Northern Rock and the Implication of the Sub-prime Crisis
1. Introduction
Unlike many other industries, banking and financial institutions are known to be more prone to crisis or issues. One of the most recent issues among banking and financial institutions is the issue of the sub-prime crisis which hits the United States and affects other international banks like Northern Rock. Primarily, the main goal of this paper is to evaluate the sub-prime crisis that heats the bank industry and how this implicates or affect the performance of the Northern Bank.
1.1 Background of the Study: Overview of Northern Rock Bank
Northern Rock Plc formerly known as Northern Rock Building Society is a UK bank which is currently owned by the government. The NRBC was established in 1965 as an outcome of the merger of the Northern Counties Permanent Building Society which is established in 1850 and the Rock Building Society which has been established in 1865. In the 30 years of the company, the Northern Rock has expanded through the acquisition of 53 smaller building societies which include the North of England Building Society in 1994. Along with many other British building societies in the 90s, the Northern Rock opted to float and demutualise on the stock exchange so as to expand their business portfolio.
The Northern Bank was formerly established in 1997 when the UK society floated on the London Stock Exchange distributing portfolio shares to their members who held mortgages and saving accounts. The bank has joined the stock exchange being a minor bank and was expected to be taken over by its considered larger competitors; however, Northern Rock has still remained independent. The company has gained their promotion in 2000 to the FTSE 100 index. However, because of some reasons, they have been demoted back to the FTSE 250 in December 2007 (BBC, 2008) and on the following months, Northern Rock has been suspended from the LSE because of the nationalisation of the bank. On September 14, 2007, Northern Rock sought and has received a liquidity support facilities from the Bank of England (Bank of England, 2008), following issues in the credit markets which is caused by the US sub-prime mortgage financial crisis. It has been said that this crisis has brought enormous impacts to the bank and their organisational performance.
1.2 Research Objectives
The main goal of this research is to analyse sub-prime crisis and its effects on banking and financial institutions. In particular, this paper attempts to achieve the following objectives:
1. To analyse the concept of sub-prime crisis and how it emerged in the banking and financial institution?
2. To determine the implications or effect of Sub-prime crisis with Northern Rock Bank.
3. To provide sound recommendation and conclusion about the issue.
1.3 Research Questions
It has been noted that the emergence of international issues such as sub-prime crisis have affect various organizations and companies. In this regard, this evaluation and analysis will be conducted. Specifically, this paper attempts to answer the following queries:
1. How does sub-prime crisis emerged and affect banking and financial institutions?
2. How sub-prime crisis affects Northern Rock Bank and its current situation in the local and international market environment?
3. How does Northern Rock Bank solve the issue?
2. Literature Review
To understand the sub-prime crisis or issue better, the following review will be discussed.
2.1 Concept of the Sub-prime Crisis
The sub-prime crisis is an ongoing economic issue which manifests itself through liquidity problems in the banking system that owes to foreclosures which accelerated in the United States which starts in latter period of 2006 and triggered a global financial crisis during 2007 and 2008. This economic issue started with the bursting of the US housing bubble (Moyers, 2008; Lahart, 2008) and intensive default rates on sub-prime and other adjustable rate mortgages (ARM) created to higher-risk borrowers with lower revenue or lesser credit history than those prime borrowers. It is noted that the reasons for the sub-prime crisis are complex and varied. Because of this, understanding and controlling the ripple impact through the global economy posts critical challenges for businesses, investors, and government institutions.
The sub-prime lending is regarded as the practice of making loans to borrowers that do not qualify for market interest rates because of different risk aspects, like size of the down payment, income level, employment status and credit history. The amount of US prime mortgages was approximately .3 trillions as of March 2007 (MSNBC, 2008), with over 7.5 million first-lien sub-prime mortgages outstanding (Bernanke, 2007). More or less 16% of the loans of sub-prime with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure process as of October 2007, nearly triple the rate of 2005 (Bernanke, 2007). By January 2008, the delinquency rate had increased to 21% (Bernanke, 2008).
