Introduction to Financial Crises

Lecture 10: The Case of Northern Rock

University of Vienna – Masters in Banking and Finance

Winter Term 2022

 Background

The Northern Rock Building Society was created in 1965 following the merger of two
smaller building societies.

Building societies are mutual institutions with no external shareholders. In the 1980s,
they were allowed to start offering normal banking services to retail customers.

On October 1 1997, Northern Rock went public and became a stock bank, with a
heavy focus on regional mortgage lending markets and a large depositor base.

Starting in 1999, however, Northern Rock started to move its business model away
from traditional originate-to-hold and towards originate-to-distribution banking.

Its liability structure also began to rely progressively less on retail depositors and more
on securitized and wholesale funding.

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 The Run on Northern Rock
Reference: Shin (2008)

Many funding markets tied to securitized assets - in particular those with an exposure
to US subprime mortgages - began to dry-up starting in the summer of 2007.

Northern Rock, which had come to become very dependent on these markets for its
liquidity management, suddenly found itself in a funding squeeze.

On September 13, news broke that Northern Rock had approached the Bank of
England (BoE) for an emergency credit line.

This precipitated a retail depositor run on September 14, leading the BoE to publicly
commit to an emergency lending scheme.

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 Northern Rock’s Assets

Northern Rock was a “specialised lender whose core business [was] the provision of UK
residential mortgages funded in both the retail and wholesale market.”

Northen Rock’s assets grew from £15.8 billion (at the end of 1997) to £101 billion (at
the end of 2006)

By the end of 2006, roughly 89% of its assets were residential mortgages.

In contrast to many banks in the US and Germany, Northern Rock did not hold
poor-quality sub-prime mortgages.

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 Northern Rock’s Liabilities

The dramatic expansion of Northern Rock’s balance sheet exhausted its regional
deposit base, leading it to look for other funding sources.

The resulting funding gap was closed through increased reliance on wholesale funding,
including:
• Securitized notes
• Covered bonds
• Other wholesale funding, including commercial paper

Consequently, retail funding fell from about 64% in 1997 to 22% in 2006.

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Figure: Composition of Northern Rock’s Liabilities. Source: Shin (2009).

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 Granite Master Trust

By June 2007, roughly 50% of Northern Rock’s liabilities consisted of securitized notes.

The securitization process was performed by the Granite Master Trust, which pooled
mortgages and issued notes of varying seniority based on the underlying cash flow.

Contrary to other financial institutions who relied on off-balance sheet vehicles, the
Granite Master Trust was booked on Northern Rock’s balance sheet.

Moreover, the securitized notes issued by the trust were of relatively long maturity
(again in stark contrast to most ABCP conduits and CDOs).

This leads Shin (2008) to conclude that: “the securitized notes issued by Northern
Rock do not appear culpable for the run” and that ”Northern Rock case was therefore
different from (...) downfalls for off-balance sheet vehicles (...) that suffered a
liquidity crisis in August 2007.”

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Structural Diagram of the Securitization Transaction for Northern Rock’s Granite
Master Issuer Series 2005-2

Assignment
of mortgage
portfolio
Northern Rock PLC Granite Finance Trustees Ltd
(Originator) (Mortgage Trustee)
Proceeds

Funding 2 Ltd
Class A Notes (Special Purpose Entity)

Class B Notes
Note proceeds

Class M Notes Granite Master Issuer PLC

(Note Issuer)
Principal
Class C Notes and interest

Class D Notes

Figure: Source: Shin (2008)

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 Wholesale Debt and Leverage

The fragility of Northern Rock’s balance sheet stemmed from its use of wholesale debt.

25% of its funding consisted of wholesale debt with a maturity of one year or less.

Northern Rock’s reliance on wholesale debt is also reflected by its high leverage ratio.

The size of Northern Rock’s leverage ratio depends on how equity is measured:
• Common Shares: Shares with voting rights that act as a first loss-absorber.
• Shareholder Equity: Common shares + preferred shares (shares w/o equity with
lower seniority than bonds but higher seniority than common shares).
• Total Equity: Shareholder equity + subordinated debt (junior debt that can be
written down but with higher seniority than shareholder equity).

