Analysis of Northern Rock Bank

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Introduction

Northern Rock is British Bank wholly owned by the British Government. The bank is located in New Castle, UK. , and was formerly identified as the Northern Rock Building Society. Creation of the society was in 1997 after being listed on the London Stock Exchange. The Northern Rock society was as a result of a merger of two very established firms in 1965… The firms were the Northern Counties Permanent Building society which was established in 1850 and the Rock Building which was also formed in 1865.

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A rapid expansion program through various mergers and acquisition initiatives ensued after its formation. This saw the acquisition of fifty three smaller societies by the Northern Rock and the major acquisition at the time were finalized in 1994 between the Northern Rock and the North of England Building Society. For expansion measures to be effected more easily the bank decided to demutualize and this resulted in the floating of shares on the stock exchange. The northern Rock foundation was created as a result of continued complaints against the demutualization as it was seen and perceived as a betrayal against the current members of the society.

The bank was heavily hit by the subprime mortgage debacle that hit the US as the society was funded by major American banks. When a liquidity freeze hit the banks, Northern Rock society was affected as major funders withdrew their support for the building society. This resulted in the Nationalization of the bank as on the twenty second of January 2008. The bank was successfully granted Government financial support and this resulted in the dissolution of all the member’s shares without any reimbursement. The whole process of nationalization was processed through after two take over bids from prospectors fell through. The bank is currently divided into two branches i.e. Asset management and banking.

Appropriate Frame work

The issue with Northern Rock was mostly contributed by the way that the bank raised its funds. Most of its funds were acquired fro the wholesale market as opposed to other banks that acquired their funding through other deposits from retail customers. The subprime mortgage crisis became the single most catastrophic event that nearly ended the existence of the bank. The business model that was being followed by he bank ate the time was that of rapid growth centered on short term borrowing from the wholesale market.

The business model seemed to have worked for Northern Rock in the beginning but its major flaws occurred when the model was exposed to the crisis that hit the other side of the Atlantic. Initially the mortgage book of the bank looked impressive even to outside critics when compared to other banks and lenders engaged in the subprime market in the United States. The defaults and repossession rate for the bank was in fact slightly higher than the industry average. All this changed when the global economic crises hit home and the bank sought to have discussion with potential buyers. This signaled an alert to the public who mad frantic efforts in withdrawing back their money.

The onset of this crisis exhibited inconsistencies in the way that three regulatory institutions worked. Whereas the Bank of England governor refused at first to offer support, the other two regulatory bodies, the financial services authority and the treasury were less hesitant in offering their support to the troubled bank. The bank hit the media in 2007 for a couple of reasons and has gone through major strategic reforms when it decided to expand in a big way and is also underwent a series of reforms before becoming a privately held company. The main business of the company involves offering mortgage lending and also offering savings accounts to its customers

PESTLE Analysis

In his book Llewellyn (2009) analyzes and finds that t Llewellyn he external environment of any organization including Northern Rock is easily defined as the common forces that do not openly affect the short term activities but its effects in the long run are widely seen. As for Northern Rock the external environment was comprised of socio-cultural forces, economic forces, technological forces as well as political-legal factors.

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All these forces were important in the manner in which decisions were made that ultimately decided the course the bank took in terms of strategy, objectives and the type of model that the business would follow. We are going to analyze each force differently and how it affected the bank in general. In our analysis we have to look at the determination of Northern Rock’s timing and its importance in respect to environmental changes that directly affected the strategies the bank undertook in conjunction with the management in place.

Socio-cultural forces

In Northern Rock’s case the Socio-cultural, the workers had a high attitude towards quality of the work they were doing and they derived satisfaction from the services they offered their clients. The bank had scaled up very quickly in a short number of years and the future of the employee only looked brighter. The bank was also famed for its work force diversity employing many people with diverse and unique qualities.

The bank had many initiatives that sought to understand the diverse cultures and people it served. According to an annual report of the company, the employees were rewarded handsomely with directors enjoying the big pieces of the cake. For example non executive directors had their annual remuneration of £294,000 in 2005 increased to £ 395,000 in 2006 while managers enjoyed salaries that ranged from £90,000 to £250,000 in accordance to position within the bank.

This amount would double in terms of bonuses when the company made a profit. The high perks enjoyed by managers are blamed as one of the reasons that a culture of undertaking risks was born. The company also had a ways of rewarding their employees through offering stock options that enabled the employees also enjoy the profits earned by the company that they worked for. This increased their motivation and this resulted in higher and higher profits each year.

