FSR

Introduction

Following the sub-prime mortgage crisis of the 2007/2008, the British Labour Government had to either bail out or nationalize a number of economically vital banks to ensure that there was no ripple effect on the other institutions and to sustain stability in the financial industry. The banks which have been nationalized or bailed out with the taxpayer money included Northern Rock. Notwithstanding the fact that there tends to be no question as to whether the Northern Rock fiasco amounted to a financial crisis (which tends to be broadly defined and loosely used), there tends no such agreement as to the direct and indirect causes of the problems faced by Northern Rock in 2007. By dissecting the downfall of the Northern Rock, this case study aims to juxtapose the current financial regulation in place with that which was existed during the 2007.

Timeline of the events leading up to Northern Rock’s fall

In June 2007, the Northern Rock decreased its expected growth profits, from 17% to 15%, singling the problems that was impending within the bank^[1]. Such warning as to falling profits was followed by a dip in its share prices, which is quite par for the course.

FSA, the Financial Services Authority, which was delegated with the responsibility of supervising banks, including Northern Rock, was as seen as nonchalant toward such decrease in the growth. The FSA’ s role in handling the Northern Rock fiasco has also come to present itself as a contributing factor as opposed to a facilitator of a fast solution.

The sliding share prices, decreased profit outlook perfectly coalesced into a perfect storm to engender the crisis. However, notwithstanding the signals Northern Rock sent with these, the FSA, the responsible body for bank supervision in UK during 2007, remained somehow oblivious to them. In fact, in June of 2007, the FSA allowed the Northern Rock to dispose of its larger part of capital against the loans, providing the key part of the prospect storm^[2].

In September of 2007, the Northern Rock request liquidity support from the Bank of England, the lender of last resort, which was approved by the Bank of England. Following the liquidity support, the run-on bank occurred, with some estimating that a total 1 billion British pounds were withdrawn in a day^[3]. While attempting to rescue the Northern Rock, the Chancellor of the Exchequer made abortive attempts to sell the Northern Rock to a private sector, followed by attempts to break up the bank and then sell it to no avail, before finally relenting into the nationalization of the bank. The whole Northern Rock’s fall resulted in it being taken into ‘public ownership’ in February of 2008, signaling the lack of private sector buys willing to pay the price desired by the Government. Cerberus, a private investment fund, purchased the securitized bonds amounting to around a record 13 billion British pounds, which were backed by the loans extended by Northern Rock prior to it being nationalized^[4].

Overall, FSA’s own actions or lack thereof as a contributing factor in the Northern Rock’s downfall cannot be overlooked or trivialized. FSA has even corroborated this by pointing out to how it could have acted more prudential in its own report^[5], even though the aggressive O&D securitization strategy pursued by the management of the bank is largely made the scapegoat for the fall of Northern Rock.

Securitization

Northern Rock, which used to be a building society based in Newcastle, enjoyed unprecedented expansion and growth, to become the fifth largest mortgage lender in the UK in 2007. Such unprecedented growth and expansion lead to many citing the mortgage securitization as the driving force for its exponential growth, which seems to be tenable since the Northern Rock was one of the first UK banks to start issuing securitization backed by mortgages in 1990s.

Unlike other banks such as RVS and US banks, which had to bailed out because of their reckless mortgage lending activities, the Northern Rock bank’s demise tends to be predicated upon the its reckless securitization strategy. The Northern Rock bank was the number one bank in Britain by the number of securitization it issued in 2007, overtaking Barclays and RBS^[6]. Securitization is the process, whereby mortgage is pooled and sold on the wholesale market, while providing sustained cash flow to the lender, which, in this particular case was the Northern Rock. In 2007, Northern Rock raised a staggering 16.8 billion British pounds through securitization, testifying to how it went overboard with relying on securitization to underwrite loans[7].

