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The failure of Northern Rock: Evidence of a money/banking crisis

01 June 2010 Robert W Vivian, University of the Witwatersrand

The world is going through one of the greatest economic crises since the 1930s. This is a serious matter which requires action to be taken.

The uncertainty regarding the cause of the economic crisis is reflected by the various names given to it: subprime crisis, credit crunch crisis, banking crisis, financial crisis, world economic crisis and so on. Each name points to a different meaning and cause.

The first fundamental principle of management, especially risk management, is that the source problems must be identified. Once this is done, appropriate steps can be taken. Unfortunately, this fundamental principle is, as Shakespeare’s Hamlet put it, honoured more in the breach than in observance.

Considered approach

It is suggested, rather than a shotgun approach, a better approach is to examine the evidence and come to a conclusion from the evidence. Two further approaches can then be adopted, firstly to assign a reason and examine the evidence which supports this reason. A second approach is to examine a specific manifestation of the failure and find out what caused that failure. For example, one manifestation of the crisis was the failure of the Northern Rock bank in England.

Thus, if the first approach is adopted, it can be assumed that the cause of the crisis was the sub-prime mortgages. If this is the case, then how this explains the failure of the Northern Rock (and Iceland, Ireland, Royal Bank of Scotland, etc.) must be demonstrated. It is very difficult to see a connection between these failures (all in different countries) and the sub-prime crisis, an American problem. Accordingly the The second approach is adopted, to examine the failure of an institution, say again, the Northern Rock, without the assumption and discover the cause of the failure. It can then been decided if the cause of that failure can be applied to other failures

Significance of Northern Rock

For this reason, the examining of the failure of the Northern Rock becomes important. When the run on the Northern Rock took place in 2007, it was the first run on a UK bank in 140 years, a significant event.

The cause of the failure of the Northern Rock is easily determined. If asked what the function of a bank is, most would say it is to accept deposits from the public and lend this money out to others, making a profit on the margin between interest paid on deposits and advances. Well, if the balance sheet of the Northern Rock is examined, it will be clear that most people will be wrong. The Northern Rock made a vast number of advances but it did not do so out of deposits. In fact, deposits covered only 25% of the cost of advances. The rest were covered by interbank accounts (25%) and the balance from the process of securitisation.

Advances        Source of funds
100 %             Deposits (25%)
                       Interbank loans (25%)
                       Securitisation (50%)

What the Northern Rock did was lend money for the purchase of fixed property secured by a mortgage bond, as if limitless funds were available existed to be advanced. It had no regard for the fact that limitless funds did not, in fact, exist. So assume someone wished to purchase a R1 million house. That person would approach the Northern Rock for a R1 million loan, which would be approved without any regard for the fact that the Northern Rock did not have the R1 million to lend. As Brian Walters, a manager of Northern Rock, put it: “It was a given that funds were available to lend. We did not pay any attention to where the funds came from.”

Locating the money

Where then did the Northern Rock get the money? The seller would receive a cheque for R1 million and deposit that cheque with his or her bank. That bank would then contact Northern Rock for payment. The claim then sits in the interbank system. In South Africa, interbank transactions can be cleared in a day - South Africa has the world’s most efficient banking system. In the case of the Northern Rock, and other UK banks, the outstanding interbank account could be left for six months, uncleared. Interest was of course charged on interbank balances, governed by the Libor (London Interbank Offer Rate) rate.

The Northern Rock used the interbank system as a source of funding. As indicated in the table above, 25% of the funding for mortgage bonds came from interbank loans. Presumably the other banks did not mind, because they had excess liquidity.

After a period of time, six months or so, when a large outstanding balance had developed, the Northern Rock would bulk the outstanding loans and on-sell these via the securitisation process into the worldwide wholesale capital market. Applegrath, the then CEO of Northern Rock quite rightly explained, “The success [up to that time] of the Northern Rock is based on securitisation”. The system could work as long a securitisation worked.

Securitisation market collapse

On the 9th August 2007, the French Bank PNB Paribas announced it was suspending three of its asset-backed security funds whereupon the securitisation market collapsed.

With the collapse of the securitisation market, the Northern Rock could not on-sell its bulked mortgages. Nor could it refinance existing securitisation contracts when these fell due. This meant that it, and other UK banks, could not clear their interbank accounts. The Libor rate, and spreads, shot-up. Banks lost confidence in the ability of other banks to settle their interbank accounts and interbank loans froze, leading to the credit crisis. So the source of the collapse of the Northern Rock bank, and the credit crisis was the collapse of the securitisation process.

Money crisis

A very important conclusion can thus be arrived at: the proximate cause of failure of the Northern Rock was the securitisation system - funding through the worldwide wholesale capital markets. Having come to this conclusion, other causes can be discarded. The Northern Rock did not fail because of subprime failures. It did not fail because of a credit crunch. In fact, it partly caused the credit crunch.

It should be clear that the securitisation process has been shown to be an unreliable process and it seems clear to me that countries cannot rely on this process to fund domestic needs. This is simply to invite another crisis somewhere down the line.

It is for this reason I argue that the world essentially faced a money crisis and banking crisis. How are advances to be funded in the face of inadequate deposits? Where does the money come from? It cannot come from the securitisation process. A more stable money mechanism is needed.

The money source This question was answered a long, long time ago. The role of the central bank, as lender of last resort, is to provide liquidity in times of crises. Providing liquidity to the bankin g system This is not the role of the taxpayer via bail-outs, but the role of the central bank. It is a banking crisis because the role of banks cannot be to artificially create money via the unstable securitisation process. The banks role must be redefined. The system of money and banking should be reconsidered. The money can banking systems failed – it is for this reason I say the current crisis is a money-banking crisis.

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