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Studi kasus Northern Rock 1 THE NORTHERN ROCK CRISIS: A MULTI-DIMENSIONAL PROBLEM WAITING TO HAPPEN David T Llewellyn1 BACKGROUND For three days in August 2007, the UK experienced its first run on a bank since Overend and Gurney, the London wholesale discount bank in 1866. Around £3 billion of deposits were withdrawn (around 11 percent of the bank’s total retail deposits) from a medium sized bank – Northern Rock (NR). The unedifying spectacle of widely-publicised long queues outside the bank’s branches testified to the bank’s serious problems. The NR crisis was the first time the Bank of England (BOE), the UK’s central bank, had operated its new money market regime in conditions of acute stress in financial markets, and it was the first time it had acted as a lender-of-last-resort for many years. Northern Rock (previously a UK mutual building society) converted to bank status in 1997. Without the previous constraints on its operating permissions, it acquired legal powers to conduct the full range of banking business. However, it remained focussed predominantly on the residential mortgage market. From the outset, it adopted a securitisation and funding strategy which was increasingly based on secured wholesale money (by issuing mortgage-backed securities) and other capital market funding. Before considering the nature of the NR crisis, several points of perspective are noted at the outset: the bank remained legally solvent (the nominal value of assets exceeding liabilities), only months earlier the bank had reported record profits, the quality of its assets was never in question, its loan-loss record was good by industry standards, and for many years the bank was regarded as a star-performer in the financial markets. Two problems emerged during the summer months of 2007: there was a generalised lack of confidence in a particular asset class (mortgage bank securities) associated in large part with developments in the sub-prime mortgage market in the United States; and doubts emerged about the viability of the NR business model in particular. In September 2007, NR was forced to seek substantial assistance from the BOE even after the regulatory authorities, the UK’s Financial Services Authority (FSA) and the Treasury (the UK government’s finance office), had given assurances that the bank was solvent, and all deposits at the bank would be guaranteed. THE CONTEXT OF FINANCIAL MARKET TURMOIL The NR episode needs to be set in the context of the global financial market turbulence experienced during the summer of 2007. Recent years have experienced an unprecedented wave of complex financial innovation with the creation of new financial instruments and vehicles. In the words of the BOE, this financial innovation had the effect of “creating often opaque and complex financial instruments with high embedded leverage” (BOE, 2007a). Two major instruments at the centre of the financial market turmoil were Securitisation and Collateralised Debt Obligations (CDOs – instruments created from a portfolio of asset-backed securities and then broken into tranches of varying default risk with resulting varied prices): in both cases issue volumes rose sharply in the years prior to the crisis. Figure 1 shows the sharp rise in European securitisations, and figure 2 indicates the volume of global CDO issues and particularly the sharp increase in 2006 and the first half of 2007, followed by an almost total collapse in the summer months of that year. Securitisation involves a bank bringing together a large number of its loans (e.g. mortgages) into a single package and selling the portfolio into the capital market. The portfolio might be bought by other financial institutions or by specially created Special Purpose Vehicles, Structured Investment Vehicles (SIVs), or Conduits established by the securitising bank itself. The buyer issues securities (e.g. FRNs, asset-backed commercial 1 Copyright David T Llewellwn Northern Rock Case Study 2 paper, longer-term paper) which are rated by a rating agency according to the quality of the underlying assets in the portfolio. In effect, the bank passes the loans to others, and the strategy is often referred to as originate-and-distribute even though the purchaser might be a specially-created bankruptcy-remote subsidiary of the bank itself. The bank may offer a line of credit to the purchaser to be activated in the event that the buyer encounters difficulty in renewing its short-term securities. Figure 1 European securitisation (1998 -2005; € billions) Figure 2 Global collateralised debt obligation issuance Cagr = 35% +78% 3200501001502002503003501998 1999 2000 2001 2002 2003 2004 2005Northern Rock Case Study 3 The global market financial turmoil during the summer of 2007 was triggered by developments in the rapidly growing sub-prime mortgage (SPM) market in the US. A high proportion of such mortgage loans were securitised and also combined into instruments such as CDOs. These