Long queues were all over the bank`s branches. In three days, panic withdrawals topped three billion pounds (£3billion). This was compounded by wide publicity in the news media. The bank was caught in this crisis because of its business model of securitisation where the mortgage loans on its books were packaged and sold to investors locally and worldwide. Some of these assets were transferred to the bank` s own self-created special purpose vehicles, either with recourse and or non-recourse. A transfer with recourse means the bank is still obligated to meet any shortfalls in case of failure of the special purpose vehicle as well as to take control of the assets back into its balance sheet. Non-recourse means without risk and the bank is insulated from any bankruptcy or inadequacies of the special purpose vehicle. The funding and credit markets for this particular asset disappeared and the bank could no longer fund its operations. The bank was solvent but illiquid. The UK Treasury and central bank came to the bank’s rescue by guaranteeing all deposits and offering a discount window for borrowing, albeit at penal rates to discourage moral hazard. This was Northern Rock Bank, a UK bank caught up in the crisis of the US financial crisis of 2007.
Lessons from the Northern Rock Crisis
1.Rollover Costs
The cost to renew maturing liabilities exceeded the return on assets, hastening default due to business insolvency. Thus, the return on the assets is less than the funding costs.
2.Concentration of Funding
The risk was inability to secure more funding to continuously run the business in a sustainable manner. It is therefore important to diversify funding sources to minimize business disruption in severe or acute economic conditions.
3.Correlation
Sources of funds that move in correlation with the economic environment should be scaled down. Negative correlated sources of funds will aid business in countering funding hurdles as it minimizes depth of the crisis and cost.
4.Communication
Proper communication in a crisis scenario should be well managed so that it does not exacerbate the situation. Business crisis communication procedures should be activated to counter negative publicity and to manage reputational damage. It should also spell out recovery procedures to the public. Public buy-in can yield positive results hence all stakeholders should be informed.
5.Resolution Speed
The central bank should have ready-made solutions to assist banks in crisis. Various crisis scenarios should be tested at central bank level so that it becomes easier and faster to implement resolution procedures. The more the delay, the more customers and investors lose confidence in the bank and banking system at large. Customers and investors will miss contractual obligations as they are not able to access their accounts. The resolution should also take into account penalty costs in terms of failure by customers to make good their obligations in time. Who should be responsible for these costs? I suggest the bank shoulders the costs.
Deposit Insurance
The stipulated amounts guaranteed by the deposit corporations will not serve purpose as long as the covered deposits are less than the uncovered deposits. I suggest banks should then tailor coverage based on their balance sheet mix to counter withdrawals in crisis situations. In current position deposit corporations are after creating confidence in the bank system and protection of retail customers.
Technology and Innovation
Due to technology, withdrawals are made at speed. This is a new factor which needs to be planned for so as to mitigate systemic funding issues.
Maturity Transformation
Some short-term deposits are used to fund long term assets. As the short-term funds mature, they will have to be refinanced at prevailing rates in the market. As long as there is negative duration gap value of equity is increased. However, if funding is concentrated in the short-term deposit market there is bound to be a crisis if this market is closed. The bank needs to have contingency funding plans to cater for the specific bank funding incidents or a market wide shock. Contingency funding plans should be tested and updated with changes in micro and macroeconomic factors.
Capital Adequacy
Regulatory capital buffers are a minimum requirement to cater for cyclical downturns and crisis economic situations. The bank risk profile and complexity of its products plus its capital structure determines the requisite capital to sustain the business strategy within its risk appetite and tolerance. The bank supervision can still increase the capital limits depending on the riskiness of the bank operations over and above the regulated capital.
Human Capital
Continuous training of employees to adapt to the changing business landscape is a cornerstone of business success. Tangible training plan including succession planning is of utmost importance in achieving targets and organisational goals. A dedicated expert in risk management from the central bank should also be included in the bank board of directors as non-executive director. His independency will in some way increase effectiveness of the board overall function and oversight.
Central Bank Stress Testing
The mother bank should also be stress tested under different worst-case scenarios to gauge effectiveness in resolution and crisis management over its financial stability role of banks.
Stable sources of banking funding promote the achievement of banks short- and long-term strategic targets and objectives. The structure and diversity of bank funding is of primary importance in meeting profitability, capital adequacy and positive shareholder returns.
It is not only the funding source but also the bank’s core strategy that can give rise to costly funding mismatches. Board of directors should have clear oversight of the bank strategy as the responsibility lies with them despite delegation to senior management.
In adverse economic environments all normal plans and strategies are inadequate to meet intended targets. Hence there is need to readjust and resize with speed to cater for the new normal in adverse economic environments.
