Wednesday, October 03, 2007

In defence of Northern Rock

I commented earlier on the Northern Rock debacle (the UK bank that went under recently)- I mentioned how the reliance on capital markets for funds had proved the bank's undoing.

In the latest Economist, its chairman offers a spirited defence. He argues that the conventional wisdom has been that as long as a bank's loan portfolio is good, funding is always available. Northern Rock maintained a high quality of loans. So there was good reason for either the wholesale markets or retail depositors to desert it. For no apparent reason, the capital markets decide one day that they are not in a mood to take risk. Boom!- there go the institutions that had accessed funds from capital markets.

Northern Rock's strategy was at all time transparent to the market and to the regulator. Our lending was and is prudent. We have half the industry average of arrears and no subprime loans. To manage liquidity risk, our funding is deliberately diversified, both geographically and between four funding streams—retail, wholesale, securitisation and covered bonds. Of the non-retail funding, less than 20% has a shorter term than the average three-year duration of a mortgage on our balance sheet.

We were repeatedly advised that liquidity in wholesale markets depended on lending quality: good loan books would continue to attract funding when bad loan books began to default. Instead, from August 9th, liquidity has dried up across all wholesale markets, making no distinction between loans of different quality, for much longer than even the most extreme forecast. In America and Germany, where many subprime loans have ended up on banks' balance sheets, the liquidity crisis has been managed smoothly, whereas in Britain, with low arrears, a bank with a high-quality loan book nonetheless found itself in a situation where its retail depositors temporarily felt threatened.

Northern Rock's Chairman has a point. But his bank's debacle only highlights a shortcoming in the present way of managing risk. Capital in a bank is viewed as a cushion against as a defence against loan deterioration, most of the focus is on managing credit risk or market risk. But banks have not been adequately mindful of liquidity risk. You really cannot have capital to take care of liquidity risk, you will need lines of credit for contingencies of the sort that Northern Rock faced. The management of liquidity risk is an area that will preoccupy regulators and banks alike in the near future.

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