LESSONS FROM THE NORTHERN ROCK EPISODE

1
LESSONS FROM THE NORTHERN ROCK EPISODE

• David Mayes Geoffrey Wood
• David T Llewellyn
• Loughborough University,

2
AREAS OF LESSONS

• Business models
• Financial innovation risk-shifting
  characteristics
• Institutional architecture two dimensions
• Role of central bank
• Role of government

3
NEW MODELS

• Bank assets relative to deposits funding gap
• Bank loans relative to sum of RWA
• Investments and trading relative to balance sheet
• Money market funding and securitisation
• Credit derivatives

4
Major UK banks customer funding gap(a)
Sources Dealogic, published accounts and Bank
calculations. (a) Data exclude Nationwide. (b)
Customer funding gap less securitised debt.
Where not available, stocks of securitisations
are estimated from issuance data.
5
BANK MODELS
Traditional Originate and hold Securitisation
Originate and sell CDS Originate and insure
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WHAT REVEALED

• Not fully understand risk-shifting
  characteristics in new banking models
• Importance of liquidity in market-centric systems
• Credit risk v. liquidity risk v. funding risk
• Under-estimate and under-price risk

7
KEY STRUCTURAL FAULT-LINES INDEPENDENT OF NR

• Inconsistency in deposit protection regime
• No special insolvency regime for banks
• No ex ante Resolution strategy
• (4) No PCA
• (5) Crisis management structure
• (6) Institutional structure?

8
INSOLVENCY REGIME PROBLEMS

• Very protracted
• Need to freeze deposits
• Unique systemic dimension externalities
• Banks are special depositors as creditors
• No prompt payment
• Banks vulnerable to losses of confidence
• Continuation of business

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RESOLUTION CRITERIA

• Minimal loss and/or risk to the tax-payer.
• Predictable resolution arrangements
• Resolution based on a viable business model.
• Continuous business
• Shareholders not be protected.
• Not create moral hazard for the future.
• Sustain financial stability.
• Resolution model not infringe EU competition law.
• Competitive neutrality
• Avoid bargaining for economic rents.

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SQUARING THE CIRCLEAN HOLISTIC STRATEGY

• Deposit protection
• - 100 of X
• - risk-based pricing
• - immediate compensation
• - funded scheme
• Insolvency arrangements for banks
• - clear/credible/predictable/continuous
  services
• Resolution strategy SRR
• PCA
• Crisis management

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PRE-INSOLVENCY INTERVENTION

• What are shareholder rights?
• Pecuniary v. governance rights
• Are SH rights absolute?
• ECHR
• Legal challenge e.g. NR case
• Private v. public interest
• What is the public interest?
• Who decides?
• Proportionality

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SRR FEATURES

• Allow resolution with positive capital
• New insolvency procedures
• Continuity of business
• Power to transfer business to 3rd parties
• Power to create a Bridge Bank authority to take
  control
• Fast pay-out
• Covert emergency funding
• Further assistance measures

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THE BRIDGE BANK

• Continuous services
• Enables re-sale
• Buys time
• Avoids asset sales
• Reduces DP claims
• Control
• Restructuring
• Franchise value maintained if any!

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CRISIS MANAGEMENT

• There were clearly some problems.of these
  various agencies playing their roles as the
  others would feel appropriate
• 5. Some designated institution needs to be in
  charge of intervention in failing banks to ensure
  rapid and concerted action.

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REFORM AGENDA

• Complete reform of institutional architecture
• V
• Minimalist

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DESIGNATED INSTITUTION

• Institutions v. systemic
• ----------------
• LLR to FSA
• or
• Supervision to B/E

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A CATHARTIC EXPERIENCE

• The NR experience has been a fortunate
  opportunity to focus attention on an area that
  governments in particular have not thought in
  need of serious attention, for it has done so
  without causing important losses