial service authority had also issued similar warning. However, Northern Rock’s business strategy entailed a lot of borrowing both in the United Kingdom and in the international markets. The bank would the extend mortgages using the funds obtained from the borrowed money (Ndong and Scialom, 2008). During the global financial crisis in 2007, the demand for securitized mortgages dropped drastically. This drop in demand led to markets drying up and therefore, Northern Rock was unable to raise fund s to repay their debts. Northern Rock became the first case of bank run in Europe for over a century and a half.

Since Northern Rock had been forewarned of the upcoming crisis, the bank of England took its stance and decided that it would not bail out Northern Rock. This was because the crisis that occurred at Northern Rock was cause by imprudent decisions (Ndong and Scialom, 2008). Therefore, the bank of England wanted to leave the situation to the market forces. However, after the crisis was highly publicized in the media, the governor of the bank of England made a U-turn and decided that the bank needed rescuing. Some analysts and scholars deemed the decision to bail out Northern Rock as imprudent. This is because, in a capitalistic nation, organizations with poor management should be left to burn themselves out in order to cut losses.

Background of the Study

In 1997, Northern Rock underwent a demutualisation process. Initially, Northern Rock was a building society. Therefore, after the demutualisation process they became a public limited company that specialized in mortgages. The change in status indicated he beginning of radical changes in the company. To begin with, the balance sheet increased by a considerable figure between 1997 and 2006. For instance the assets increased by approximately 20%.

In order to sustain the growth in the balance sheet, Northern rock had to change some of its strategies. For example, the bank had to change the structure of its liabilities. Therefore, in 1999, the bank adopted a new liability system that allowed them to purchase loans from specialized brokers. These loans were then transferred to special purpose vehicles where they were repackaged for sale. A good example of a special purpose vehicle was Granite, which provided about a half of the securitized loans.

As northern Rock continued its business, the demand for loans increased. Therefore, for Northern Rock to meet the growth in funding needs, they had to turn to find new means of financing. In 2004, Northern Rock started using covered bonds to finance their activities (Ndong and Scialom, 2008). The use of covered bonds required the bank to change from using special purpose vehicle to limited liability partnership. Using this finance method ensured that the bank maintained ownership of its assets while they issued covered bonds. This mode of financing is advantageous to investors since limited liability partnership only starts to take effect when the bank that covered the bonds defaults (Ndong and Scialom, 2008).

The demerit of the rapid growth in wholesale funding was a decline in rate of deposits of the finances (Edwards et al., 2004). The advantage of the liability model adopted by Northern Rock was that it allowed the bank to save its capital while maintain its lending portfolio. Therefore, banks that use this system could sustain profitability easily. However, securitization has a disadvantage of reducing an organization’s ability to screening and monitoring their customers. In this light of events, it is to understand that, whereas securitization spreads the general risks, it may also increase the risk factor (Ndong and Scialom, 2008). In theory, when a bank loans out some of its assets and fails to monitor them properly, it may lose its reputation. Investors who purchase poorly performing collateral debt obligations (CDOs) have a tendency of laying blame on the bank that set up the special purpose vehicle (Ndong and Scialom, 2008). The reputation system adopted by Northern Rock is highly inefficient when it comes to offsetting a decline in incentives associated with loan securitization (Ndong and Scialom, 2008).

Analysts and scholars have tried to explain the reason behind the failure of Northern Rock. Therefore, a number of explanations exist as to why Northern Rock actually failed. The Building Society Association explained that when Northern Rock relinquished its status as a building society it created a conducive environment for its failure. This is because, under their new status, Northern Rock could adopt extreme models. In fact, the building society has rues that ensure that extremities are not reached. There is a requirement that all building societies must attract an estimated 50 % of their finances from members. The wholesale financing is capped at around 30% in the United Kingdom.

The Northern Rock crisis therefore is as a result of adoption of an extreme model. Northern Rock funded their mortgages through wholesale the wholesale market. This exposed hem to risk ad increased their vulnerability to the market’s credit squeeze. In case Northern Rock used retail financing, they would have reduced the likelihood of failure. The idea of securitization encouraged the growth of lending n the company. During their first year, the level of lending increased by an estimated 31%. Therefore, northern books of accounts started reflecting figures that caused concern among the investors.

