Northern Rock Case

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The 2007 failure of mortgage bank Northern Rock is a more recent illustration of liquidity risk arising from structural weaknesses in a bank's business model. In this case, a combination of an excessive use of short-term financing for long-term assets and a sudden loss of market confidence triggered a funding liquidity crisis that rapidly led to disaster. Northern Rock was a fast-growing medium-sized mortgage bank based in the United Kingdom. The bank had been growing assets at around 20% per year for several years by specializing in residential mortgages, and it continued to expand aggressively in the marketplace into the first quarter of 2007. The bank's rate of growth was supported by a business model and funding strategy that was unusual among U.K. banks.

 

Specifically, the bank relied on an originate-to-distribute approach, by which it raised money through securitizing mortgages, selling covered bonds, and making use of the wholesale funding markets. As a result, Northern Rock relied much more heavily on investors and wholesale markets and less on retail deposits for funding in comparison to many of its U.K. peers. The bank hoped to mitigate potential weaknesses in this funding strategy by diversifying its funding markets geographically. For example, it tapped markets in continental Europe and the Americas as well as in the United Kingdom. As it turned out, however, the bank had overestimated the benefits of geographical diversification.

 

After years of a strong economy and rising housing prices, widespread doubts about mortgage-related assets began to surface among investors early in 2007. These doubts were initiallytriggered by rising default rates in the U.S. subprime market but soon spread globally to asset-backed securities (ABS) as an investment class, then to institutions that invested in or depended on these securities and eventually to the interbank markets. When the interbank funding market froze in early August 2007, all of Northern Rock's global funding channels seized up simultaneously in a scenario that the bank's executives later claimed was "unforeseeable." Ironically, earlier in the summer of 2007, the bank had announced increased interim dividends after U.K. regulators approved a Basel II waiver that allowed the bank to adopt so-called "advanced approaches" for calculating credit risk that looked likely to reduce its minimum regulatory capital requirements.

 

 When Northern Rock became unable to fund itself through interbank loans, U.K. authorities began to discuss various strategies to relieve the bank's difficulties. News of the Bank of England's planned support operation for Northern Rock leaked, setting the scene for a run on deposits in mid-September. The panic was exacerbated by the tight rules then in effect for compensating depositors and calm only (slowly) returned after U.K. authorities publicly promised that deposits would be repaid. Northern Rock eventually accepted emergency government support and then public ownership.