The collapse of the Northern Rock: A supervisory failure

In the June 2010 edition of FAnews, I concluded that the failure of the Northern Rock was caused by the collapse of the securitisation market. To prevent further bank failures and other crises, regulators should therefore focus on the securitisation proce

The failure of the Northern Rock in the UK - the first UK bank to experience a run in nearly a 140 years – pointed to securitisation as the reason for its collapse and thus the reason why other banks failed, and, thus also, to the cause of the global financial crisis. Following its collapse, the securitisation market is slowly coming back to life and the world may thus be heading for another crisis!

Bank supervisors should therefore start thinking about how to deal with banks that are in trouble, particularly in light of the fact that they did not deal correctly with the problem of the Northern Rock. As I unpack how the regulators should have dealt with the problems of the Northern Rock, it will become clear that the failure of the Northern Rock is, in fact, a vivid example of supervisory failure.

The UK’s regulator (and supervisor) of banks

Who is the regulator of UK banks? One of Dr Gordon Brown’s 1997 innovations was to move the supervision of banks from the Bank of England to the Financial Services Authority (FSA). So, at the time of the banking collapse, the banks in the UK were regulated as mere financial institutions by the FSA.

But banks are not the same as other financial institutions! The problems of the Northern Rock could not be dealt with by a code of practice such as Treat your Customers fairly (TCF).

The risk of contagion

Banks play a vital role in the monetary system, which is based mainly on faith and trust. As such, banks are subject to contagion - if one bank collapses, it can cause others to collapse, and this could eventually cause all banks to collapse, something the world witnessed in the world financial crisis.

Contagion is not a risk in the insurance market, for example. If one insurer collapses, the business is quickly absorbed by other insurers, as evidenced in South Africa with the demise of the AA Mutual and the IGI.

The sensible approach

A different mindset is required to regulate and supervise banks. The supervision of banks forms part of the supervision of the monetary system.

In most parts of the world, as in South Africa, banks are regulated by the central bank. In South Africa, the banks are supervised by the South African Reserve Bank (SARB). There was a proposal in South Africa to follow the Gordon Brown’s UK example and transfer this supervisory role to the FSB. It was not greeted with much warmth enthusiasm, especially by the SARB and was not adopted.

From a regulatory perspective, then, the Northern Rock started off on the wrong foot – it was regulated by the wrong body. The FSA’s role in regulating banks is currently under review, with the clear intention of returning the supervisory role to the Bank of England, where it should have been.

Liquidity: a bank-specific problem

Banks, especially banks which lend money for the purchase immovable property secured by mortgage bonds, face a particular problem. They are forced to lend long, but can only borrow short. Short loans become even shorter when people fear for the stability of the bank. As depositors withdraw their deposits, a run on the bank takes place. At this point, banks face a major liquidity problem and not a solvency problem.

Although they may be solvent, as was the case with the Northern Rock (see Table 1), they may not have sufficient money or liquid funds to repay all their liabilities at one the same time. In fact, no bank can pay all its liabilities in one go. Essentially, what happened to the Northern Rock is that all its liabilities became due and payable at a single point in time.

Table 1

Advances     90               Deposits         22.5

Cash             10              Interbank         22.5

                                       loans

                                       Securtisation    45

                                       Owner's equity  10

Total             100            Total                  100

Firstly, all its interbank loans, essentially overnight loans, become payable at once. Up to that point the practice of funding the interbank loans from the securitisation process had worked very well. However, since the securitisation process had collapsed, no money was forthcoming from that source.

Secondly, the securitisation instruments themselves were also short-term instruments and would become payable within a short period of time. Normally, these instruments would have been rolled over by the issue of further securitisation instruments, but without the securitisation market this was no longer possible.

And thirdly, as the news of the problems facing the Northern Rock became public knowledge, depositors started queueing up to withdraw their deposits. Thus the sort term deposits became due and payable.