2. 2 Factors that Leads to Emergence of Sub-Prime crisis
The sub-crime crisis can be attributed to various factors. These factors include the incapacity of the homeowners to make their mortgage payments principally because of the loss of employment or health related aspects; insufficient mortgage i like short fixed term and buy downs adjustable rate mortgages couples with incentives fast rising adjustable mortgage values, poor judgement either by the lender and/or by the borrower. In addition, the declines of home prices have made the re-financing more complex. Due to the changes in line with securitization, it has been noted that the risks is related to the inability of the homeowners to attain mortgage payments had been distributed widely, with a series of consequential effects. Principally, there are four primary categories of risk involved with sub-prime crisis. These include credit risk, liquidity risk, and asset price risk and counter party risk. Specifically, the business organization is most interested in keeping counter party risk at low level since the volume of the bank’s total portfolio is largely determined by its trading activities. It was evident that counterparty risks associated with derivative trading activities are rooted among over-the-counter (OTC) transactions wherein additional expense or reduced revenue that would result from the replacement of the transaction by an equivalent position in the event of a default is evaluated and given necessary action. As such, there is a need for the people within Northern Rock organization to conceptualize means of minimizing the losses in terms of revenue and expenditure in over-the-counter transactions that the bank engages in. Moreover, counterparty selection is vital in order to maintain the strong hold of the business organization in the international banking industry.
The cross-product master netting agreements with business partners so as to reduce counterparty risks allowed all claims and liabilities not yet due to be offset against each other in the case of counterparty default. This served as contingency action in order to keep the expenses of over-the-counter transactions at minimum level while taking into account other factors and variables which causes loss in revenue. The use of global multi-stage limit system to9 address credit risk exposure in credit and counterparty risk management by taking into account the replacement costs as well as other potential future price fluctuations will provide a comprehensive understanding and holistic view of the economic environment of the international banking industry guaranteeing safety nets among active participants in the business of global banking transactions. Other measures of unforeseen and emergent cases of loan loss allowances initiated by the management of Northern Rock include a value at risk procedure in quantifying collateralized transactions, and simulation procedure for unsecured transactions to assess the portfolio and correlations effects for calculating exposure.
Since it was revealed that the potential exposure could be reduced significantly in currency and interest rate transactions, succeeding business operations of the bank should be made to characterize these descriptions so as to contribute to the overall reduction of loan loss allowances.
In line with the credit risk, this risk is assumed by the bank which originates the loan. However, because of the major changes in securitization, credit risks are often transferred to third-party investors. Herein, the rights to mortgage payments have considered repackaging into a variety of complex investment vehicles, which generally categorized as collateralized debt obligations or mortgage-backed securities (MBS). Essentially, CDO is a repacking of present debt, and in previous years MBS collateral has generate a large proportion of issuance. In exchange of buying CDO or MBS and assuming credit risk, third party investors have gained a claim on the mortgage assets and related cash flows, which became collateral in the event of default.
On one hand, in line with asset price risk, CDO and MBS asset valuation is multifaceted and related fair value or mark to market accounting is subject ot broad interpretation. The valuation is derived from both the existence of viable market and the collectibility of sub-prime mortgage payments into which such assets can be traded which are interrelated. The rising mortgage delinquency rates have decreased demand for such assets. Banking and other institutional investors have identified substantial losses as they revalue their mortgage-backed securities downward. Several industries which borrowed money through CDO or MBS assets as collateral have encountered margin calls, as lenders provided their contractual rights to get their money back. There is a growing consensus about the view on whether fair value accounting should not be suspended or temporarily modified, as large write-downs of complex value MBS and CDO assets might worsen the crisis (Gross, 2008).