Political Factors

The manner in which the government was able to support Northern Rock’s expansion initiatives together with the business model in which it operated on. Although it was cited that the model was very risky, Northern Rock enjoyed the full support of the government and this was manifested through full government support when the financial crisis hit the bank after 2007. The Financial Services Authority had judged the bank as having a sound and stable financial base. The bank was judged to be solvent even it times the lines of depositors grew. This shows that the government fully supported the bank and its risky initiatives that it undertook.

The fall of the bank exposed the soft underbelly that constituted the financial institutional infrastructure that held banks and other financial service providers in the UK. The political component also covers the political changes that could adversely affect the bank. It has been noted that the current structure that regulates the financial services in the UK were formulated just after the Labour party came into power in 1997.

It is these same regulations and implementations that have severely weakened the financial services in UK as banks such as Northern Rock could not withstand the pressure that came after the economic crisis. The problems faced by Northern Rock were aggravated by the weaknesses within the UK regime, these problems manifested themselves through the flawed deposit protection scheme and the arrangement between the regulators i.e. Financial Service Authority, Treasury and the Bank of England did not offer enough coverage for Northern Rock during uncertain times of the crisis.

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Technological Aspects

Since the bank employed qualified staff, the bank was at the forefront of coming up with solutions that were catered for their clients. This was after a series of research and development initiatives by the bank. Marketing campaigns of the bank were driven mostly by the technology from both within and without. Solutions were marketed and packaged in a manner that made it easy for salespersons to sell their products. Also using technology the bank was able to identify the revenue streams that boosted its bottom-line.

Economic forces

Within these forces lie factors such as inflation rates, interest rates and global economic health. This is clearly seen in the case of Northern Rock, although being solvent, jitters and fears by depositors about the crisis in other institutions both locally and internationally played a role. Northern Rock had borrowed heavily from International markets and when these markets shrunk, Northern rock was faced with a liquidity issue. Prior to its eminent demise, Northern rock exhibited a risky strategy of borrowing from other banks and not its depositors.

SWOT Analysis

A SWOT analysis is a method of identifying a firm’s particular, strengths, weaknesses opportunities and threats. All these are major factors in the identification of a firm’s core competencies and the opportunities that it may not presently utilize because of lack of the right and appropriate resources. In his book Maximilian (2008) explaining that before conducting the SWOT analysis we must first evaluate the market. A SWOT analysis enables us to identify our customers, identify our strengths and weakness and also that of our competitors. A SWOT analysis also helps us to recognize the engine that drives sales within our organization in conjunction with the identification of markets

A SWOT analysis aids a company in evaluating the company itself in its core functions and its important resources that are imperative to its needs and product. Another purpose of a SWORT analysis for a company is in the determination of its capabilities. A SWOT analysis also aids a company in assessing the competition and analyzing the market conditions of products and services offered by our competition.

When conducting a SOT analysis of the bank we have to take into consideration various factors such as the identification of occurrences that were both internal and external and affected the bank. When looking at the internal occurrences we can dwell on the internal capabilities that greatly assume that the bank is diverse with respect to the resources they are able to control. Hence it can be argued that the bank had a meteoric rise and fall not from the products and services they offered customers but because of its business processes. In 1999, the bank decided to employ securitization as a source of extra funding rather than using it as an instrument for the management of capital, this was an alteration of its business strategy.

Strengths

The brand of Northern Rock was very strong at the time due to constant advertising. It was quoted that Northern Rock spent more on advertising than its competitors leading to rise in its brand name. Northern Rock leveraged on the power of the internet by investing in Northern Rock Online, the bank was able to come up with easier way of approving mortgage processes hence appealing to more clients. Using IT, the company was able to exchange information online in real time hence speeding up processes. This enabled the company to react faster to market needs while also managing costs efficiently.

Another point of strength was that the company was an amalgam of over fifty companies hence knowledge among the companies that formed it was vast and this knowledge was as a result of experiences that each building society had before being swallowed by the big company. This form of acquisition enabled the company to scale up very quickly and cost efficiently.

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Weaknesses

The strategy employed by the bank although very scalable and easy to deploy, put the company in a precarious position. The overall strategy of reliance on funding from the wholesale market exposed the company to a number of liquidity risks. Another strategy of issuing mortgaged backed securities also placed the bank in a very tight position when investor confidence on mortgage bank securities was dashed after the development in the US subprime mortgage market.

Opportunities

These were the opportunities that the company would utilize in going foreword and be able to match up to the market needs. In his book Llewellyn (2009) analyzes that for Northern Rock, such opportunities presented themselves through easy access to credit through wholesale funding. This enabled the company to keep its cost base down. Other opportunities that the company enjoyed were the I.T infrastructure that it had implemented. This made it possible for the company to be able to offer mortgage facilities to more clients and be able to process application at a faster rate.

