Question

Outline the liquidity problem and the systemic failure which led to a run on Northern Rock and the financial crisis.

Answer 1

Following conversion from a UK mutual building society to bank status in 1997, Northern Rock primarily focused on the residential mortgage market. The company mainly relied on the issuance of mortgage-backed securities for its funding needs. However, in the middle of 2007, as a result of the sub-prime mortgage crisis in the United States, the markets all over the world (including in the UK) started losing confidence in the mortgage bank securities. The sub-prime mortgage crisis emerged due to a decline in US house prices which triggered large-scale defaults in the sub-prime mortgage market and a plunge in the price of these securities. Thus, the main source of Northern Rock's liquidity effectively dried up as it could not securitise and sell new mortgage assets, despite the bank being legally solvent (nominal value of assets exceeded liabilities) and having a decent-quality loan book. Also, a sharp rise in the interest rates in the money market dried up short-term money market funding sources as well because borrowing costs exceeded Northern Rock's yield on the mortgage assets.

Consequently, in August 2007, the bank experienced a 'bank run', which resulted in the withdrawal of ~GBP 3 billion of deposits (nearly 11% of the bank's total retail deposits).