In line with the liquidity risk, many industry rely on access to short-term funding market for operations of cash, these include the commercial paper and repurchase markets. Industries and structured investment vehicles often get short-term loans by issuing commercial paper, CDO and pledging mortgage assets as collateral. In this regard, the investors provide cash in exchange for the commercial paper, which receive money-market interest rated. Nonetheless, due to the concerns about the value of the mortgage asset collateral associated with sub-prime and Alt-A loans, the capability of various industries to issue such paper has been impacted (Barr, 2007). Furthermore, the interest rate charged by some investors to give loans for commercial paper has substantially increased above the historical level (Unmack, 2007).
Since there is a possibility that Northern Rock might not be able to meet its current and future payment obligations in full or in time wherein the bank would need to settle its liabilities through refinancing when the company is at higher market rates or liquidating assets at a discount to the market risks, liquidity risks that the business that the organization may encounter should be fully accounted by the management. As such, risk management was addressed by the people within the company by integrating risk instruments in the form of daily preparation of a scenario-based run-off profile and an associated limit system. This provided the company with updated and ready back up plan in cases where the business organization might not be capable to handle some of its other responsibilities.
In order to manage the risks of liquidity in the company, members of the business organization carry out clearly laid out terms of duties so that there is a systematic approach of handling shortcomings. The structure of the organization was designed so that internal committees are able to communicate effectively and efficiently. The Group Treasury, Regional Treasury units and the Risk Control committees are responsible for managing risks in terms of the company’s asset liquidity.
The liquidity policies conceptualized by the Group Treasury and the Risk Control were made to meet the standards of both the regulatory requirements and the internal standards which consist the setting of liquidity risk limits as well as the establishment of an escalation process when limits were breached. In this light, the company adheres for the organization’s internal and external economic system. Aside from the mentioned measures, the volumes of liquid assets, securities deposited as collateral with central banks and unsecured funding through banks and market for certificates for deposit are monitored on the daily basis. As such, the company does not only take into account its economic interest as a business organization, but also makes sure that the trust accorded by the clients is met.
Several liquidity inflow and outflow scenarios and stress tests are initiated by the Risk Control in order to monitor and analyze short-term liquidity mismatch limits as well as the long-term refinancing ratio limits. In this way, the bank is able to control a systematic system of observing the short-term and long-term plans and objectives of the company for growth and development. Securing the market position of the company will enable the bank to be internationally competitive in its aim to build a strong and diverse market base.
The last is the counterparty risk. Accordingly, major investment banks and other financial industries have considered significant positions in terms of credit derivatives transactions. In this, some serve as a kind of credit default insurance. Because of the impacts of the risks mentioned the financial health of investment banks have declined, potentially enhancing the risk to their counterparties, and generating more risks in financial markets.
3. Research Methodology
3.0 Methodology
Basically, this study, as a whole, can be classified as a descriptive research, whose objective is to portray an accurate profile of persons, events or situations, and may be an extension or a forerunner to a piece of exploratory research, a research that tries to establish causal relationship between variables. (Robson, 2002; Saunders et al, 2003) Accordingly, with the descriptive research, it is necessary to have a clear picture of the phenomena on which a researcher wishes to collect data prior to the collection of the data. (Saunders et al, 2003)
Further, even if many project tutors are often wary or work that is too descriptive, and they will want a researcher to go further and draw conclusions from the data gathered, description in management and business research has a very clear place, although, it should not be thought of as an end in itself, but only as a means to an end. (Saunders et al, 2003).
The research described in this document is based solely on qualitative research methods. This permits a flexible and iterative approach. During data gathering the choice and design of methods are constantly modified, based on ongoing analysis. This allows investigation of important new issues and questions as they arise, and allows the investigators to drop unproductive areas of research from the original research plan.
3.0 Methodology
Basically, this study, as a whole, can be classified as a descriptive research, whose objective is to portray an accurate profile of persons, events or situations, and may be an extension or a forerunner to a piece of exploratory research, a research that tries to establish causal relationship between variables. (Robson, 2002; Saunders et al, 2003) Accordingly, with the descriptive research, it is necessary to have a clear picture of the phenomena on which a researcher wishes to collect data prior to the collection of the data. (Saunders et al, 2003)
Further, even if many project tutors are often wary or work that is too descriptive, and they will want a researcher to go further and draw conclusions from the data gathered, description in management and business research has a very clear place, although, it should not be thought of as an end in itself, but only as a means to an end. (Saunders et al, 2003).
