Northern Rock has been the biggest story in British banking this year. But some people may be asking themselves why. There are many people who don’t quite know what went wrong with Northern Rock and why it caused such a stir among the City, the Government and retail bankers alike.
Northern Rock was founded in 1965 as a result of the merger of two building societies in the North East of England. During the 1980s, Building societies were allowed to start upgrading to bank status. By now, this meant that one of the primary objectives of the new banks was to make a profit, as banks should, rather than exist for the core benefit of its members, as a building society should.
In 1997, Northern Rock decided it wanted a piece of this profit pie and went from Northern Rock Building Society to the slick, Northern-favourite bank that we see in our high streets today. For some people at the time, this was a concern; Northern Rock Building Society was a big source of support for Northerners and, increasingly so, everybody else too. A building society can be trusted. One can be sure of its intentions when it is handling one’s money.
To overcome this concern, the Northern Rock Foundation was formed. The sole purpose of the Foundation was to divide five per cent of the Rock’s profits between good causes in the North East of England.
So, when the Rock demutualised and the Northern Rock Foundation was formed, we had a bank that was very, very generous. This went some way to dismissing fears that Northern Rock was about to become just another British money-making bank. The City looked very favourably upon this and, with the induction of new chief Adam Applegarth, things were looking bright for Northern Rock.
Applegarth had decided that he wanted Northern Rock to become a big player in the mortgage market. His plan was to lend 125 per cent of the value of customers’ houses. One problem with that was that the Rock was still a relatively tiny bank. So, to work around that Northern Rock would borrow more and more money from other banks.
Borrowing between banks is was nothing uncommon. In fact it was very common indeed. But Northern Rock was borrowing 75% of its money from these banks, shifting their financial footing onto progressively riskier ground. But at this time, nobody foresaw the crisis looming with the sub-prime mortgage market in the States.
In laymens’ terms, a sub-prime mortgage is one lent to somebody who is less likely to be able to pay it back, and ‘default’ on their loan. Sub-prime lending had become increasingly popular in America and more and more money was being lent and borrowed between banks in small pieces; security protecting against the risks of lending in the sub-prime market. The American banks severely underestimated just how many people would take advantage of the offers and then be unable to follow through on their repayments.
Never has the word unfortunate been used so literally and, with the sub-prime mortgage market now floundering, the system came grinding to a halt on the 9th of August this year. A French bank decided to suspend three of the credit funds that were open to banks in the US to borrow from. This had a domino effect and, in the ensuing panic, virtually all banks stopped lending each other money. Those who did, lent the credit on massively inflated interest rates. The European Central Bank then had to plough more than £70bn into the European banking system. The extra funding gave the markets a boost in liquidity, but did little to assuage the concerns of the major international banks.
It soon became too much for the Rock, who had relied all-too-heavily on borrowing at the previously manageable rates. On the 14th of August 2007, the Financial Services Authority alerted the head of the Bank of England, Mervyn King, of the effects that the global credit crunch might have on Northern Rock.
By the 4th of September, the rate at which London banks lent to each other (London Interbank Offered Rate, or LIBOR) had reached its highest level in nine years. The credit marked dried up completely, with banks practically refusing to lend to each other whatsoever. Mervyn King made it clear that the Bank of England would provide emergency funding to any bank which might need it. But he would not be injecting money in to the banking system itself, unlike the European Central Bank and the US Federal Reserve.
On the morning if the 13th of September, the news broke that Northern Rock had sought emergency funding from the Bank of England to keep its repayments up to other London banks. The Bank of England is known in situations like this as the ‘Lender of Last Resort’, and is one of the country’s last resort contingencies to ensure the fluidity of the British financial system.
The very next day, confidence in the Rock is severely shaken and analysts and customers alike are not convinced by Adam Applegarth’s reassurances that it was “business as usual”. Customers began to queue outside their local branches of the Rock and withdrew more than a billion pounds of their deposits, largely from branches in the London and the South East. The value of shares in the company also plummeted by more than thirty per cent. Customers began to realise that their money may not be safe, despite assurances, and crashed Northern Rock’s Web site and phone system while trying to withdraw more money.
The following day, the crisis worsened and queues formed again, this time taking over £2bn. Share prices in the company plunged a further forty per cent, with the crisis showing no sign of letting up. Confidence in the banking system itself was at serious risk of being shattered, so the Chancellor Alistair Darling announced that every customer who had money in Northern Rock would have their funds underwritten by the Treasury, meaning that the Government would pay back every penny the Rock owed them, should the bank go bust.
This was, however, severely criticised by financial analysts as being a move tantamount to bailing out an already sinking ship – inconceivable, and out of proportion in that the bank was unlikely to go bust anyway. Where would he get the money if he did have to repay the £24 billion that was ‘at stake’? His announcement was seen as a way of boosting confidence with words, but nothing more. At this point, Lloyds TSB was asked by the Bank of England to buy Northern Rock, but nothing materialised.
Things calmed down for a while and the queues outside Northern Rock branches countrywide waned. Northern Rock took out double page spread adverts in national newspapers claiming that the bank would “prevail” and that the situation would get better.
On the 20th of September, the Bank of England injected ten billion pounds into the banking system in an attempt to lower the interest rates at which the major banks were lending each other money. This came despite their earlier vow not to do such a thing.
By late September, Northern Rock announced that it would cancel the dividends it was due to pay its shareholders, costing them sixty million pounds. It was then that the bank began to look for offers from other major consortia and large firms who may wish to buy Northern Rock. This would mean that the debt the bank owed would be passed on to a buyer who can afford to repay it.
In mid-October, it was announced that a consortium led by Richard Branson’s Virgin Group had made an offer to buy the bank. As part of the proposal, Northern Rock would be kept as-is but under the Virgin Money brand.
With the resignation of Adam Applegarth as Chief Executive earlier this month, and today’s announcement that Virgin’s bid was the favoured one, it looks as though the Northern Rock brand has been well and truly ripped to pieces, despite massive faith in the bank in Northern England.
What was once a solid bank and one of the country’s leading mortgage lenders has now become something of a blister on the body that is the British banking system. Without careful and cautious management over the healing period, the bank could start haemorrhaging money again. But under new leadership, a new brand and what now seems like proper support from the Government and the Bank of England, you can bet your bottom dollar that Northern Rock as you knew it yesterday, will not be the bank of tomorrow.
Author: Lee
EDITOR
Contributor: Tom Loze-Thwaite
SCIENCE EDITOR
