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Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

EVENTS
In 1997, Northern Rock converted to bank status, with a:
Central securitisation strategy
Funding predominantly on secured wholesale and other
capital market funding
During the summer of 2007,
It was a victim of the general market turbulence and lack
of confidence triggered by worsening developments in
the US sub-prime mortgage market

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

EVENTS
In the summer of 2007,
Notwithstanding unprecedented UK government support,
depositors withdrew funds on a large scale
In September 2007,
Northern Rock was forced to seek massive financial

assistance from the BOE, and eventually reverted to UK


government ownership

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

STRATEGY
Originate and distribute model as the core business

strategy

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

STRATEGY
Funding mainly from the wholesale markets, rather than

from retail deposits.


The proportion of
the retail deposits
and funds declined
from 62.7% in late
1997 to 22.4% at the
end of 2006

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

STRATEGY
That strategy exposed to the following problems:
An unexpected downturn in the securitization market

would have a high impact on the bank.


Northern Rock was the only major UK bank to
have securitisation as its core strategy.

Overreliance on wholesale funding and short term

financing left the bank very vulnerable to a LPHI


event :
Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

STRATEGY
During the 2007 turmoil,
The bank or its conduits were unable to roll-over
maturing funding
The liquidity squeeze raised the cost of wholesale

funding

As liquidity dried up, Northern Rock could not finance its


off-balance-sheet vehicle and was :
Forced to take assets back on to the balance sheet or

hold on to assets it was planning to securitize.

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

THE COLLAPSE

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

SOLVENCY & LIQUIDITY


During the crisis NR remained legally solvent (its equity

was greater than zero)


If the BOE didnt provide the funding NR needed, it

would have been forced into insolvency to pay out


depositors
NR was business insolvent as the borrowing rate was

greater than interest on assets

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

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THE RESCUE
The government rescued NR by arbitrarily guaranteeing

all deposits held which was contrary to the wellestablished deposit protection scheme.
Creating serious moral hazard issues with respect to

depositor protection and the role of the BOEs money


market operations.

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

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RISKS INCURRED
Portfolio

and Capital Funding Risk - Excessive


dependency on one sector ((Handbook Volume III,
Chapter 10)

Operational and Reputational Risk A sharp decline in

confidence can lead counterparties in the wholesale


markets and retail depositors to suddenly withdraw
funding from a suspect bank, driving the institution into a
funding liquidity crisis. (Handbook Volume III, Chapter 13)

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

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STRESS AND SCENARIO TESTING FAILURE


Absence of stress testing the business model for the

multi-dimensional LPHI covariance incidences


Neither the bank nor the FSA had incorporated a stress

test scenario of liquidity squeeze on various marketbased funding sources upon which it relied heavily.
Simulations carried out jointly by the FSA, the Bank of

England and the Treasury failed to involve banks


themselves as players

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

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MITIGATIONS & LESSONS LEARNED


Identification and measurement of the full range of

liquidity risks
Design and use of severe stress test scenarios
LPHI risks need to be more explicitly considered and

managed
Corporate governance

Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

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MITIGATIONS & LESSONS LEARNED


A business model which emphasises short term wholesale

funding and securitisation for matching long-term


liabilities with short term funding is a recipe for disaster.
Shareholders can still lose everything even when a bank is

bailed out.
Maintenance of an adequate level of liquidity, including

through a cushion of liquid assets


Necessity of allocating liquidity costs, benefits and risks to

all significant business activities


Universit Paris Dauphine - Rgis LOWE

PRM PREPARATION - EXAM IV

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