Northern Rock – How A Problem Became a Disaster

Northern Rock has been a cloud over the UK financial sector since it ran out of cash in August 2007. This was due to the fact that most of its funds were being raised in the wholesale market, that is from other financial institutions rather than deposits from retail customers. The problems of the US subprime mortgage crisis, to which most UK banks remain exposed, dried up Northern Rock’s funding.

This business model of financing rapid growth on the basis of short term borrowing from the wholesale market assisted Northern Rock to progress from a regional lender to a major player in the UK mortgage market. They had achieved a 22% share of new mortgages taken out in the first 6 months of 2007.

Unlike the US subprime market, the mortgage book of Northern Rock was healthy. Defaults and repossessions were not significantly higher than the UK industry average.

The management of Northern Rock did approach the Financial Services Authority (FSA) and advise them of the situation, There were talks between Northern Rock and Lloyds TSB, but a take over bid did not materialise. This was partially due to the fact that the Bank of England was unwilling to underpin the takeover with significant public lending.

The initial response of the Governor of the Bank of England was to lecture the City and the nation on the ‘moral hazard’ of baling out financial institutions who are in difficulty. Perhaps the Bank had considered opening a lapdancing club in Threadneedle Street.

By mid November, the crisis had grown and the Bank of England had been forced to improve liquidity in financial markets, that is, print money and make it available for other banks.

The Governor also announced a series of auctions whereby the Bank would lend US$ 80 billion to financial institutions at an interest rate of 6.75%. There were no takers for this initiative. This was due to the high interest rates, but also to the fact that no bank wished to have the inevitable adverse publicity of being forced to beg from the Bank of England. It should be recalled that the run on Northern Rock was triggered by a leak to the media.

The announcement of a government guarantee to depositors provided a breathing space during which interested parties could prepare bids for Northern Rock. There were 3 bidders, the favourite being the Virgin proposal, promoted by Sir Richard Branson.

It was generally felt that the Virgin bid was too advantageous to Sir Richard at the expense of the UK taxpayer. The prospect of ‘obscene’ profits for Virgin prompted the Prime Minister, Gordon Brown, to announce nationalisation in mid February 2008.

The handing of the Northern Rock saga reflects ill on all the parties involved. While the management must take responsibility for the risky business model, they were helpless in the face of the global credit crunch. Once they had disclosed their problems to the FSA, then the public agencies took control of the situation.

However, the suggestion that any public body ‘took control’ is risible. The drama moved from the boardroom of Northern Rock in Newcastle to the tripartite regime established by Gordon Brown while he was Chancellor of the Exchequer during the Blair years. The parties in the tripartite regime are the Bank of England, the Financial Services Authority, and the UK Treasury. The Bank of England lectured on moral hazard, the FSA claimed to be powerless, and the Treasury dithered.

Gordon Brown repeatedly claimed during the successive Blair governments that the relative prosperity of the UK, and the success of London as an international financial centre was based on his vision of a tripartite regulatory regime, with an independent Bank of England at the centre.

It is true that London overtook New York as the leading global financial centre, but this was due to the efforts of those employed in the City and the restrictions imposed on the financial sector in New York. The bankruptcy of Enron in 2001 and subsequent criminal prosecutions further weakened New York as a financial centre.

Northern Rock was the first real test that the UK regulatory bodies had faced since the secondary banking crisis of 1973. By any yardstick, the tripartite regime was a dismal failure.

The run on Northern Rock was triggered by a media leak, allegedly from the tripartite regime, and the reaction of the regime was lamentable.

This can be compared with the news blackout on the deployment of Prince Harry in Afghanistan, which lasted for 10 weeks. The fact that the Prince had been posted to Afghanistan during December 2007 and that the UK media had unanimously agreed to suppress the story is breathtaking.

One would suggest that a similar period of confidentiality surrounding the problems of Northern Rock would have led to a resolution of their difficulties.

The fact that the UK media conspired to suppress the Prince Harry story but exposed the problems at Northern Rock with glee is a sad reflection of contemporary UK celebrity culture. The financial standing of the UK banking industry is infinitely more important than a young man’s desire to see military action.

Another unfavourable comparison is with the French banking crisis at Societe Generale. This crisis was occasioned by a rogue trader who caused losses of US$ 7.26 billion, rather than the global credit crunch.

However, as soon as news broke in January 2008, the French authorities stepped in. As well as providing funds, they also warned off foreign predators. This makes a mockery of EU rules, but the French always have a healthy disregard for EU regulations when their own national interest is threatened.

The bank has been rescued by a rights issue of US$ 8.4 billion. The one-for-four rights issue has been completely taken up by shareholders and the company share price has started recovering.

The Chairman of Societe Generale, Daniel Bouton, has personally invested US$2.2 million in the rights issue. He has also waived his bonus and six month’s salary.

This episode further discredits the UK government’s handing of Northern Rock. The French authorities reacted quickly and decisively to prevent a foreign takeover of the bank, and the funding shortfall was resolved within weeks by a fully subscribed rights issue.

The commitment of Messr Bouton should also be congratulated. This contrasts markedly with the UK, where the government has appointed Ron Sandler on a salary of GBP 1.1 million per annum to run Northern Rock. Mr Sandler is allegedly non domiciled in the UK for tax purposes.

Based on their failure to monitor and regulate the banking sector, the UK government has nationalised Northern Rock. For some inexplicable reason, they believe that while they were unable to regulate the bank, they will now be successful in managing the company.