The research described in this document is based solely on qualitative research methods. This permits a flexible and iterative approach. During data gathering the choice and design of methods are constantly modified, based on ongoing analysis. This allows investigation of important new issues and questions as they arise, and allows the investigators to drop unproductive areas of research from the original research plan.
3.1 Secondary data
For this research design, the researcher will be using secondary data. Herein, the researcher gathered data, collated published studies from different local and foreign universities and articles about textile and apparel industries; and made a content analysis of the collected documentary and verbal material. Afterwards, the researcher summarized all the information, made a conclusion based on the objectives posited and provided insightful recommendations for the issue.
Accordingly, finding relevant secondary data involves two interlinked stages. The first stage is identifying whether or not the data that a researcher looks for are available as secondary data, while the second stage is finding the precise data that is needed for the study. (Saunders et al, 2003)
For this study, the researcher was able to establish that the pertinent data needed for the fulfillment of this research’s objectives are available through the literature review previously conducted. Because of the review, the researcher was able to gather full references to the sources of the needed data. Tertiary literature (like indexes and data archive catalogues) also helped especially those on-line indexes and catalogues of Universities, and organizations.
3.2 Effectiveness and limitations of secondary data
The researcher has opted to use secondary data to make sure that the information that will be used in this study is already proven and that all information has substantial evidences to justify the result of the study. In addition, the use of secondary data enables the researcher to gather only pertinent information relevant to the topic. However, secondary data has also some limitations. Since, most of the secondary data that will be gathered is not updated; this can affect the overall result of the study. In addition, data used in this study depends on the discretion of the researcher, hence, any other data that should be included might not be considered by the researcher.
4. Evaluation and Analysis
Based on the gathered data and the used of qualitative design, the findings of the study will be discussed in this section. Herein, the analysis will include the discussion of the emergence of sub-prime crisis and its effect on Northern Rock bank. In addition this will also provide details on how Northern Rock attempts to solve the issue with the help of the bank of England.
Driven by low interest rates as well as liquidity, the boom of housing in the US has lasted for more than 10 years during which mortgage industries extended loans to borrowers which have poor credit records. In this regard, the brokers who were given big commissions attracted these borrowers for availing housing loans having a minimal down payment with lax documentation and credit checks.
As mentioned, these loans are referred to as the sub-prime mortgages, usually charge 2% to 3% points more than those individuals with less-risky credit profiles, and carry modifiable interest rates which can cause payments to jump in the coming years. While this process was good, homeowners have notices that housing prices escalates, which leads them to take out home equity loans which helped fuel consumer spending.
As noted, sub-prime mortgage simply means providing loans to borrowers with marginal or weak credit background to avail houses. The existence of the sub-prime financial crisis has brought different effects on various institutions in the global market and one of these is the banking and financial institutions. The sub-prime crisis has impacted various banks, real estate investment trusts, mortgage lenders, and hedge funds. These institutions have suffered significant losses as an outcome of mortgage payment defaults or the mortgage asset devaluation. It has been noted that as of April 25, 2008 banking and financial industries has noted sub-prime related losses or write-downs which exceeds U.S. 0 billion. In this regard, the profits at the American banks insured by the FDIC has decreased from .2 billion to .8 billion comprising 83.5% of the total loss during the fourth quarter of 2007 versus the present year, due to increasing loan defaults and provisions for loan losses. It is said that this phenomena has been the worst bank and thrift performance since the fourth quarter of 1991. In the year 2007, these banks have only earned 5.5 billion, which is lesser than 27.4% from a record profit of 5.2 billion in the previous year 2006. Other institutions from the global market including the IKB Deutsche Industriebank have also experienced significant losses and mortgage scores of lenders have already filed bankruptcy. Aside for the effect of the crisis to the company, it also affects top management performance as the CEOs of Merrill Lynch and Citigroup has been forced to resign from their respective industries. Different companies have considered a merger-deal to survive in the business market. Furthermore, Bear Stearns and Northern Rock have acquired emergency assistance from the Bank of England. The Crisis has also been felt in the Indian banking and financial institutions which have ventured into USA.