The reason behind the failure in Northern Rock is in the similarity of its business model with that of the American lenders. Northern Rock committed business suicide by designating a business model that made it vulnerable to the subprime crisis, which originated from the United States. The financial crisis that occurred in 2008 was one of the major debacles that has ever occurred in the global economic scene. This crisis was triggered by careless banking mistakes and insurance errors (Pinyo, 2008). Moreover, greed contributed the financial crisis that occurred in 2008 (Pinyo, 2008). Hofstede (2009) cites culture as one of the causes of financial crisis in the world. However most analysts believe that apart from culture, there are other factors that caused the financial crisis in 2008. Haspeslagh (2010) attributed the financial crisis to failure in corporate governance like most economic analysts. Other major causes of the financial crisis included greed and “dreaming big” (Haspeslagh, 2010). Most managers have stopped making decisions based on the logical judgment. Instead, they are dependent on mathematical models, linear extrapolation, and market situations to make decisions. This has led to incompetence in the work setting and finally it led to the global financial crisis of 2008. The shortcoming in corporate governance remains one of the most probable cause of 2008 financial crisis. The crisis in 2008 had a domino effect in other economies that are interconnected (Hofstede, 2001). Most of the countries were affected by the 2008 crisis that began in the United States. Among the affected nations was the United Kingdom, specifically Northern Rock bank.

Did the FSA Fail Northern Rock?

The timing of the credit crisis was highly disadvantageous to Northern Rock. This is because the company was low on cash and it was planning another securitisation in September of 2007 (Ndong and Scialom, 2008). However, even if the global crisis had occurred at another time the demise of Northern Rock was imminent. Northern Rock was involved in risky business practices. The desire to expand its market share using securitized fund can easily be considered as a risky business financial practice. Nevertheless, the Financial Service Authority (FSA) did not act to prevent any further risky behavior. FSA remained passive and ignored the situation in Northern Rock. In addition to this, they went ahead and granted Northern Rock a waiver, which enabled the bank to adopt other means of managing its credit risks (Ndong and Scialom, 2008).

To say that the FSA failed Northern Rock may be very true. This is because the bank had undergone all the stress-testing exercises that most banks undertake to test their ability to handle risk. It is obvious that both the Financial Service Authority and Northern Rock did not think of a scenario where all the bank’s sources of finance would dry up at the same time. When Northern Rock was allowed to use an advanced approach to manage the risks, they were granted with the power to use their own estimation of probability of any failure that may occur. The advanced approach led to Northern Rock increasing their capital. This in turn led to Northern Rock raising their interim dividends by 30.3%.

It is a mistake to blame the FSA solely in the case of Northern Rock failure. This is because the United Kingdom is a capitalistic economy and most entities are allowed to make their own decisions. Moreover, capitalism encourages business entities to work in a manner that will benefit its interest alone. Therefore, in relinquishing its status as a building society it is safe to that Northern Rock thought they were acting to enhance self-interest. Moreover, when northern Rock made their decision to use wholesale markets to finance its activities, it can be said that they were sure they could still safeguard self-interest.

However, the Bank of England had issued warnings on the changing financial trends in the market. In addition, on a lesser extend the financial service authority had also issued similar warning. Therefore, the failure of Northern Rock was totally self-inflicted to a given extend. Management of Northern Rock assumed that the bank impervious to the global financial changes and therefore they did not incorporate any measures that would mitigate the predicted risk. Northern Rock failure is a good example of case where ignorance or may be arrogance acted against the managerial strategies. The bank was over confident in its operations such that they did not think that the global crisis would actually affect its operations. When the trickledown effect actually reached the United Kingdom, the wholesale market dried up and Northern rock could not obtain any funds that they could use to support their activities. Therefore, after a century and a half of no incidences in the United Kingdom’s banking industry, Northern Rock became the first bank to experience a bank run.

Nevertheless, this explanation does not exclude the FSA from any blame. This is because they ignored all the symptoms that Northern Rock exhibited. In fact, in 2007 the FSA was involved in granting Northern Rock with a chance to adopt an advanced approach in managing its risks. Moreover, the FSA supervised Northern Rock’s series of stress testing tests in the first half of the year 2007. Therefore, the question on who was to blame still remains open. Did the FSA fail Northern Rock? In my opinion the answer is yes they did. The question that still cannot be answered is: to what extend did the FSA actually fail Northern Rock?