As a result, the Northern Rock faced a massive liquidity crisis – it did not have the cash to refund the various classes of depositors. – It not face a solvency problem; it assets exceeded its liabilities too.

Central banks - lenders of last resort

The liquidity risk facing banks is well understood and, for this reason, central banks were invented, as lenders of last resort. If a bank is solvent, but faces a liquidity problem, the central bank - in theory, at least - should lend the bank all the money it needs. The Bank of England should have lent Northern Rock all the money it required to meet its liquidity obligations. If the central bank acted as it should have, there is no reason why a run should take place on the bank. In the case of the Northern Rock, assuming the worst case, where all existing liabilities are replaced by loans from the Bank of England, the balance sheet immediately after the loans had been made would have looked like Table 2.

Table 2

Debit                               Credit

Assets          %                Liailities          %

Advances      90               Bank of          90

                                        England

Cash            10                Owner's equity   10

Total             100              Total                  100

Had the Bank of England did done what it should have done, there would have been no Northern Rock crisis and possibly no UK banking crisis. In fact, it would have highlighted a significant problem, not clearly understood that of : international monetary flows. The money advanced by the Bank of England to the UK depositors of the Northern Rock would be re-deposited in other UK banks, resulting in a neutral position from a banking perspective in. However, much of the securitised funds came from depositors foreign to the UK – for example, from Chinese surplus or savers, via American investment banks. International money flowst is a complicated situation matter well beyond the control of individual banks. The impact of these transactions must be carefully considered by the regulator. It This is not a Northern Rock problem, but a money system and banking supervisory problem.

Central bank failure

Why, then, did the Bank of England, which started to lend the Northern Rock money not continue and act as it should have as the complete lender of the last resort, as it should have? At this stage, I can only speculate. Firstly, it had not dealt with such a situation for 140 years, so there is probably no one alive who knew how to deal with the problem, despite the fact that central bankers should be trained to do what they are supposed to do. Instead, of using the central bank the central bank Gordon Brown’s government shifted the problem to the taxpayer.

Secondly, the regulation of the banks had been moved to the FSA - an organisation that had no skills to deal with the problem in any event.

Thirdly, changes in accounting standards hadve clouded the true financial positions of banks. The FSA had had very limited contact with the Northern Rock. The central bank is supposed to act as the as lender of last resort only when dealing with a liquidity problem, not a solvency problem. With the new accounting standards, no one can be sure any more if any entity is solvent. Historically, as and when mortgage loans defaulted, the outstanding amounts would be written off as bad debts in that year. The current practice, confused by the balance sheets of Asset Managers, is to revalue assets and write changes in asset values through the income statement, resulting in a completely different picture.

Local banking problems

Fortunately, the SARB has much more experience in dealing with banking problems. Many years ago, Nedbank got in to trouble, and if I recall correctly, there was a short run on Nedbank. That night, after trading hours, the then Governor of the SARB appeared on national television and assured the public that Nedbank was in a position to honour all of its obligations. When the banks opened the next morning, there was no further run on Nedbank.

The Cape Investment Bank had problems. Later there was the issue of Bankcorp, including the troubled Trust Bank. Trust Bank ended up in Absa, which silently received a R1 billion lifeline from the SARB. A bit later African Bank appeared to get into trouble, followed by Unifer and Saambou and Regal Bank.

In the case of Saambou, the SARB did probably for political reasons decided not act as lender of last resort and the bank went under. Absa was involved with Unifer and it solved the Unifer problem in a different fashion. BoE appeared to have problems, at which stage the SARB did step in with assurances as lender of last resort. South Africa witness the rare but real problem of contagion as bank after bank faced problems.

By that time, the lower tier banks had been virtually wiped out – a domino effect that looked very much like contagion.

An even bigger problem…

Besides distinguishing between solvency and liquidity, central banks face another challenge: how once stepping in, to exit. This challenge is playing out in the US at the moment, following the stimulation package, and the central bank must now figure out how to end the ‘assistance’, without re-sparking the crisis.