Reflections on Northern Rock

Original by Hyun Song Shin, 2009, 19 pages 

This summary note was Posted on

The Bank run that heralded the global financial crisis

Journal of economic perspectives volume 23, number I

  • September 2007, TV shows customers queuing outside Northern Rock.
  • Last bank run was on Overend Gurney, London, in 1866
  • Bank run common in US until 1930’s until start of deposit insurance by federal deposit insurance.
  • UK bank deposits only fully insured up to 2’000 pounds and then 90% of the deposits up to 35’000 pounds with insurance funded by bank industry
  • Bank run started in Northern Rock after central bank announced its support to the bank
  • Had heavy reliance on non retail funding unusual among UK mortgage banks
  • Virtually no subprime lending but used same pool for short term funding
  • Northern Rock deposit run was however an aftermath of the liquidity crisis
  • Why would sophisticated lenders who operating in capital markets suddenly deny lending to a bank with no apparent solid asset book and virtually no subprime lending.
  • Northern Rock in the business of prime mortgage lending in the UK
  • June 1998, retail funding was 60% of book liabilities, 23% in June 2007
  • Composition of retail deposit:
  • Small portion was branch based.
    • Post accounts where you have to announce by post that you are withdrawing. Customers rewarded for their inconvenience with slightly higher rates
    • Telephone account (same but with the phone)
  • Postal and telephone based where the first to be withdrawn by customers
  • Gap funding between the amount lent out and the amount non retail depositors put in was made up of securitised notes, interbank deposits and covered bonds (long term).
  • Securitised notes made of medium to long term maturity with average maturity of over one year.
  • “Wholesale funding” non retail funding that does not fall under either covered bonds or securitised notes declined from 26.7 billion pounds in June to 11.5 billion pounds in December 2007
  • Whole sale was more short term of less than a year and shorter and thus more vulnerable to the liquidity crisis.
  • Northern rock managed to raide 2.5 billion pounds of wholsale in the first half of the year but saw outside flows of 11.7 billion in second half as maturing loans and deposits we not renewed.
  • The key of the initial run on Northern Rock was the non renewal of its short and medium term paper. That was the run that led to its demise out of sight of the television cameras
  • The branch based customers deposits saw smaller falls from 5.6 bln to 3 bln. Postal deposits, offshore deposits and internet deposits saw much more substantial falls.
  • Evidence suggests that the non standard deposits are the first to flee in a deposit run. Thus the coverage of the Northern Rock bank run showing images of depositors queuing at the branch offices was ironic. This branch deposits were actually the most stable of them.
  • Individual depositor runs for fear that others will run, leaving no assets in place for those who do not run Northern Rock may be better seen as the tightening of constraints on the creditors of Northern Rock rather than as a coordination failure among them
  • Banking and capital market conditions should not be viewed in isolation
  • Traditional bank holds short-term liabilities, in the form of deposits, and uses them to finance longer-term, less-liquid assets, such as loans. The financial system as a whole works the same.
  • Raising new equity is notoriously difficult in distressed market condition but selling assets in a depressed market is not much better.
  • A common approach to this situation is to make the necessary adjustment by reducing lending (which in effect is reducing assets) and by repaying debt.
  • In effect, Northern Rock was faced with a giant margin call, where lenders demanded higher haircuts. The usual way to meet a margin call is to sell some assets to raise the cash. But the assets of Northern Rock were illiquid long-term mortgages, so that it could not meet those margin calls. The inability to meet this margin call led to Northern Rock’s demise. (Margin spiral)
  • When that short-term liquidity did not materialize, it felt like a run from the point of view of these institutions. Bear Stearns and Lehman Brothers were two more high-profile failures of this type.
  • A bank can survive a run if 1) it has sufficient liquid assets and cash or 2) it has sufficiently stable (that is, illiquid) liabilities such as long-term debt.

Lessons

  • Put limits on the raw leverage ratio rather than the risk weighted assets
  • Economists should further deepen their understanding of the potential benefits and costs of financial intermediation that uses short-term liabilities to finance long-term assets.