Threats

Threats that were imminent to the company involved the sub prime mortgage debacle that engulfed the US Economy. This debacle threatened to reduce the confidence that Northern Rock had built over the years with its customers. Another source of threat that the company was exposed to was its competitors who were implementing business models that were far less risky that Northern Rock.

Why Northern Rock Ignored Imminent threats

Having followed a business model that emphasized more on short term funding and the securitization of mortgages, Northern Rock had believed for sometime that liquidity within the capital markets would be constant and short term capital required to run its business would always be available. Another apparent assumption made by the company was that it was very solvent and this would count for something in case things went wrong in the future, with assets worth over 100 Billion, the bank never anticipated that at one time all the depositors would be withdrawing their funds from the bank at the same time due to fears about its liquidity.

The Bank of England being the lender of last resort, whose main purpose is to shore up support for troubled banks, was expected by Northern Rock to fully support it while it was undergoing the severe crisis brought about by the mortgage crisis on the other side of the Atlantic. However he Bank of England was at first reluctant in injecting liquidity into Northern Rock and as a result this led to jittery fears by investors and depositors of Northern Rock.By 2007, new instruments that such as derivatives and other securities had been developed for the sole purpose of banks and other financial institution to shift credit from their balance sheets. Northern Rock clearly underestimated the risk component of such instruments.

Scenario Planning

Northern Rock would have benefited from scenario planning had it put such programs in place. Scenario planning is a method that would have enabled Northern Rock formulate flexible and plans that would have covered he long term. Scenario planning would ensure that Northern Rock was able to avert the crisis that t underwent prior to being nationalized by the Government. In his studies Keasey (2008) summarizes that the process of scenario planning involves the identification of the drivers that are relevant towards change. In our case of Northern Rock, this would involve the bank taking into considerations as many assumptions as there could be.

This would ensure that each risk that the company faced would have a contingency plan ready to be effected when the risk occurred. The second step in the formulation of the scenario planning would involve collecting all the drivers together and forming a framework that would be considered as feasible. In the case of Northern Rock, this would be the integrating all the risks into one framework. This is followed by coming up with several mini scenarios that the company was likely to have faced in the course of it doing business. This would produce a better picture of the risks that the company was exposed to.

The next process involves the management cutting down the scenarios to become less and more realistic. In his book Maximilian (2008) by this time management would have identified that the bank was facing an imminent crisis and would have initiated programs that would have had positive consequences for the bank. The last two steps involve the policy makers within Northern Rock drafting the scenarios and identifying the issues that may arise.

My belief is that Northern Rock would have been able to avoid or mitigate the effects that it underwent as a result of the mortgage sub prime crisis that hit England. This debacle as already said, had a big effect on the financial institutions that had fully adopted business strategies that fully relied on the mortgage securitization and wholesale funding.

Development of Early warning systems

If Northern Rock had developed an early warning system, the bank would have been able to avert most of the problems it encountered. An early waning system would have taken into account warnings from the financial Services authority that had raised concerns over the scale of expansion of credit within UK. An early warning system would have been able to evaluate the symptoms that led to the fall of the bank.

The early warning detection system would have alerted the board of the bank on the risky nature of its managers as they tries to increase the profit margin of the form. Since managers were well remunerated for their efforts, they were liable to taking more risks than was expected of them. Some went against the core practices and regulation set out by the regulators as they tried to earn more in terms of bonuses and other perks that came with performing well. The early warning system would have already have foreseen the crisis that was about to happen in the sub-prime mortgage market in the US.

The liquidity freeze that followed after the sub-prime mortgage forced the bank to become helpless as it did not have enough money for its operations. An early detection system would not prevent the bank completely from some of the effects of the global credit crunch, but it would have prepared the bank for any eventualities and this would have assisted in increasing the pace at which the stakeholders would have acted in mitigating the impact that was felt by the bank and its shareholders. The impact was also felt by the government which nationalized the bank. The position of the bank turned from that of being a tax payer to that of consuming public funds, and all these would have been prevented if proper mechanisms had been put in place.

Literature Review

In the book by Kevin Keasey, potently titled: “Lessons from the Northern Rock Affair.” Northern Rock should have been rated more accurately so as to provide the true picture of actually what went wrong at the bank. The credibility of credit rating agency was art the spot when it erred in its provision of correct evaluations of the risks concerning securitized instruments. The credit agencies should have been more clear and transparent in order to allow the liquidity risk of loan originators to be better appreciated.

The complete inertia by the tripartite system is also scrutinized. The recent credit crunch is espoused as having started as a result of a series of events starting in 1986, when the “big bang” effect when the liberalization of the economy was first taking root. The era of competition was fostered within this period leading to a rise in advances in the types of financial products offered to customers. Example of transformation seen was where loans could be divided and packaged up to form securities in order to facilitate easier access to credit. The result of such actions was the rapid rise of economies and the reduction of inflation in many countries.

