Historical collapse in the UK banking system

Today’s post will be dedicated to Northern Rock – one of the biggest mortgage lenders in the UK before it failed and asked for help from the Bank of England in September 2007. I will emphasize the connection of the recent global financial crisis and the UK mortgage market and the consequences for the savers and investors after Northern Rock failure.

Before 1997 Northern Rock was a building society, did not take much risk, which suggests the idea that the profits of the institution were limited and the asset growth was small. Afterwards it was converted into a stock bank. The business strategy fundamentally changed. Northern Rock started to originate and repackage mortgage loans selling them as securities to investors. Before 2007 the markets were confident and were willing to lend Northern Rock due it strong financial health and of course in order to make profits.

The bank increased the leverage significantly. The funding strategy of the bank was 75% borrowing from short term wholesale markets and 25% from the deposits. According to the SUERF study due to risk taking strategy its assets doubled from $16 billion in 2005 to $32 billion in 2007 and it increased it’s share of mortgage lending to 19% in 2007.

Northern Rock could have prospered and continue to increase its profits, but due to
the global financial turmoil interest rates in short term wholesale markets soared and subsequently it created liquidity problem for Northern Rock. As I mentioned before it borrowed heavily from the markets and when the markets became unwilling to lend, the bank had found itself unable to fund short term operations. Depositors started to worry about their savings and were trying to withdraw their money.

What makes this story interesting is that Northern Rock was only one financial institution in the UK in the last 100 years that applied for government bailout. Finally, in February 2008 it was nationalized as no private buyer was found.
Northern Rock collapse had widespread implications for the British savers. As Bank of England started to cut interest rates in an effort to boost economic growth, savers became to lose their savings as the low deposit rates were not able to keep up with the inflation.

Other losers were Northern Rock shareholders whose investments wiped out after nationalization of the bank. After 2007 banking sector became less attractive to the investors as its share of dividend income dropped from 21% in 2007 to 9.7% in 2011.

Another significant change was tightened credit standards for home borrowers in the UK. After the failure of the institution creditors became increasingly risk averse. In my opinion, Northern Rock collapse was a good lesson both for supervisors and shareholders as it suggests that more rigorous analysis and tougher regulations required in order to make the financial system work for the benefit of the society.