Considering the heavy reliance of Northern Rock on the securitization, it was considered inevitable that the aggressive securitization strategy pursued by the bank would lead to a point where the bank lacks new products to sell. Therefore, Northern Rock’s business strategy takes on a new mission to explore new markets to sustain such unprecedented growth. The new business model was predicated upon the so-called originate and distribute model (i.e. O &D) securitization^[8].  Granite, Northern Rock’s SPV, and Northern Rock’s aggressive O& D model is largely seen as the decisive factor leading to it being nationalized by the Bank of England.  The House of Commons Report also detailed that that Northern Rock was more vulnerable to the sub-prime credit crisis, because its business model relied heavily on the wholesale market, rather than retail deposits.^[9]

Reforms introduced post Northern Rock

To respond to the fiasco Northern Rock had created and ensure that the ripple effect risk of the NR crisis was mitigated, the Parliament enacted the Banking (Special Provisions) Act 2008 to grant the financial regulation bodies (the Financial Services Authority, The Bank of England and the Treasury) the power to either put up the distressed financial institutions (i.e. the Northern Rock) for sale or nationalize it. The legal powers the Banking (Special Provisions) Act 2008^[10] granted to the financial regulation bodies were crystallized into the Banking Act  of 2009. The main tool formulated and implemented by the Parliament is the so-called ‘Special Resolution Regime’, and is derived from the Banking Act of 2009. The Special Resolutions Regime (SRR) encompasses two prongs, the pre- insolvency and post-insolvency. The pre-insolvency of SRR regime introduced by the Banking Act of 2009^[11] provides for mechanisms whereby distressed financial institutions are rescued.  This optionality of the mechanisms of SRS include the transfer of the bank to a private purchaser, to the so-called bridge bank, to the Bank of England or the nationalization of the bank, all listed in order of desirability.

Post-insolvency response, as per the Banking Act of 2009^[12], has also been modified to ensure that trust in the banking sector does not take a nosedive following a future bailout of a financial institution. Firstly, to achieve such goal, there were provisions included in the Banking Act of 2009, which stipulate that depositors are offered unbridled access to their FSCS deposits following such a crisis^[13].  Secondly, when Northern Rock fell, there was ambiguity as to the respective roles played by three financial regulations bodies. To ensure that such ambiguity was averted in case of future financial crisis, the Banking Act 2009 also provided for more transparency as to which authority (i.e. financial regulation body) will take the lead during future banking crisis. However, in the suggestion below, there are more codification that are necessary. Finally, to effect changes to the substantive law of banking and ensure sustained progress, the UK Government, introduced the so-called overhaul of banking regulation. The Financial Services (Banking Reform) Bill of 2013^[14] was enacted to ensure that the financial fiascos experienced in 2007 and 2008 do not occur again. Unlike the Banking Act of 2009 which largely deals with the so-called SRR (as discussed above), the Financial Services Bill of 2013 derived much of its substance from Vickers Report of 2011, which examined the UK financial regulation post 2007 financial crisis. The Financial Services Bill of 2013 also looked to protect the ‘core services’. The PRA has been granted to ensure that the consistent supply of core services is protected and sustained. The key feature of the bill was the provision of the so-called ‘the ring-fence’ protection. By introducing ring-fence, the Financial Services (Banking Reform) Bill of 2013 envisaged that a financial institution’s core activities- accepting depositing, overdrafts and etc.– are fenced, thereby, protecting them from riskier activities a bank pursues.  Tim Wallace, in an interview with the Telegraph, hailed the efficacy of the new ring-fence mechanism, stating that in cases of a crisis, the investment banking activities would be let to fall, while retail banking would be largely.[15]Therefore, the incorporation of the new ring-fencing provision as a viable mechanism in the Financial Services Bill of 2013 to ensure that there will be no more Northern Rock bailout seems tenable. Nonetheless, there are still inherent risks with the so-called ring -fencing. Ring-fenced financial institution (ie. bank) might fall short of providing the absolute protection the Bill aims to provide to retail customers, with some asserting the limitations of the ring-fence when it comes to deterring future financial crisis such as Northern Rock, Llyods and etc.^[16]

