The global financial crisis evident from the year 2007 led to the collapse or near-collapse of numerous business entities worldwide. Despite the fact that a sizeable number of the deeply affected institutions were non financial institutions, it is the banks and other non banking financial institutions which were most affected globally. Different institutions were affected differently due to the differences in management models and structures, which defined the extent to which they were exposed to the crisis.
What is most evident is the fact that the institutions which engaged in high-risk ventures prior to the financial crunch were the most affected by the crisis. Indeed, the level of risk was the selective tool that determined who was to collapse. This paper explores the financial crisis and its implications for banking institutions. It focuses on Northern Rock, a banking institution in the UK, which was on the brink of collapse due to the spread of the financial crisis to the UK.
The US was the epitome of the credit crunch, which quickly spread first to other western countries and then to the east and other parts of the world. The credit crunch started in the housing markets of the US. Prior to the crunch, the lending institutions had aggressively extended credit to people, therefore unsustainably boosting the demand for housing in the American Markets. This was supported by a loose regulatory framework for the financial institutions, which allowed them to continually innovate and develop new financial products, which allowed them to extend credit to clients with no ability to repay.
The most important product here was subprime lending. This was the riskiest category of loans. Under the arrangement, the traditionally approved structures of determining the creditworthiness are almost fully disregarded, prompting the access of loans to a vast majority of people with weak financial standing. The effect of this was an unsustainable surge in demand for housing, which blew the prices up to unsustainable levels. The overvaluation of the housing markets could soon not be sustained; hence the bubble burst. The prices of the housing units drastically reduced, meaning that in the case of the rising disclosures, the values which were realized from the properties were far less than the loans. This meant massive losses for the sub-prime lenders as the category of bad debts astronomically rose to unprecedented levels.
Faced with these situations, the financial institutions could not trust each other and were extra cautious before lending to anyone else. This triggered the credit crunch, which led to the overall economic slowdown. The US is not only the biggest economy in the world but also has close finance and business ties with the UK. This meant that the problems in the US quickly spread to the UK and other European Nations (Shin, 2009, par3).
Northern Rock was the first casualty in the UK. The institution was converted to a bank in 1997 from a mutual building society. On conversion, it could offer all banking services, but it chose to focus on offering mortgages for the purchase of residential properties. Its business strategy prior to the financial crisis focused more on mortgage-backed securities. This meant securitization as well as a funding strategy that relied mainly on wholesale money, which is secured through assets and, by extension, the inclusion of other funding from the capital markets. Though the bank was listed as the seventh-largest mortgage lender in the UK, its market share was growing immensely. Indeed, the bank accounted for a quarter of the mortgage lending in the first three months of 2007 (Santos, 2008, par4).
In the period leading to the financial crisis, the bank had employed aggressive marketing strategies that saw the lending books swell to unprecedented levels. The bank had assets valued above ÂŁ100 billion, which had been accumulated over the ten year period as the growth levels were maintained at levels averaging at 20% for the entire period (Shin, 2009, par5). This growth in mortgage lending was far above the banks growth in deposits.
The implication is that the bank could not substantially fund the mortgages through deposits received, as is supposed to be the case. The developing funding gap had to be filled through further and further securitization and employment of other wholesale market funding. Indeed over 70% of the banks funding originated from securitization and wholesale finance markets by early 2007. Only 27% of the funding originated from real deposits got from institutional and personal savings. This proved too risky for the bank.
It is important to note that securitization involves distributing risk by combining debts in a pool and then using the pool to issue securities to investors. Securitizing debt is prone to market volatilities depending on time and structures. This can introduce hefty financial risks. In a case where the structure is right, the risks are significantly minimized, but if the structure is not right, then huge losses could occur. The correctness of a structure is hinged on the ability to predict interest rates as well as cash flows relating to the debts. Wholesale market lending, on the other hand, is a short-term lending practice among banks and other financial institutions.
The inherent risks of employing a bigger proportion of securitization and wholesale lending, as opposed to relying on real deposits, are significantly higher. This is worse, especially in situations where interest rates become volatile or in cases where the global financial markets are not smooth. This put the Northern Rock to a more risky position than other lenders who had real substation deposits to back their lending.
The start of the financial crisis spelled two major problems with the Northern Rock’s business model. The collapse of the sub-prime mortgage in the US drastically reduced confidence in the mortgage bank securities as they were touted as the most important causes of the collapse of the sub-prime mortgage experienced in the US. This cast serious doubts on the model adopted by Northern rock. Investors were thus reluctant to invest in the securities issued by the bank, yet this was the banks lifeline. Secondly, other financial institutions could not also trust the institution; thus, they had to cut lending (Upton, 2007, para4).
This underlying problems resulting from the risks associated with the bank’s business model, which triggered the banks problems. However, the management also had a big role in the imminent collapse of the institution. In addition to the risks described above, they incorporated off-balance-sheet subsidiaries so as to obtain even more mortgage-backed as well as asset-backed securities across the UK borders. Much of these would not have been allowed within the UK. This heightened the already high-risk business strategy adopted by the bank (Upton, 2007, par6).
Notably, using the securitization as well as wholesale markets is not considered wrong per se. It was the scale to which the bank took the process. Financial experts recommend a 50% funding from real deposits, while the rest can originate from other sources (Llewellyn, 2009, par7).
As credit flow hitches hit the UK credit markets. The Northern rock got the worst beating due to erosion of confidence by investor’s and other lenders. As a result, it could not adequately service existing loans and mortgages. The accumulation of matured short term loans could not be paid off with other loans at a profit as the interest rates had soared partly due to the actions of the bank of England to tame inflation in the period as well as the inability of the institution to convince investors and other lenders. Despite assurances from the company’s management, the bank had to seek funds from the Bank of England, which serves as a lender of the last resort as it could hardly secure funding from anywhere else. This announcement triggered panic from the institution’s savers, and the general public compounding the problem even further (Llewellyn, 2009, par9).
Savers rushed to withdraw from the bank due to fear of imminent losses. This drained the already struggling bank, even further pushing it to the verge of collapsing. This necessitated government intervention. At first, the government guaranteed savings hence effectively stopping the rash for savings. It later injected fresh capital to boost the liquidity levels for the bank and instill confidence among the investors (Northern Rock besieged by savers, 2007, par2). It is, however, notable that the high-risk model overexposed it to the financial crisis in comparison to other institutions.
Reference List
Llewellyn, D. (2009). The Northern Rock Crisis: a multi-dimensional Problem. Web.
Northern Rock besieged by savers. (2007). BBC News. Web.
Santos, R. (2008). Between Northern Rock and a financial crisis. Scottish Socialist Party. Web.
Shin, H. (2009). Reflections on Northern Rock: The Bank Run that Heralded the Global Financial Crisis. Journal of Economic Perspectives. Web.
Upton, M. (2007). Northern Rock: a business model unravels. Web.