Northern Rock Case Study

Register to read the introduction… During August 2007 in Germany, a rescue package of €3.5 billion was arranged by the German government for the country’s IKB Deutsche Industriebank AG which had also been afflicted by the US sub-prime market crisis. The whole affair, however, was handled much more cautiously with the public being given no serious indication towards the extent of IKB’s plight. The rationale for this type of secrecy, in the event where wide-spread panic has not yet occurred, was set out in a speech by Eddie George, Governor of the Bank of England in 1994 (cited in Financial Stability Review, 1999, p. 160): “…we usually try to keep the fact that we are providing systemic support secret at the time…If people know that we are so concerned about systemic fragility that we have judged it necessary to provide support, which could lead to a wider loss of confidence. They would wonder how far that support would be extended, and we could rapidly find ourselves in the position where we are in practice underwriting all the liabilities of the banking system.” A well-established system of deposit insurance could have also gone a long way in preventing the run on Northern Rock. Deposit insurance significantly reduces the risk of a systemic crisis since depositors will have little reason to withdraw their money if they know it is safe. Prior to the run, the Financial Services Compensation Scheme guaranteed a hundred percent repayment on savings of up to £2,000 and a ninety percent repayment on the next £33,000. Only after Alistair Darling, Chancellor of the Exchequer announced that the government would guarantee all deposits of Northern Rock account holders did the bank run stop. Mr. Darling said in a statement that “should it be necessary, we and the Bank of England will put into place arrangements that guarantee all the existing deposit arrangements” (September 17, Financial Times). If a more effective deposit insurance system had been in place before the announcement of the emergency funding of Northern Rock by the central bank, there may have been greater chances that the bank panic would not have occurred. After this Northern Rock fiasco, however, the Government has made it clear that a longer term reform of deposit insurance is under review. Banking Regulation The failure of Northern Rock can also be seen from the aspect of a failure of banking regulation. …show more content…
General public opinion is in favour of the notion that the permission granted for a business model like Northern Rock’s to exist, demonstrates a fundamental flaw in the current regulatory regime. It can be said that the authorities failed to recognise the risk attached to the bank’s funding model and that Northern Rock’s business methods made it unduly vulnerable to wholesale money market volatility.

To some extent, the Tripartite arrangement between the Treasury, the Financial Services Authority (FSA) and the Bank of England also caused some hindrance in a more effective management plan for the crisis of Northern Rock. Under the system, which was set up by Gordon Brown in 1997 when he was Chancellor, the Bank of England has the liquid financial sources to carry out the bail-out of a troubled bank, the FSA has all the supervisory information which it receives from regulating and monitoring individual banks, while the Treasury confirms the release of any funds from the Bank. When the UK financial market started showing signs of being affected by the global credit crunch, there were opposing reactions from the institutions concerned. The independence of all three organizations led to delay and un-coordination in decision-making. Unlike the Federal Reserve in the United States as well as the European Central Bank who injected liquidity into their banking systems as soon as credit concerns were ignited, …show more content…
(2007) Northern Rock: Solutions and Problems. Sage Publications). Policies encouraging liquidity insurance could have pressured other banks to make long-term loans to Northern Rock if it had insured with those banks. In effect, liquidity insurance would have helped to recycle the deposits from other banks to Northern rock, preventing the panic and the ensuing run. In the event of banks not lending to each other during inter-bank market dry-ups, liquidity insurance would take over with the insurance contracts compelling the banks to provide funds to those banks which need