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Study Notes

Global Financial Crisis - A Short History of Northern Rock

Level:
AS, A-Level, IB
Board:
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 15 Jan 2023

For many in the UK, the rise and fall of Northern Rock epitomised the causes and effects of the Global Financial Crisis.

Northern Rock was a UK-based mortgage lender based in Newcastle upon Tyne that was ultimately nationalised by the UK government in 2008 after experiencing a run by savers on their deposits. This was the first bank run in the UK since the 19th century.

The bank had become heavily reliant on short-term wholesale funding to finance its ambitious and fast-growth mortgage lending, and when the global credit markets froze in the credit crunch of the summer of 2007, it was unable to roll over its short-term debt, causing severe liquidity problems.

The government intervened by guaranteeing all deposits, providing a loan facility to Northern Rock, and later nationalising the bank. The bank was split into two parts: the "good bank" was sold to Virgin Money in 2012 and the "bad bank" was retained by the government to manage the remaining assets and liabilities.

The nationalisation of Northern Rock was seen as a significant moment in the global financial crisis, as it was one of the first major banks to experience financial difficulties, and it highlighted the risks of banks that had lent out too much becoming overly-reliant on short-term wholesale funding.

The government's intervention in Northern Rock also sparked a debate about the appropriate role of government in the financial system, and it led to an increase in regulatory oversight and a focus on improving the resilience of the financial system to prevent future crises.

Why did Northern Rock fail?

Northern Rock failed in 2007-2008 due to a combination of factors, including:

  1. Business model: Northern Rock's business model was heavily reliant on short-term wholesale funding to finance its mortgage lending. This means it borrowed from other financial institutions to fund its operations, rather than relying on attracting fresh deposits from savers. When the global credit markets froze in 2007-2008, it was unable to roll over its short-term debt, causing liquidity problems.
  2. Risky lending practices: Northern Rock had been heavily involved in the securitisation of mortgages, which is the process of packaging mortgages and selling them as securities to investors. This allowed the bank to sell more mortgages than it could have otherwise, but it also exposed the bank to significant risks if the mortgages defaulted as they started to do in the summer of 2007.
  3. Housing market downturn: The bank had also made significant investments in the UK housing market, which had been growing rapidly in the years leading up to the crisis. When the UK housing market began to decline, the value of the bank's assets fell, and the bank found itself with significant losses.
  4. Lack of diversification: Northern Rock had a high concentration of risk in its mortgage portfolio, with a high percentage of the mortgages being subprime loans (home loans given to borrowers with poor credit) and interest-only mortgages. This lack of diversification left the bank exposed to significant losses if there was a downturn in the housing market.
  5. Lack of proper risk management: Northern Rock didn't have a proper risk management system in place to manage the risks associated with its business model and lending practices.

These factors, along with other external factors like the global financial crisis, led to a liquidity crisis for Northern Rock. The bank was not able to access the short-term funding it needed to meet its financial obligations and faced bankruptcy, leading to the government's intervention and nationalisation.

What is a bank run?

A bank run happens when a large number of customers lose confidence in a bank and attempt to withdraw their savings deposits at the same time, due to a perceived or actual lack of solvency or liquidity of the bank. Bank runs can occur when customers fear that the bank may become insolvent or unable to repay their deposits, and they want to withdraw their money before the bank collapses.

During a bank run, the bank may not have enough cash on hand to meet the demand for withdrawals. This can lead to a self-fulfilling cycle, where the bank becomes increasingly illiquid as more and more customers withdraw their deposits, increasing the chances of the bank failing.

To prevent bank runs, governments and central banks have implemented deposit insurance schemes and other measures to protect depositors and stabilize the financial system.

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