Crisis Management and Future of Banking Regulations

Northern Rock remained unaffected by the United State’s mortgage crisis for a considerable amount of time. In fact, until July of 2007, Northern rock had not been affected by the crisis in any noticeable manner. Their policy of borrowing from the wholesale market had minute impact on the market’s view of the risk. This is because the risk was measured by collateral debt obligations spread. However, as this article has previously stated, while Northern Rock’s credit spread showed stability, its share prices showed a sharp decline from the beginning of 2007.

The authorities that controlled the financial institutions in the United Kingdom had been monitoring the global financial crisis closely. Financial stability in the United Kingdom was achieved through a memorandum of understanding between three bodies that controlled financial activities in the UK. These bodies include the bank of England, the FSA, and the Treasury. The memorandum of understanding outlined the functions and duties of each of these bodies. The relation between these three banking bodies is known as the tripartite arrangement and its main function is to ensure that there is existence of a stable financial system in the United Kingdom. The functions of the FSA include authorization of individual banks, supervising banks, and checking the institutional structure of the financial regulatory system (Ndong and Scialom, 2008).

The government together with the tripartite implemented several strategies in order to reduce the risks of crises in the future. Northern Rock was given the option of reducing the effect of the financial crisis by its own activities in the short-term money markets and securitizing its debts (Ndong and Scialom, 2008). This option was aimed at resolving Northern Rock liquidity crisis. The idea behind this strategy was that, England money markets operations could restore the liquidity and help Northern Rock liquefy its assets. However, this plan failed to work as anticipated and the bank of England had to bail out Northern Rock from the self-inflicted crisis.

The existence of large and complex multinational banks like Northern Rock is both beneficial and dangerous. Multinational banks are highly beneficial to the consumers because they simplify the procedures involved during banking transactions. Moreover, the banks act as lubricants to world market capital circulation. However, these banks present risks to the global financial markets. The governor of England forewarned the financial world that while the banks may be operating globally, their failure only affects a single nation. This is because in cases where banks fail, the regulator of the banks at the country of origin has the responsibility of resolving the issues. This unenviable task of trying to solve banking crises would present many problems to a country because they would have limited control over the outcome of the banking operations in the country. The fact that banking crises are responsibility of the country where the parent bank is, has called for action to be taken in order to reduce the chances of failure in the future.

In 2008, the financial service authority published a report that showed a review of the audit carried on Northern Rock. According to the report, the failure of Northern Rock was as result of the poor management and lack of the executives setting a durable funding system. Moreover, the FSA admitted that it exercised little supervision on Northern Rock. However, the FSA defended itself saying that the outcome would not have been different if they had exercised all the caution required. Northern Rock Bank acted as a catalyst to change in the banking regulation. The government proposed some regulations in order to avoid any future crises that may arise. Some of the regulations that would be adopted in the future include changing the capital requirements, regulating the liquidity, and formation of a council to enhance stability.

Changing the Capital Requirements

Introduction of the macro prudential supervision is one of the major ways in which a crisis similar to the Northern Rock case can be avoided in the future. Financial markets have shown that they are vulnerable to the demands of the market when the times are good. They only resort to financial caution when the economic cycle changes. This characteristic leads to amplification of the economic cycle and is usually referred to as pro-cyclicality. Since the private banks do not have the ability to manage systemic risks government intervention is necessary in order to eliminate the possibility of future crises. One mistake in the regulation over the past decade is that it focused its attention on individual organizations, rather than the risks that may face these organizations. Measures are needed to prevent occurrence of systemic risks in the markets.

The tools needed to control the crisis that may occur in the financial markets are what we call macro prudential instruments. Many banks are multinationals and therefore they operate across borders. Therefore, it is clear that the way forward in eliminating financial crises is the formation of a regulation that surpasses the boundaries. However, the idea of a cross boundary regulation is hard. Seeking to find a way a single set of rules will regulate all the financial institution may prove to be difficult because most financial periods are not synchronized. Moreover, financial cycles in the different countries are very variable.

The present European capital rules revolve around the Basel II framework. These rules were drafted in 2008. Therefore, the credit crunch and the Northern Rock failure occurred under a system of laws that did not consider risks. To reduce the risks of future crises, the Basel framework sets minimum requirement of capital for banks in the developed countries. However, the losses that occurred during the financial crisis showed the capital requirements that the Basel framework set were not sufficient. Therefore, the regulatory measures taken in this mostly involves capital regulation.

