QFIP - 117 Reflections on Northern Rock

Question 1

Risk Exposure Quote from Northern Rock Reading

Answer 1

When a financial crisis strikes, prudent risk management by lenders leads to a generalized retrenchment as they attempt to meet the crisis by shedding risk exposures.

Question 2

Northern Rock Background

Answer 2

• Northern Rock was classified as a “building society”, also known as a mutually owned savings and mortgage bank
• Went public in 1997
• Between demutualization in June 1998 and June 2007, Northern Rock’s total assets grew from 17.4 billion pounds to 113.5 billion pounds
• Average yearly compounded growth rate of 23.2%
• Covered bonds - long-term liability written against segregated mortgage assets
  
  • Illiquid
  • Long-term
  • Not directly implicated in the run
• What set Northern Rock apart from other UK banks was not that it used nonretail funding, but the extent to which it relied on such funding

Question 3

The Run on Northern Rock

Answer 3

• After the financial crisis, the main change in liabilities was a 28.5 billion pound loan from the Bank of England
• The branch deposits were actually the most stable liability item throughout the financial crisis
• The key to the initial run on Northern Rock was the nonrenewal of Northern Rocks’ short-term and medium-term paper

Question 4

Reassessing the Run on Northern Rock

Answer 4

• Two Main Differences Between Northern Rock and a “Standard Bank Run”
  
  1. Typical bank runs have coordination failure, but other institutions that had short-term funding issues did not face such severe issues
  2. In the coordination failure model of bank runs, the creditors are individual consumers who choose to run based of beliefs of depositor behavior
     
     • The problems peaked before the public announcements, and were by sophisticated institutional investors and not individuals
• The run can be better viewed as a tightening of constraints on the creditors of Northern Rock
• Traditional bank balance sheet:
  
  • Short-term liabilities (e.g. deposits)
  • Longer-term, less liquid assets (e.g. loans)
  • This mean liquidity and duration issues

Question 5

How Market Conditions impact Leveraged Financial Firms

Answer 5

• Key point: For leveraged financial firms, market conditions are pivotal to determine their leverage
• Leverage is the ratio of total assets and equity
• Haircuts are generally higher when credit is weak, and higher leverage is more easy achieved when credit is strong
• Repurchase agreement - the borrower sells a security today for a price below the current market price and gets it back in the future (usually short-term) at a pre-specified price
• Haircut example: If the haircut is 2%, then you can borrow $98 with $100 worth of securities
• Haircut rates increased dramatically during the recession, making it more difficult to borrow
• Maximum Possible Leverage Ratio = 1/Haircut Rate
• An increase in haircuts can cause substantial reductions in leverage
• If haircuts increase and leverage falls, the borrower has two main choices, both of which are usually difficult in financially distressed times:
  
  • Raise new equity
  • Sell assets
• Leverage is the ratio of total assets and equity

Question 6

Northern Rock Three Possible Definitions of Equity

Answer 6

• Common Equity
• Leverage is the ratio of total assets and equity
• Total Equity = Shareholder Equity + Subordinated Debt

Question 7

How Leverage caused Northern Rock Failure

Answer 7

• When a bank is highly leveraged, a small increase in haircut usually causes a large withdrawal of funding
• Leverage on common equity was very high, even before the recession at over 50
• Northern Rock was faced with a giant margin call when higher haircuts were demanded

Question 8

Economic Role of Short-Term Debt

Answer 8

• Traditional banking has long-term assets and short-term liabilities
• This timing mismatch can cause problems if not handled correctly (e.g. liquidity risk, interest rate risk)
• Sometimes creditors are subject to external constaints
• Creditors may have to take actions that are the consequence of factors outside the immediate principal-agent relationship with the bank

Question 9

Implications for Financial Regulation

Answer 9

• Northern Rock relied on short-term liquidity to roll over expiring short-term debts
• Two specific policy recommendations by the author:
  
  1. Liquidity Regulation
     
     • Constraints on the asset composition
  2. Limit on Raw Leverage
• The key determinant of the size of the regulatory capital buffer should be the riskiness of the bank’s assets

Question 10

Critique the “capital buffer” approach for financial regulation of banks

Answer 10

• (+)
  
  • Quantitative restriction on the minimum size of capital buffer is relative to equity
  • Rationale of capital buffer approach is to maintain solvency
  • The approach is in the interest of both depositors and creditors
  • Capital buffer is related to riskiness of the assets
• (-)
  
  • Does not take into consideration that interests of one institution impacts the interests of others
  • Does not take into consideration the risks posed by mismatch of assets and liabilities

Question 11

Describe two alternative approaches for liquidity regulations that
overcome the shortfalls of the traditional approach of a capital buffer

Answer 11

1. First:
   
   • Regulation that constrains the composition of assets.
   • Bank can survive a run if it holds more liquid assets
   • Bank can survive a run if it holds more illiquid liabilities
   • Creates liquidity buffers – will help mitigate shocks in liquidity within the markets
2. Second:
   
   • Limit on the raw leverage ratio
   • Prevents buildup of leverage in the market, but does not take into account asset risk classes.
   • For creditors, the leverage ratio constraint will reduce the need to hold back lending in down times.
   • For borrowers, the lower leverage ratio minimizes the impact from an increase in haircut.