in turn were rated by rating agencies although, in hindsight, in a misleading way in that a CDO would be given a high rating based on only the small proportion of loans within it that was low risk. The mortgage-backed securities (MBS) and CDOs were purchased by banks around the world, hedge funds, and conduits established by banks either for themselves or clients. Such purchases were funded in the main by the issue of short term securities (e.g. asset-backed commercial paper) and in some cases received lines of credit from banks including banks initiating securitisation programmes. Problems emerged at various times during 2007 as a result of a combination of factors: a decline in house prices in the US, the impact of the earlier rise in US interest rates, large-scale defaults on SPMs (during 2007 repossession in the US reached a thirty-seven year high), and a sharp decline in the prices of mortgage-backed securities. Above all, both the primary and secondary markets in SPM securities effectively closed and concern developed over the exposure of some banks in the market. There was uncertainty, for instance, about which banks were holding MBSs and CDOs. In particular, some banks who were dependent on securitisation programmes encountered serious funding problems because of all these uncertainties. Issuing banks and their conduits faced both a liquidity constraint and a rise in the cost of funding as it became increasingly difficult to roll-over short-term debt issues. Liquidity in the inter-bank markets also weakened and a tiering of interest rates emerged during the summer. Banks encountered funding difficulties because of their uncertain exposure to the weakening MBS market, or because of their commitment to provide lines of credit to MBS holders. There was also concern that some banks would be required to hold on their balance sheets mortgage assets they had originally intended to securitise and sell. Overall, there was a sharp movement away from the MBS market. All of this created considerable market uncertainty in the summer months of 2007 which lead to a sharp fall in many asset classes, considerable uncertainty as to the risk exposure of banks, credit markets dried up and most especially those focussed on asset backed securities, and liquidity dried up in the markets for MBSs and CDOs. Overall, there was considerable uncertainty regarding the true value of credit instruments (partly because the market had virtually ceased to function effectively) and the risk exposure of banks. As a result, a loss of confidence developed in the value of all asset-backed securities on a global basis. This was the general context of some banks (and notably NR) facing funding problems. The liquidity problem became serious because securitisation vehicles such as conduits and SIVs were funding the acquisition of long-term mortgages (and other loans) by issuing short-term debt instruments such as asset-backed commercial paper. As liquidity dried up, banks could not finance their off-balance-sheet vehicles and were forced to take assets back on to the balance sheet or hold on to assets they were planning to securitise. This effectively amounts to a process of re-intermediation. Although NR was not exposed to the US SPM market, it became caught up in all this because of its business model: securitisation as a central strategy, and reliance on shortterm money market funding. It faced several related problems: it could not securitise and sell new mortgage assets and hence needed to keep assets on the balance sheet that it had intended to sell, and it faced a sharp rise in interest rates in the money market with the result that borrowing costs (even in the event that it could borrow at all) rose above the yield on its mortgage assets. The most serious dimension from a systemic point of view was the run on deposits at NR. Clearly, statements to the effect that the bank was solvent did not convince Northern Rock Case Study
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depositors. In any case, a bank run can be rational if all depositors believe the bank is solvent but also believe that all other depositors believe it is not. THE RESCUE OPERATION A traditional role of a central bank is to act as a lender-of-last-resort (LLR) to illiquid solvent banks. In order to limit the moral hazard, this is done against good quality collateral and at a penalty rate of interest. In order not to aggravate a temporary liquidity problem of a bank by panicking depositors to withdraw funds, in the past in the UK this has been done on a covert basis and without publicity at the time. The BOE now judges (though this has been challenged by the European Commission) that current requirements of transparency mean that any such support must be public. In the UK, the ultimate responsibility for authorisation of support operations by the BOE in a financial crisis rests with the Chancellor of the Exchequer (UK equivalent to the mi
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