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In the UK, the repercussions of the recent banking crisis affecting the financial sector are now being observed in the wider economy. In January 2009, it was confirmed that the UK is officially in recession as the criteria of two consecutive quarters of negative economic growth has been met. Gross domestic product (GDP) fell by 1.5% in the last three months of 2008 following a 0.6% drop in the previous quarter.
Many events leading to the current situation have stemmed from the managerial decisions made within various financial institutions. The following gives an insight into how the crisis evolved and also explores the two key aspects of why Northern Rock opted for their chosen business model and secondly, the actions of the Bank of England (BoE) as the crisis unfolded.
The Northern Rock Affair
The crisis witnessed at Northern Rock widely demonstrates how poor management can contribute to the failing of a huge financial institution. In pursuit of continuing rapid expansion and growth, the bank adopted a business model they believed would enable them to become one of the market leaders in mortgage lending. This model was based upon relying on the wholesale markets rather than the more traditional approach of the retail markets to finance the majority of its lending. This method of operating is considered high risk. Therefore, it is fundamental to understand why Northern Rock chose to implement this type of model.
Primarily, reporting to shareholders the responsibility of the bank executives is to maximise the profitability of the bank. Choosing to securitize its loans, they packaged them together and traded on the wholesale markets. By selling these packages to investors they were able to make immediate financial gains whilst also ridding themselves of potential bad debt. Operating in this way, Northern Rock had announced record profits for 2006 and further securitisations during the first six months of 2007 generated even greater profits. This model appeared highly successful, yet at the same time fraught with risk. As long as the markets continued to flourish the bank returned increased profits and also achieved their objective of continuing to grow at a phenomenal rate.
A degree of managerial ignorance, or more likely incompetence, began to emerge as the effects of the American subprime lending became apparent. It had been widely known that problems with the banks in the US were due to the phenomenon of sub-prime lending for housing.
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Similar to Northern Rock, the banks continued to give loans in this manner as they too chose to securitise their loans because this method of trading appeared so profitable. This was a highly successful mechanism to operate until the number of defaulters increased to the point where these assets began to turn illiquid. Investors started to avoid securities as it was now evident many were flawed. Moreover, Northern Rock in their quest for greater financial returns found securities that attractive they also invested in them.
With trading slowing in the financial markets, many institutions began to react to the impending crisis by taking a more cautious approach to lending. In comparison Northern Rock were so focussed on returning profits and generating growth that, at a time when monetary policy was tightening faster than expected, the bank had agreed to issue a tranche of mortgages at interest rates that were lower than those it had to eventually pay in the markets to finance them (The Economist, 2007, Lessons of the fall, 20/10/2007). In hindsight, this was a disastrous decision, which contributed to the impending shortfall in cash and ultimately the need to be bailed out.
The managerial failings of Northern Rock are clearly evident as the bank was not prepared for the effects of liquidity within the financial markets to dry up. Northern Rock had chosen to carry insufficient capital to cover its loans, further evidence of their tendency to ignore risk. Furthermore, they had not secured sufficient credit with other banks or arranged contingency plans to gain access to central bank liquidity. Remarkably, the bank had chosen to operate in this high risk manner even though it had experienced similar problems four years earlier.
To assume the bank executives were ignorant of the effects of the markets drying up and were not appreciative of the consequences is unlikely. In the subsequent inquest following the BoE bail out, there were claims from the bank that they had not forecasted the markets drying up and were caught off guard by the speed of the crisis. Again, this is questionable. Therefore, it is imperative to understand if there are any other reasons why the bank chose to adopt a business model that was engulfed in high risk.
One final consideration is the mechanism for remuneration packages for bank executives which are highly incentivised. Bonuses are closely linked to bank performance and profitability. Senior executives employed in this way can leave the long term business exposed if not regulated correctly. There is no firm evidence to suggest that the failings of Northern Rock were down to personal gain; however, the many warnings and danger of liquidity risk from respected economists and the BoE for some reason had chosen not to be acted upon.
The Bank of England
The primary role of the BoE is to maintain stability and retain confidence across the UK banking system. This responsibility was ultimately tested in the final six months of 2008 as the banking crisis deepened. The strategy they first adopted to handle the situation was very different from the world’s other two main central banks: the FED and ECB. As the crisis developed they held back from initially injecting cash into the banks to relieve the problems with illiquidity. They also held back from immediately bailing out Northern Rock in agreement with the treasury and the FSA stating that it would be more appropriate if another bank conducted a takeover.
In theory, the BoE adopted this hard line approach as they were trying to teach the banks a lesson in that they must feel the consequences for their actions. However, it soon became apparent that there was no alternative other than the central bank to step in and save the Northern Rock. At this point, the crisis had deepened to the point where all the financial markets had dried up and it was only the intervention of the BoE that could alleviate further banks going bust. This decision was announced publically on September 14th and what should have brought relief within the financial sector actually contributed to the sharp increase in Libor rates causing further disruption amongst the banks (see chart 1).
Chart 1 (The Economist, 2008, Lifelines, 09/10/08)
Although some may argue it was too late, the BoE initiated a plan that looked to resolve the issues with capital, liquidity and funding. Tackling the problem head on they looked to inject billions into the banks. The plan they developed was widely applauded and immediately recognised as one both the Fed and ECB should adopt.
The BoE also tried to tackle the problem of going into recession by aggressively cutting interest rates to the lowest level in history. Aimed at trying to increase spending to kick start the economy and making it easier for consumers and businesses to access credit, the plan has so far not worked, as banks are still reluctant to lend. In despite of insurance backed guarantees against high risk loans, it now appears whatever the BoE do, it is too late to prevent the repercussions from escalating in the wider economy.
The management of Northern Rock leading up to the crisis can only be described as incompetent. They chose to adopt an aggressive business model leaving the bank exposed to the markets drying up. Their short sightedness in pursuing this business model led to lessons not being learned. Furthermore, in their pursuit of greed and seeking rapid expansion they chose to ignore the warning signs. Arguably, the regulating bodies should have acted in a way to prevent this high risk operating strategy and even the shareholders are partly responsible for electing the board. Yet, undoubtedly the responsibility lies with the senior management executives who led Northern Rock into the crisis.
However, the role played throughout the crisis by the BoE is more transparent. They were more cautious in not immediately jumping to the rescue of Northern Rock which although ensured some criticism was the right thing to do. Furthermore, if they had reacted immediately it is unlikely they would have prevented the crisis. The global network of banks is so closely related that the actions of the BoE alone would not have prevented the repercussions that have spread globally. All the main central banks have now implemented bail out packages, yet the economy is still in decline. Therefore, the BoE appear to have acted in good faith in putting the needs of the UK economy first which is ultimately their primary responsibility.
The Economist, 2008, Lifelines, The Economist, 09/10/08.
The Economist, 2007, Lessons of the fall, The Economist, Vol 385 Issue 8551, p91-93, 20/10/2007.