About twenty years down the line, the system has cracked under the pressure due to the consumer suspicions. The outcome of these suspicions has left many individuals and businesses exposed including the system itself. The same innovations disregarded practices such as assessing credit worthiness of individuals and businesses. This was also fuelled by the competitive nature within the financial sector. The new innovations were also perceived to have tighter control measures of assessing risk hence the price of risk was assumed to be low. This led to a dangerous turn of events that led to the credit crunch.

The securitization of loans meant that loans could be divided up together and tied together into new units. The debts could be priced at a discounted rate through the advantage of diversification. What was however not thought about is that if you bundle up fifteen parts of separate trash, one ends up with a unit of packaged trash. These actions aided the financial firms in pricing loans cheaply to individuals who could not afford them in the first place.

The domino effect was felt when a large number of those individuals were unable to service their loans, this led to a situation where the bank and other financial institutions became jittery as they could not fully comprehend the bearer of the risk. The creation of asset bubble was as a result of lack of proper pricing of risk and accurate evaluations.

Northern Rock’s mechanism for business strategy was bent on the principle that banks could receive funding from other banks through various interbank facilities. This enabled the bank to scale very rapidly.

The downside of this mechanism is that banks will restrict funding on any suspicions of issues with liquidity or solvency. This is exactly what befell Northern Rock. The company was exposing itself too much to risks that were not very far off from hitting the financial services industry in the United States. The article casts a big question about the whole process of decision making as it was the role of an internal compliance official and department to id management in these extreme decision making events. These extreme environments are attributed to the ever dynamic and competitive nature of the industry.

Northern Rock did not expect the turn of events to be as rapid once the issue of borrowing from the Bank of England came to the public limelight. The precipitated bank runs were not expected as it was generally assumed that banks have control measures which continually scrutinize the type and level of loans prepared. However this was not the case as the business strategy followed by Northern Rock was that of aggressive growth which placed strain on monitoring initiatives.

Another piece of literature that we reviewed during the answering of the six questions above was by Maximilian J.B Hall titled “The sub-Prime crisis, the credit squeeze and Northern Rock: the lessons to be learned.” The author espouses on the prevention measures that can be taken to prevent a catastrophe such as the one witnessed and experienced by Northern Rock. The article analyses the functions of the tripartite state that is an amalgamation of the bank of England, Treasury and Financial services authority. The system is blamed for not regulating risky business practices and strategies that were being committed and initiated by Northern Rock.

The practices were not only confined to Northern Rock but were being followed by other banks in the United Kingdom as well. The author goes on to detail of how the financial service authority contradicted with the treasury on the solvency state of Northern Rock. When The FSA was busy calming the nerves of jittery investors and depositors by publishing statements revealing how solvent Northern Rock was while the Bank of England had refused to lend to the bank leading to further uneasiness in the financial markets. The article also critics the management of Northern Rock for choosing a risky strategy at the expense of the shareholders and other stake holders.

The credit squeeze caused the lending banks to hoard credit facilities and cash to individuals and businesses all over the world leading to further collapse of businesses that employed many workers. In a mid term balance sheet chronicled in the article for the year 2007, Northern Rock’s asset base stood at £113.5 billion, this was by the end of June. The banks position was strong, being the seventh largest mortgage provider in the UK.

The mortgage base of the bank stood at £87.9 billion while liabilities comprised of £30.1 billion of customer deposits in the institution. The equity held by the shareholders made up about £1.95 billion. This was a very dangerous model to follow as the bank left it exposed vulnerable to any destabilizing force in the financial markets. Fears of the critics came to the fore when sub prime mortgage crisis hit, which led to unexpected bank runs that were last seen during the 19th century.

The other literature that was reviewed was a book by Llewellyn David, titled “The failure of northern rock: a multi-dimensional case study.” The book reviews and evaluates in detail the events surrounding the near collapse of Northern Rock and the actions of everyone involved from the management, regulators, shareholders and employees of the bank. The bank takes into consideration perspectives from observers from both within and without the United Kingdom as they analyze the rise and collapse of the bank from the day of inception to the business model that the company was leaning towards to. A multi dimensional perspective is offered in which the author looks at the problems that the bank faced form the positions of all those who had interests in the bank.

Reference List

Keasey, K. (2008) Lessons from the Northern Rock affair. Sydney, CRC Publishers.

Llewellyn, T. (2009) The Failure of Northern Rock: A Multi-Dimensional Case Study. London, Oxford Publishers.

Maximilian, H. (2008) The sub-Prime crisis, the credit squeeze and Northern Rock: the lessons to be learned. New York, Wiley Publishers.

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