The problem with Northern Rock was compounded since the institution have received most of its fund in large values from institutional lenders rather than small depositors which are more stable source of fund than others (Lim, 2008). According to some sources, Northern Rock’s account holders have withdrawn about £1 billion or more than billion in 2007 after Northern Rock turned to the Bank of England for an emergent credit line. However, this issue still remains unconfirmed (IHT, 2008).
Although the reasons for this apparent shortage of liquidity are not known, Northern Rock would have needed sufficient liquidity to adjust with a withdrawal of wholesale funding for more than a month so as to avoid needing assistance or help from the Bank of England. It is not likely that a change to liquidity regulation would help the banking institution.
Some scholars have drawn attention to the sorts of transformation which would prevent banking and financial institutions to be affected by runs (King, 2007); In line with the Northern Rock, many of its account holders withdrew their deposits to deposit it to other banks. For the most part, these depositors did not ask for cash. If Northern Rock has been insured with other banks, then the insurance policies might have allowed the banks to make long-term loans, to provide them with enough funds which they need to adjust with the loss of account deposits. In this regard, liquidity insurance in effect would attempt to recycle deposits from the other banks to the institution which is Northern Rock. With this, these insurance contracts would force the other banks to do what they did in times of the sub-prime crisis, to lend money wholesale for the Northern Rock.
In order for the system to presumably operate the entire banks, these institutions must be obliged to insure each other. It is unlikely that banking institutions could insure with bodies external of the banking system since non-banks do not usually have the liquidity needed to give the resources needed in a banking run. If banking institutions pay each other insurance premia, then, unless some industries can be recognised as more expose to liquidity issues than others, the profit earned by each industry from giving insurance to other banks, might be expected more or less to suit what the bank pays for its own insurance. This is the outcome that liquidity insurance has become a mutual aid arrangement which is an agreement between banks to assist each other in financial aspects when the interbank market ahs continue to dry up.
It is noted that the problems of Northern Rock were also triggered by the announcement of Bank of England in providing aids for the bank. It is noted that the market Abused Directive limits the Bank from giving aid disjointedly because the banking institutions was a publicly traded industry. With this there are separate rules to be considered and these include the Exchange Rules which requires Northern rock would require making public that they had received help. In this regard, one of the solutions for the Bank of England is to nationalise Northern Rock. The Northern rock nationalisation and the proposal for supporting other distressed banking institutions are said to be based upon the claims that such would safeguard the interests of employees and depositors. However, even this solution has challenge the bank since depositors have withdrawn their accounts.
5. Recommendation and Conclusion
Northern Rock faces issues and challenges which affects its performance in the market. The sub-prime crisis have affect become critical and detrimental to the profit-generating prospects of the company especially during economic fluctuations in the regional as well as the local social, economic, and political situations of the locations where the branches of the bank are situated. As such currency rates, foreign exchanges, as well as the unexpected changes in the trends that characterize the volatile nature of the international market will post issues and problems that the management of the bank should address immediately.
The possibility that Northern Rock might not be able to meet its current and future payment obligations in full or in time, particularly in the business organization’s international deals, wherein the bank would need to settle its liabilities through refinancing when the company is at higher market rates or liquidating assets at a discount to the market risks, increases the company’s responsibility of handling risks.