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Figure 5
Northern Rock’s Leverage, June 1998 –December 2007

90
Leverage on common equity
80

70
Leverage on shareholder equity
Leverage ratio

60

50

40 Leverage on total equity

30

20

10
Ju

J u -98

J u -99

Ju -00

Ju -01

J u -02

Ju -03

Ju -04

J u -0 5

Ju -06
D -98

D -99

D -00

D -01

D -02

D -03

D -04

D -05

D -06

D -07
ec

ec

ec

ec
ec

ec

ec

ec

ec

ec
n

n
-0
7
Source: Northern Rock, annual and interim reports, 1998 –2007.
Note: The leverage ratio is the ratio of total assets to equity.

Figure: Source: Shin (2008)

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 The Run

Following BNP Paribas’ decision to freeze redemption from its investment funds in
August 2007, wholesale debt markets dried up.

Northern Rock experienced a sudden reduction in its funding base as investors refused
to roll–over maturing wholesale debt.

Contrary to other banks experiencing funding difficulties (e.g. Countrywide Financial),

Northern Rock had no contractual private liquidity back-up lines.

The announcement that Northern Rock had requested an emergency credit lines from
the Bank of England precipitated a retail bank run on September 13.

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Composition of Northern Rock’s Liabilities Before and After the Run
(millions of pounds)

26,710
28,473

Loan from Bank of England

24,350 11,472
Wholesale
10,469 Retail
8,105 8,938 Covered bonds
Securitized notes

45,698 43,070

June 2007 Dec 2007

Source: Northern Rock annual report for 2007.

Figure: Source: Shin (2008)

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 High and Dry

The fragility of Northern Rock’s balance sheet did not stem from its securitized notes.

Rather, it resulted from that is was “fishing from the same [wholesale debt] pool of
short-term funding" as other financial institutions exposed to sub-prime mortgages.

Its high leverage ratio meant that it was very susceptible to sudden disruptions in
funding conditions.

Northern Rock’s management wrongly assumed that the strength of its assets would
protect it against funding dry-ups and did not acquire private liquidity guarantees.

Consequently, when “the tide eventually turned” and wholesale debt markets froze
Northern Rock was “left on the beach.”

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 Analysis: Balance Sheet Fragility

The run on Northern Rock demonstrates how fragile balance sheet structures can
precipitate bank failure.

Up Next: Stylized model by Eisenbach et. al. (2014).

Allows to analyze how different balance sheet characteristics (e.g. debt maturity,
leverage) contribute to bank fragility.

Informs debate about how regulation should be designed to mitigate fragility of banks
that rely on wholesale funding markets.

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 Funding Stability
Reference: Eisenbach et. al. (2014) Stability of Funding Models: An Analytical Framework1

Consider a three period economy with t ∈ {0, 1, 2}.

We focus attention on a representative financial institution, with balance sheet:

m are safe, liquid assets (i.e. cash); y are long-term risky assets; s is short-term debt;
ℓ is long-term debt; and e is equity.

Return to cash: r1 ≡ 1 (from t = 0 to t = 1) and rs < rℓ (from t = 1 to t = 2).

Return to risky asset in t = 2: θ. If liquidated early: τ θ, with τ < 1.

Exercise: Under what conditions will ST debt holders roll-over their funds in t = 1?

1
Downloadable from: https://www.newyorkfed.org/medialibrary/media/research/epr/2014/1402yor3.pdf
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 Funding Stability (cont.)
Two Assumptions:
1
1 rs < r ℓ < τ
: ST debt is cheaper than LT debt iff no early liquidation.
2 τ θ < 1: paying early withdrawals with cash is cheaper than liquidating asset.

Some Notation:
• Fraction of ST debt funding withdrawn in t = 1: α ∈ [0, 1].

If m ≥ αs, the bank can pay all withdrawals using cash. Otherwise, it must liquidate
some of its long-term asset, y, at price 1/τ .