During the crisis of Northern Rock, the Basel I capital requirements did not help the situation. This is because the Base I framework used the risk weighted assets to determine the capital. Therefore, England had to review their capital requirements upwards. It was observed that Basel II maintained the capital requirements that were in Basel I framework. However, the regulators introduced in the Basel II framework improved the ability of the authorities and banks to foresee future crises.

There is a robust case in favor of introducing capital regulation to enhance the financial stability in the United Kingdom. Something of importance is that banks must be forced to create capital reserves during the boom years. This capital would come in handy during inevitable crisis years that follow the boom period. By reducing the levels of credit growth during the boom phase, banks would generally minimize the risk of getting into crises. The new capital rules may also prove to be the solution of the financial markets’ habits of amplifying the economic phase due to irrational thinking. This idea is very welcome in the financial society. There is now a general agreement that new capital rules are required; the debate on this subject has moved on to explore what new capital rules would actually mean when they are put in force. At a personal level, I am of the idea that any new capital requirements should, as much as practicable, be based on simple policies and procedures. This is so because in the first place the banks need to know where the new rules would put them before they continue to make complicated modifications.

Moreover, introduction of new rules in the industry that would reinforce the ability of the regulator to avoid giving in to lobbying for lower capital needs. In addition to this, these new rules in the industry should remove the need for any single financial entity to call the economic cycle. However, this task has proven to be extremely difficult in the past. Furthermore, it promises to continue being difficult to implement such a rule. Nevertheless, there is room for regulatory decisions. Therefore, we are bound to have limited flexibility when it comes to application and implementation of the rules.

Liquidity Regulation

The solutions to the challenges of regulating liquidity must be distinguished between the inability of firms to manage liquidity risk and the increasing liquidity crises that results from freezing all asset markets. In the case of a firm’s inability to manage risks, the regulator’s obligation should be to ensure that such financial organizations are given the right motivation to manage the risk, in order to avoid crises. In cases where there is systemic market freezing, liquidity should be considered as a public commodity. Therefore, the central bank will have the task of ensuring that liquidity is maintained at acceptable levels. Analyzing balance sheet activities is one of the ways that the FSA may use to approach the concept of liquidity regulation in the future. Therefore, ton this matter the FSA needs to voice their opinion.

Formation of a Council to Enhance Stability

Currently the tripartite committee is discussing and coordinating the question of financial stability in the United Kingdom. The treasury white paper provided information that proposed legislation of new policies that would change the status of the standing committee into a council for financial stability. This council would be set up on a statutory order and would publish clear responsibilities that would enhance the financial stability. The council would have to meet regularly to ensure that they discussed any matters on risks and consider the appropriate course of action.

The council for financial stability would also meet in case risks to the financial stability of the United Kingdom arose. All the discussion that takes place in the council would be recorded and published on a quarterly basis. The reason for this is to ensure that the information reached the public. The major difference between the new council and the old committee is that the council for financial stability would be operating on a statutory basis (House of Commons Treasury Committee, 2009). Moreover, the CFS would have published minutes to ensure that information is disseminated to the public. In addition to formation of the council, the treasury also promised to form mechanisms that would increase the democracy in accountability of the council. This would be done through parliamentary scrutiny.

In the treasury’s white paper, they stressed that the organizational structure of regulating financial activities did not have many problems. To defend their observation the white paper intimated that different countries possessed different institutional frameworks yet none had fully managed to insulate its economy from trickle in effects of global crises. Therefore, the white paper proposed that change should not be made in the tripartite arrangement. However, the white paper proposed smaller changes that would be made in order to strengthen the position of the tripartite. The changes would involve increasing the power of the financial service authority. Moreover, the power of the Bank of England would also be increased. Apart from increasing power, the white paper also proposed better coordination between the parties that made the tripartite. Increasing coordination would lead to strengthening of governance and greater transparency could be achieved.

Re-evaluation of the tripartite systems would lead to a system where the decisions will be made on medium terms (House of Commons Treasury Committee, 2009). The authorities would have to choose the body that would perform the duties set by the macro prudential supervision. In this matter, the bank of England would seem to be in an advantageous position to bear these responsibilities. This is because the Bank of England already bears the responsibility for considering any cases of system-wide risks. On the other hand, the duty of the Financial Services Authority is supervision. Therefore, they would be better placed to implement supervisory duties and judgments. However, the treasury came up with an argument that stated that it was still early in the process to determine institutional duties and responsibilities. According to the treasury argument, they would have to wait and see what the new tools would be before they could assign the duties. Both the FSA and the bank of England supported this idea. The governor decided that determination of duties would come after they had established he proper tools to use in preventing future crises.

