The Failure of Northern Rock in the Light of Banking Economics and Regulation

2301 Words Nov 5th, 2008 10 Pages
The Failure of Northern Rock in the Light of Banking Economics and Regulation

Increasing global connectivity and integration in today’s world ensures that almost any serious problem has worldwide ramifications. The global financial system can serve as a key example of this phenomenon. Very recently, Britain’s fifth-largest mortgage lender Northern Rock was rescued by emergency funding from the Bank of England. This made the Newcastle-based firm the highest profile UK victim of the global credit crunch that had been triggered by the sub-prime mortgage crisis in the US. The bank run on Northern Rock that followed was unprecedented in recent UK monetary history. The Overend Guerney crash of 1866 was the last recorded bank
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The downside is that it involves a greater liquidity risk in the event of scarcity of these short-term funds. In effect, the failure of Northern Rock was not due to any doubts of the credit quality of its assets, rather it was due to an inability of the bank to fund those assets.

Banking Economics
As already stated, a distinctive feature of banks is the maturity mismatch of their assets and liabilities. Assets are chiefly illiquid term loans whereas liabilities comprise largely short-term deposits. This trait of bank’s balance sheets makes it more receptive to bank runs during times of financial crises. Furthermore, since bank assets are generally not easily sellable, such runs can result in the ‘fire-sale’ of assets of otherwise essentially solvent banks at considerably depressed prices. This could involve a conceivable welfare loss to the public which would justify public sector intervention and the provision of liquidity to a financial institution by the central bank.

The rescue of Northern Rock by the Bank of England’s emergency funding prompted criticism from many fronts on the basis that the role of BOE as the lender of last resort was exercised too leniently. Generally, the central bank’s role as the LOLR (lender-of-last-resort) comes into play for two broad reasons. Firstly, there could be the existence of informational asymmetry

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