Inconsistencies in the operation system of the company due to lapses in the communication structure and the ineffective and inefficient flow of relevant information for the immediate needs of the management to provide aggressive solution to the problems related to the organization’s operations, post as a hindrance to the development and growth of the bank. The fact that the bank is in the international business wherein operations are made complicated by the needs for preparation and other documentation processes to complete a transaction as well as to monitor the workflow and performances of the branches increases the risk of the Northern Rock.
Strategically implementing management measures to ensure that the interests of the bank is secured and the company’s need to conceptualize and design effective business plans are of primary consideration due to the complex structure of the organization and ever-changing economic environment of the international banking industry. Compliance with international business principles and regulations calls for necessary means of adapting the policies and laws within the company to complement with the outside provisions of the industry.
Careful allocation of the business organization’s resources should be realized in the company’s quest to achieve productivity and profitability amidst the competitive international banking industry. Identifying the priorities and immediate needs of the bank should be immediately recognized and laid out to facilitate and conduct necessary actions that will adhere to the goals of the company. Although the sub-prime issue is still ongoing, Northern rock should continue to think of possible ways to limit or totally eliminate the effects of this issue with their organisation. It can be concluded that the issue of sub-prime has affected the organisational performance of different banks in the global market. The inclusion of Northern Rock with this issue should be solved by the management without affecting how they perform in the British market.
All in all, it can be said that the Northern Rock crisis is just a part of a much huge crisis in the international financial system. This issue for the banking and financial markets as well as ordinary people is that nobody knows where the next break in the system will be. In addition, it can be said that if sub-prime issues would not be able to solve immediately, this would create extreme chaos for banking and financial institutions which would lead to various bankruptcies in the banking sector leading to turmoil in the international financial system.
6. Reference
Bank of England (2008). Online available http://www.bankofengland.co.uk/publications/news/2007/090.htm. Retrieve April 29, 2008.
Barr, A. (2007). Subprime woes infect commercial paper market: KKR Financial, Thornburg, Coventree among firms reporting disruptions. Online available http://www.marketwatch.com/news/story/subprime-mortgage-woes-infect-commercial/story.aspx?guid=%7B1989DE0D-9031-46A1-B3C5-8E07436CF37C%7D. Retrieve April 29, 2008.
BBC (2008). Northern Rock drops from FTSE 100. Online available http://news.bbc.co.uk/1/hi/business/7139241.stm. Retrieve April 29, 2008.
Bernanke, BS (2007). The Recent Financial Turmoil and its Economic and Policy Consequences, Online available http://www.federalreserve.gov/newsevents/speech/bernanke20071015a.htm Retrieve April 29, 2008.
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International Herald Tribune (2008). Crisis deepens for Northern Rock. Online available http://www.iht.com/articles/2007/09/17/asia/17northern.php. Retrieve April 29, 2008.
King, M. (2007), ‘Evidence to the Treasury Select Committee’, http://www.publications.parliament.uk/pa/cm200607/cmselect/ cmtreasy/uc999-i/uc99902.htm. Q90. Retrieve April 29, 2008.
Lahart, J (2008). Egg Cracks Differ In Housing, Finance Shells. Online available http://online.wsj.com/article/SB119845906460548071.html?mod=googlenews_wsj. Retrieve April 29, 2008.
Lim, M. (2008). Subprime mortgage meltdown: Roots of the crisis. Online available http://opinion.inquirer.net/inquireropinion/talkofthetown/view_article.php?article_id=101568. Retrieve April 29, 2008.
Moyers, B (2008). Online available http://www.pbs.org/moyers/journal/06292007/transcript5.html. Retrieve April 29, 2008.
MSNBC (2007). Will subprime mess ripple through economy? Q&A: Looking at the impact of the mortgage meltdown. Online available http://www.msnbc.msn.com/id/17584725 Retrieve April 29, 2008.
Unmack, N (2007). Rhinebridge Commercial Paper SIV May Not Repay Debt (Update1). Online available http://www.bloomberg.com/apps/news?pid=20601087&sid=aEacPeg9pmLg&refer=home. Retrieve April 29, 2008.
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