In 2009, the banking act stated and formalized the power and responsibility to be wielded by the bank of England. The bank of England had the objective of protecting and enhancing the financial systems n the UK (House of Commons Treasury Committee, 2009). Moreover, the bank of England had been vested with more powers to ensure that future financial crisis did not occur. The powers of the bank were limited to the provisions set in the new resolutions to ensure that United Kingdom achieved stability in the financial sector. The new resolutions however did promise to prevent crises totally but they promised to minimize the chances of crises occurring.

Conclusion

Northern Rock relied heavily on securitization. Therefore, when the mortgage crisis occurred in the United States, it affected Northern Rock’s ability to lend. This in turn led to financial caution among institutions. Most financial institutions were scared of lending to other institution due to the uncertainty brought about by the global crisis. Analysts and scholars have tried to explain the reason behind the failure of Northern Rock. Therefore, a number of explanations exist as to why Northern Rock actually failed. The Building Society Association explained that when Northern Rock relinquished its status as a building society it created a conducive environment for its failure. However, the Bank of England had issued warnings on the changing financial trends in the market. In addition, on a lesser extend the financial service authority had also issued similar warning.

The failure of northern Rock affected the financial regulations of the United Kingdom. This article tried to explain some procedures and solutions that may be useful in the future of regulation and supervision of financial entities in United Kingdom. It is clear that after the failure of Northern Rock some measures were taken to ensure that there is no reoccurrence of similar crises. The government’s proposed measures are currently at a point where agreements are being reached, nationally and internationally. Moreover, the government is contemplating reforms that will ensure future crises do affect the financial industry as much as that of Northern Rock. However, the idea of international agreements is not close since different countries have different financial regulations. On the other hand, the government and the tripartite have acknowledged that implementation of counter-cyclical capital agreements, and regulation of liquidity in banks may be the solution to the banking crises. The article has shown that the solution to future financial crises lies with the government and the tripartite. Therefore, the United Kingdom is in the forefront of the agenda to ensure that there are global rules that govern financial institutions. This is very vital since he united kingdom hast a vast financial industry and the economy is dependent on a sound financial industry. At the moment there is an assumption that the banks may be too large to fail. However, careful analysis and the case of northern Rock shows that the banks are very vulnerable to financial crises if they are not operated under strict rules and regulations.

There may not be an urgent need for new rules for the banking industry given the fact that managers of banks are currently ensuring that the financial institutions can handle risks. The banks are withdrawing from some of the risky business that get the industry into trouble. Nevertheless, there is an urgent need for government to maintain momentum and the design a better framework, which will ensure that the financial institutions are well placed to handle risk in the future. It is expected that the tripartite bodies will review some of their regulations and come up with safer and calmer banking supervision.

Introduction of the macro prudential supervision is one of the major ways in which crises similar to the Northern Rock case can be avoided in the future. Financial markets have shown that they are vulnerable to the demands of the market when the times are good. Currently the tripartite committee is discussing and coordinating the question of financial stability in the United Kingdom. The treasury white paper provided information that proposed legislation of new policies that would change the status of the standing committee into a council for financial stability. This council would be set up on a statutory order and would publish clear responsibilities that would enhance the financial stability. The council would have to meet regularly to ensure that they discussed any matters on risks and consider the appropriate course of action.

References

Edwards, P, Shaoul, J, Stafford, A and Arblaster, L 2004, Evaluating the Operation of PFI in Roads and Hospitals, Association of Chartered Certified Accountants, Sage, London.

Haspeslagh, P 2010, “Corporate governance and the current crisis”, Corporate Governance, vol. 10 no. 4, pp. 375 – 377

Hofstede, G 2001, Culture’s Consequences: Comparing Values, Behaviors, Institutions and Organizations Across Nations, Sage, California.

Hofstede, G 2009, American culture and the 2008 financial crisis, European Business Review, Vol. 21 No. 4, pp. 307-312

House of Commons Treasury Committee 2009, Banking Crisis: regulation and supervision House of Commons London, The Stationery Office Limited, London

Ndong, S O and Scialom, L 2008, Northern Rock: The Anatomy of a Crisis-The Prudential Lessons, Web.

Pinyo, M., What Caused the Economic Crisis of 2008, Web.

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