In my previous post today, I described what I had learnt about managing liquidity risk from studying Northern Rock; in this post, I shall discuss the implications for the regulatory architecture (separation of bank supervision from the monetary authority).
Many observers appear to think that Northern Rock has revealed the dangers of the UK system of separating bank supervision from the central bank. In my view, it has on the contrary, revealed the strengths of this system. It is clear from the evidence, that the banking supervisor (Financial Services Authority) was keen to solve the problem of Northern Rock by making changes in monetary policy while the monetary authority (Bank of England) was unwilling to do this. If the central bank were in charge of both monetary policy and bank supervision, there is little doubt that monetary policy would have been changed to save Northern Rock. The deficiences if any in banking supervision would then have never come to light at all. This is a form of regulatory moral hazard – regulators will tweak the regulatory system to hide their failures. The UK system where the central bank is not the bank supervisor is less vulnerable to this kind of moral hazard.
That the UK had not had a bank run for 140 years prior to Northern Rock is to me a troubling thing. Banks are highly fragile institutions. If in 140 years including two world wars, a great depression, the loss of a vast empire and over three decades of chronic exchange rate difficulties, the UK did not have any bank runs, then it tells us not that banks were well regulated but that they were saved covertly. In these covert operations, doubtless the reputations of bank regulators (and perhaps bank managers) were also protected at the tax payers expense. That Northern Rock has dented many reputations is not such a bad thing by comparison.
I have spent a fair amount of time trying to understand the collapse of Northern Rock in the United Kingdom by poring through the transcripts of the Treasury Committee hearings that took evidence from the Bank of England, the Financial Services Authority and the directors of Northern Rock as well as the financial statements of Northern Rock itself.
In a separate post, I shall discuss the implications for the regulatory architecture (separation of bank supervision from the monetary authority. In this posting, I shall focus on what I have learnt from all this about managing liquidity risk:
- While much of the discussion about Northern Rock assumes that
their problem was one of borrowing short and lending long, this does
not appear to be correct.
- The FSA categorically stated in response to Question 315 that “the figures do not suggest that [Northern Rock] was an outlier in respect of its dependency on very short-term funding ... The actual percentage of its funding which was dependent on three months or under was not a particular outlier, and also just to remind us again, I think it is important to remember that it did not actually fail to fund itself is this period.”
- The CEO of Northern Rock stated in response to Questions 517 and 518 that “The average life of a mortgage product is three years and one month and the average life of our funding was three and a half years ... We had 10% of our borrowings which had a maturity of less than one year; we had 10% of our borrowings that were over one year; we had 50% of our borrowings that were three and a half years; and we had 10% of our borrowings with an average life of seven years.”
- There does not appear to have been a significant difference in the costs of various maturities of borrowing. The CEO of Northern Rock stated in response to Questions 519 and 520 that “The average rate on securitisation for the stock was about LIBOR plus ten basis points; the average price for covered bonds, which is the seven year, was about LIBOR plus one basis point; the average price of longer term wholesale was about LIBOR plus five; the average rate for shorter, ie less than year, was about LIBOR flat. ... The interest rates on our lending, including fees that are effective interest rate were about LIBOR plus 90 basis points.”
- It appears from the available information that there was no serious problem of asset quality. Northern Rock’s Chairman stated in response to Question 402 that Northern Rock was “below half the industry average of arrears on our mortgage book.” While some of this may be due to the rapid growth of the loan book, it does not appear likely that the credit quality of the loan book was below average, let alone bad. Their exposure to US subprime and CDOs was negligible.
- It appears from all the information that I have read that the standard tools of gap analysis and asset liability mismatches would not have revealed any problems in the liquidity management of Northern Rock. Yet, when I re-read the BIS document on Sound Practices for Managing Liquidity in Banking Organisations, I do not think there is any need to rethink the basic principles of liquidity management. The problem as I see it is that in organizations like Northern Rock, the dynamic aspects of liquidity management (as measured by cash flow projections) are more critical than the static aspect (as measured by mismatches and gap analysis). The problem is that securitization tends to be done in a few large transactions at intervals of several months. Profitability considerations will then dictate that the maturity of the short term funding would be shrunk ahead of an impending securitization. If this is not done, then the securitization would produce a huge cash surplus that cannot be profitabily deployed for several weeks. If a closure of a securitization markets takes place at this point, the liquidity position of the bank can become quite acute. This becomes worse if the non securitization lenders also shrink the maturity at which they are willing to lend in the build up to the crisis. All through the crisis, Northern Rock remained funded but by the end, the only funding that they could access was overnight funding. Dynamic liquidity analysis using what-if scenarios are unavoidable for wholesale oriented banks like Northern Rock. However, it is really hard for a regulator to review and comment on the adequacy of this analysis. Gap analysis is so much simpler for a regulator to understand and comment upon.
- There were more than ten questions to the directors of Northern Rock asking them why they were the only bank that failed (Questions 460, 474, 475, 476, 529, 640, 641, 642, 643, 644 and 649). This was a grim reminder of what Keynes wrote 75 years ago: “A ‘sound banker’, alas, is not one who forsees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.” (Consequences to the Banks of a Collapse in Money Values, 1931).