Proposed suggestions to Director of HM Treasury

Based on the above post-mortem of the Northern Rock’s downfall, the reforms introduced by the Banking Act of 2009, and the Financial Services Bill of 2013 are commendable given how they could help mitigate the consequences of such future financial debacles. However, in light of the dissection of the Northern Rock’s downfall, there can be a few suggestions proffered as to make the current financial regulations system of UK more efficient and effective.

Firstly, pursuant to the above-presented discussion about the merits of the ring-fence, the Director of HM Treasury would be wise to ensure that instead of a ring-fence, there is a wall: a clear and transparent division of banking activities which are risky (casino activities) and which are not (utility activities). The proposal of a wall instead of a dubious ring-fence, which was introduced in the Financial Services Bill of 2013, has been also advocated by Hudson^[17].

Secondly, the fact that the Financial Services Act 2012^[18] disposed of the FSA, and supplanted it with two bodies, Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) is an incremental improvement given how the previous supervising body FSA was remiss not to be more proactive in its response to the Northern Rock’s fall.  These two bodies are tasked with supervising and regulating banks in UK.  However, the powers granted to the FSA and PRA has to be increased to ensure that they are capable of dealing with a future crisis like Northern Rock’s. Thirdly, the financial debacle of Northern Rock had culminated in customers of the Northern Rock lawfully demanding their deposits. Nevertheless, the British Labour Government could neither order Northern Rock to honor the savings or demand it to be offered for sale, which was a testament to how impotent the previous financial regulators were when faced with such scenarios. Since the Bank of England, acting through regulators, lacked the legal powers to intervene earlier in the Northern Rock case and others where a bank is failing because of a lack of liquidity, a new legislation- The Banking (Special Provisions) Act 2008- was introduced.  The case of run on the Northern Rock’s branches testified to the lack of legal powers vested in the financial regulatory authorities which, in the wake of the crisis, included the Financial Services Authority, The Bank of England and the Treasury. Even though the Banking Act of 2009 provided for a mechanism whereby the regulators could handle a distressed bank, the Act itself omits to codify the requisite legal powers of the regulators. Thus, it is suggested that the legal powers as to deal with the financial crisis of banks of the regulators are codified.

Overall, with the enactment of Banking Act 2009, the Financial Services Act 2012, Financial Services Bill of 2013 and the new mechanisms to deal with new financial crisis (‘SRR’) is a testament to how far the UK Government has come to overhaul the financial regulation following the fall of the Northern Rock. However, there a number of suggestions for the Director of HM Treasury to take into consideration to ensure that more robust reforms are introduced in the financial regulation realm.

Reference

• The Financial Services (Banking Reform) Bill of 2013
• Financial Services Act 2012
• The Banking Act of 2009
• The Banking (Special Provisions) Act 2008

• Alastair Hudson, Hudson-The Law of Finance (2nd edn, Sweet & Maxwell, 2013)
• EP Ellinger, Eva Lomnicka and CVM Hare, Ellinger’s Modern Banking Law (5th end, OUP, 2011)
• House of Commoons, Treasury- Fifith Report (24 January, 2008) <https://publications.parliament.uk/pa/cm200708/cmselect/cmtreasy/56/5602.htm? > accessed 20 December, 2017

• FSA, Internal Audit Division, the Supervison of Northern Rock: a lesson learned review (2008) <https://www.fca.org.uk/publication/corporate/fsa-nr-report.pdf> accessed 20 December, 2017

