Northern Rock Bank Failure Lessons

Running head: NORTHERN ROCK BANK FAILURE LESSONS
NORTHERN ROCK BANK FAILURE LESSONS
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1NORTHERN ROCK BANK FAILURE LESSONS
Table of Contents
Risk Management Lessons.........................................................................................................2
Recommendations......................................................................................................................3
References..................................................................................................................................5

2NORTHERN ROCK BANK FAILURE LESSONS
Risk Management Lessons
The failure of the Northern Rock bank in Britain, Europe, in the year of 2007, was
solely because of the flaws in the risk management practices. The fifth largest mortgage
lender of Europe suffered the liquidity crisis due to improper risk management and it
originated from the mortgage market of US subprime (Chen et al., 2018). The crisis came
into the scenario when the BNP Paribas bank in France suspended three of its investment
funds in the US markets because of their trading in toxic assets. Due to this sudden end to the
collaboration, there was a rapid fall in the share market prices and as a result, the major
central banks of the world denied monetary lending to each other (Bellini, 2017). The
European Central Bank, just like the other banks tried to inject liquidity in the other banking
systems of Europe however, the Bank of England did not take any precautionary measures to
mitigate the situation. The other banks including the Northern Rock bank depended on the
rationalisation of the England Bank and induced on more liquidity risk thinking that the latter
would save them under any circumstances. This major risk led to the failure of the Northern
Rock bank.
The liquidity risk is the type of hazard where a firm or a bank although incorporates a
solvent of the balance-sheet fails to maintain or generate enough resources in cash to meet the
due in payments or mitigate the situation by in terms of material exchanges that are highly
disadvantageous (Bace, 2016). The bank could not mitigate the risk at neither the private,
corporate nor the state level. Although established as a building in the society, the bank after
demutualising became a plc. in the year 1997. Initially the bank’s balance sheet grew six
times and 50% of the funding came from SPV’Granite’ (Brown, Trautmann & Vlahu, 2017).
The bank continued to hold on to its assets using a Limited Liability Partnership and thus
became a secure deal for the investors. However, another risk was that the Northern Rock

3NORTHERN ROCK BANK FAILURE LESSONS
bank mainly relied on the wholesale money market for fund gathering and incorporated an
aggressive business model (Chen et al., 2018). Since the bank did not rely on its own
deposits, the Northern Rock bank was exposed to an imminent liquidity risk The US market
was hit by the liquidity crisis, which hit the Northern Bank too.
The three micro-risks of the Northern Rock bank consisted of was a) the inability to
re-receive funds that were matured already, b) the inability to secure the mortgaged that were
planned in advance and c) the rise in the cost of funding that were relative to the loans of the
mortgage that were kept on the balance sheet (Scannella, 2016). The loan book quality of the
bank was degrading gradually over time and the bank was unable to provide with sufficient
lending facilities to its customers. The risk was at such high level that the bank had to supply
away the mortgages at a tremendous rate to its customers. The biggest risk from the bank’s
end was that they did not take any precautionary measures to manage the liquidity as well as
the operational risks (Ogbechie, 2016). Northern Rock banks were already running low on
monetary aspects since its last securitization, and by that time, the liquidity risk hit the bank
too hard due to the drying up of money markets. The funding side of the banking system of
Northern Rock suffered from a major crisis because of the continuous expansionary lending
policy of the bank that required a continuous success on the strategy of the funding aspect.
Due to the failure in the monetary funding strategy, there were significant risks incorporated
in the wholesale funding of the banks that the managers did not give at attention at proper
timing.
Recommendations
The Northern Rock bank failure was a lesson for many other banking systems in the
world to mitigate the liquidity risks and take measures in advance to deal with the reducing
market shares. However, the bank itself could have been saved if they would have taken steps

4NORTHERN ROCK BANK FAILURE LESSONS
to diversify their risks and balance the risk appetite continuously, consciously and by taking
immediate active measures. Firstly, the bank could have taken steps to strengthen their
financial base of their own rather than solely depending on the money markets (Chen et al.,
2018). The finance of the bank was global while the regulatory measures were national and
thus the accident was likely to happen at a severe rate. Hence, regulated and coordinated
international action should have been taken to mitigate the US market risks that in turn would
have helped the concerned bank to mitigate its failure significantly (Hopkin, 2018). The
improvement in the running of the securitization markets would have been an influential step
to mitigate the hopeless situation of the Northern Rock bank in Britain. The originator of the
assets such as homes or loans in the process of securitization should have retained their
equity. This could have strengthened the incentives for effective monitoring of the assets and
thus reduce the issues in securitization.
The second step to mitigate the situation was to reduce the chances of the failure in all
the banks of Europe and make provision as well as disclosure for assistance in liquidity. The
Northern Rock bank should have funded liquidity that potentially refers to the cost and the
availability of the finance that is available externally and the speed with which the bank can
access it (Ippolito et al., 2016). The liquidity in funds is a primary property of economic
agents as well as financial institutions and thus would have been a substantial help to the
banking system of Northern Rock. The concerned authorities deliver the funding of this
liquidity by the open market operations. On the other hand, market liquidity refers to the
smooth selling of an asset by incorporating the lowest transactional costs and by maintaining
a price close to the fair value (Ogbechie, 2016). Hence, the bank of Northern Rock being a
private one could have opted for both funding liquidity and market liquidity to survive the
adverse conditions than solely depending on the bank of England.

5NORTHERN ROCK BANK FAILURE LESSONS
References
Bace, E. (2016). Bank profitability: Liquidity, capital and asset quality. Journal of Risk
Management in Financial Institutions, 9(4), 327-331.
Bellini, T. (2017). Stress Testing and Risk Integration in Banks. Stress, (1/53).
Brown, M., Trautmann, S. T., & Vlahu, R. (2017). Understanding bank-run
contagion. Management Science, 63(7), 2272-2282.
Chen, Y. K., Shen, C. H., Kao, L., & Yeh, C. Y. (2018). Bank liquidity risk and
performance. Review of Pacific Basin Financial Markets and Policies, 21(01),
1850007.
Hopkin, P. (2018). Fundamentals of risk management: understanding, evaluating and
implementing effective risk management. Kogan Page Publishers.
Ippolito, F., Peydró, J. L., Polo, A., & Sette, E. (2016). Double bank runs and liquidity risk
management. Journal of Financial Economics, 122(1), 135-154.
Ogbechie, C. (2016). Corporate governance practices in the Nigerian banking industry.
In Handbook on Corporate Governance in Financial Institutions. Edward Elgar
Publishing.
Scannella, E. (2016). Theory and regulation of liquidity risk management in
banking. International Journal of Risk Assessment and Management, 19(1-2), 4-21.