The value of bank’s assets at the beginning of t = 2 is

(
rs if m ≥ αs
θy + χ(α)(m − αs), where χ(α) =
1
τ
if m < αs

The bank is insolvent in t = 2 iff

θy + χ(α)(m − αs) < (1 − α)rs s + rℓ ℓ (1)

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 Solvency and Liquidity

For m < αs, we can solve equation (1) for θ to obtain a “solvency threshold:”

rs s + rℓ ℓ + (1/τ − rs )αs − (1/τ )m

θ∗ (α) ≡
y

which is strictly increasing in α.

We can distinguish between three cases:

1 For θ > θ ≡ θ∗ (1) the bank is fundamentally solvent: whatever the action of ST
creditors in t = 1, the bank can always repay its outstanding liabilities in t = 2.
r s+r ℓ−r m
2 For θ < θ ≡ s ℓ
y
s
the bank is fundamentally insolvent: whatever the
action of ST creditors in t = 1, the bank can never repay its liabilities in t = 2.
3 For θ ∈ [θ, θ] the bank is conditionally (in)solvent: whether the bank can repay
its liabilities in t = 2 depends on how many ST creditors withdraw, α.

Conditionally (in)solvent banks are often referred to as being (il)liquid!

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 Solvency Regions

θ
Fundamentally
solvent
θ

θ*

Conditionally
solvent Conditionally
insolvent

θ
Fundamentally insolvent

m 1 α
s

Source: Eisenbach et al (2014).

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 Determinants of Funding Stability – Liability Side

Lower Leverage ( s+d

e
↓): reduces insolvency risk by making the bank better able to
withstand shocks to its asset values (τ ) and sudden withdrawals (α).

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 Effects of Lower Leverage

θ Lower
leverage

m 1 α
s

Source: Eisenbach et al (2014).

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 Determinants of Funding Stability – Liability Side

s
Longer Maturity Structure ( s+d ↓): reduces conditional solvency risk (liquidity risk)
but increases fundamental solvency risk as ST debt is cheaper than LT debt.

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 Effect of Longer Debt Maturity Structure

θ'
Less ST
θ debt

m m 1 α
s s'

Source: Eisenbach et al (2014).

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 Determinants of Funding Stability – Asset Side

Changes in Liquidation Value (τ ): affects conditional solvency risk (liquidity risk) but
does not affect fundamental solvency risk.

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 Effects of Change in Liquidation Values

θ
θ*(α|τ )
low

θ(τ)
θ*(α|τ)

θ*(α|τ )
max
θ

m 1 α
s

Source: Eisenbach et al (2014).

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 Determinants of Funding Stability – Asset Side

m
Effect of Higher Liquidity Holdings ( m+y ↑): reduces conditional solvency risk
(liquidity risk) but has an ambiguous effect on fundamental solvency risk.

1 If θ < rs : higher liquidity holdings lowers fundamental solvency risk.

2 If θ > rs : higher liquidity holdings increases fundamental solvency risk.

Whether θ ≷ rs depends on whether:

srs + ℓrℓ ≷ rs

Case (2) is therefore more likely to obtain when:

• Overall leverage is high
• Debt maturity is long

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 Effect of Higher Liquidity Holdings

Source: Eisenbach et al (2014).

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 Applying the Model to Northern Rock

What does this model tell us about the fragility of Northern Rock’s business model?

Recall that Northern Rock’s balance sheet was characterized by high leverage and
short debt maturity structure.

According to the model, while a short debt maturity structure may in fact reduce
solvency risk (by lowering the face value of debt), it also increases liquidity risk.

Also, higher leverage unambiguously increases both solvency and liquidity risk.

Thus even though a bank with high leverage and short debt maturity may face
relatively mild solvency risk, it is very much exposed to liquidity risk due to its
susceptibility to short-term funding withdrawals.

This latter effect is further amplified if market conditions lead to a deterioration in the
liquidation value of banks’ assets.

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