• Frances Coppola, Structural Reform of Banks is Pointless, But It Will Go Ahead Anyway (7 February, 2014) <https://www.forbes.com/sites/francescoppola/2014/02/07/structural-reform-of-banks-is-pointless-but-it-will-go-ahead-anyway/#6c72c422489e> accessed 20 December, 2017
• Anousha Sakoui and Paul J Davies, Northern Rock calls it a day on Granite (21 November, 2008) <https://www.ft.com/content/2db1ec8c-b748-11dd-8e01-0000779fd18c> accessed December 15, 2017
• The Economist, Lessons of the fall (18 Oct 2017) <http://www.economist.com/node/9988865> accessed 26 December, 2017
• Emma Dunkley, UK Treasury sells £13bn of Northern Rock mortgages to Cerberus (23 November, 2015) <https://www.ft.com/content/d6566948-89dd-11e5-9f8c-a8d619fa707c> accessed 20 December, 2017

• The Telegraph, The Northern Rock crisis explained (16 September 2007) http://www.telegraph.co.uk/news/uknews/1563266/The-Northern-Rock-crisis-explained.html>accessed 20 December, 2017

• Tim Wallace, Q&A: What is bank ring-fencing? (15 October 2015) < http://www.telegraph.co.uk/finance/bank-of-england/11934139/QandA-What-is-bank-ring-fencing.html> accessed 20 December 2017

^[1] The Economist, Lessons of the fall (18 Oct 2017) <http://www.economist.com/node/9988865> accessed 26 December, 2017

^[2]  The Economist, Lessons of the fall (18 Oct 2017) <http://www.economist.com/node/9988865> accessed 26 December, 2017

^[3] The Telegraph, The Northern Rock crisis explained (16 September 2007) http://www.telegraph.co.uk/news/uknews/1563266/The-Northern-Rock-crisis-explained.html>

accessed 20 December, 2017

^[4] Emma Dunkley, UK Treasury sells £13bn of Northern Rock mortgages to Cerberus (23 November, 2015) <https://www.ft.com/content/d6566948-89dd-11e5-9f8c-a8d619fa707c> accessed 20 December, 2017

^[5] FSA, Internal Audit Division, the Supervison of Northern Rock: a lesson learned review (2008) <https://www.fca.org.uk/publication/corporate/fsa-nr-report.pdf> accessed 20 December, 2017

^[6] The Economist, Lessons of the fall (18 Oct 2017) <http://www.economist.com/node/9988865> accessed 26 December, 2017

[7] The Economist, Lessons of the fall (18 Oct 2017) <http://www.economist.com/node/9988865> accessed 26 December, 2017

^[8] Anousha Sakoui and Paul J Davies, Northern Rock calls it a day on Granite (21 November, 2008) <https://www.ft.com/content/2db1ec8c-b748-11dd-8e01-0000779fd18c> accessed December 15, 2017

^[9] House of Commoons, Treasury- Fifith Report (24 January, 2008) <https://publications.parliament.uk/pa/cm200708/cmselect/cmtreasy/56/5602.htm? > accessed 20 December, 2017

^[10] The Banking (Special Provisions) Act 2008

^[11] The Banking Act of 2009

^[12] ibid.

^[13] EP Ellinger, Eva Lomnicka and CVM Hare, Ellinger’s Modern Banking Law (5th end, OUP, 2011)

^[14] The Financial Services (Banking Reform) Bill of 2013
[15] Tim Wallace, Q&A: What is bank ring-fencing? (15 October 2015) < http://www.telegraph.co.uk/finance/bank-of-england/11934139/QandA-What-is-bank-ring-fencing.html> accessed 20 December 2017
^[16] Frances Coppola, Structural Reform of Banks is Pointless, But It Will Go Ahead Anyway (7 February, 2014) <https://www.forbes.com/sites/francescoppola/2014/02/07/structural-reform-of-banks-is-pointless-but-it-will-go-ahead-anyway/#6c72c422489e> accessed 20 December, 2017

^[17] Alastair Hudson, Hudson-The Law of Finance (2nd edn, Sweet & Maxwell, 2013)

^[18] Financial Services Act 2012