Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Liquidity Risk and Northern Rock

I have spent a fair amount of time trying to understand the
collapse of Northern Rock in the United Kingdom by poring through the
transcripts of the Treasury Committee hearings that took evidence from
the Bank
of England
, the Financial
Services Authority
and the directors
of Northern Rock
as well as the financial statements of Northern Rock

In a separate
, I shall discuss the implications for the regulatory
architecture (separation of bank supervision from the monetary
authority. In this posting, I shall focus on what I have learnt from
all this about managing liquidity risk:

  • While much of the discussion about Northern Rock assumes that
    their problem was one of borrowing short and lending long, this does
    not appear to be correct.

    1. The FSA categorically stated in response to Question 315 that
      “the figures do not suggest that [Northern Rock] was an outlier
      in respect of its dependency on very short-term funding … The actual
      percentage of its funding which was dependent on three months or under
      was not a particular outlier, and also just to remind us again, I
      think it is important to remember that it did not actually fail to
      fund itself is this period.”
    2. The CEO of Northern Rock stated in response to Questions 517 and 518
      that “The average life of a mortgage product is three years and
      one month and the average life of our funding was three and a half
      years … We had 10% of our borrowings which had a maturity of less
      than one year; we had 10% of our borrowings that were over one year;
      we had 50% of our borrowings that were three and a half years; and we
      had 10% of our borrowings with an average life of seven
    3. There does not appear to have been a significant difference in
      the costs of various maturities of borrowing. The CEO of Northern Rock
      stated in response to Questions 519 and 520 that “The average
      rate on securitisation for the stock was about LIBOR plus ten basis
      points; the average price for covered bonds, which is the seven year,
      was about LIBOR plus one basis point; the average price of longer term
      wholesale was about LIBOR plus five; the average rate for shorter, ie
      less than year, was about LIBOR flat. … The interest rates on our
      lending, including fees that are effective interest rate were about
      LIBOR plus 90 basis points.”
  • It appears from the available information that there was no
    serious problem of asset quality. Northern Rock’s Chairman
    stated in response to Question 402 that Northern Rock was “below
    half the industry average of arrears on our mortgage book.”
    While some of this may be due to the rapid growth of the loan book, it
    does not appear likely that the credit quality of the loan book was
    below average, let alone bad. Their exposure to US subprime and CDOs
    was negligible.
  • It appears from all the information that I have read that the
    standard tools of gap analysis and asset liability mismatches would
    not have revealed any problems in the liquidity management of Northern
    Rock. Yet, when I re-read the BIS document on Sound Practices for Managing
    Liquidity in Banking Organisations
    , I do not think there is any
    need to rethink the basic principles of liquidity management. The
    problem as I see it is that in organizations like Northern Rock, the
    dynamic aspects of liquidity management (as measured by cash flow
    projections) are more critical than the static aspect (as measured by
    mismatches and gap analysis). The problem is that securitization tends
    to be done in a few large transactions at intervals of several
    months. Profitability considerations will then dictate that the
    maturity of the short term funding would be shrunk ahead of an
    impending securitization. If this is not done, then the securitization
    would produce a huge cash surplus that cannot be profitabily deployed
    for several weeks. If a closure of a securitization markets takes
    place at this point, the liquidity position of the bank can become
    quite acute. This becomes worse if the non securitization lenders also
    shrink the maturity at which they are willing to lend in the build up
    to the crisis. All through the crisis, Northern Rock remained funded
    but by the end, the only funding that they could access was overnight
    funding. Dynamic liquidity analysis using what-if scenarios are
    unavoidable for wholesale oriented banks like Northern Rock. However,
    it is really hard for a regulator to review and comment on the
    adequacy of this analysis. Gap analysis is so much simpler for a
    regulator to understand and comment upon.
  • There were more than ten questions to the directors of Northern
    Rock asking them why they were the only bank that failed (Questions
    460, 474, 475, 476, 529, 640, 641, 642, 643, 644 and 649). This was a
    grim reminder of what Keynes wrote 75 years ago: “A ‘sound
    banker’, alas, is not one who forsees danger and avoids it, but
    one who, when he is ruined, is ruined in a conventional and orthodox
    way along with his fellows, so that no one can really blame
    him.” (Consequences to the Banks of a Collapse in Money
    , 1931).


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