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10 years on from Northern Rock's failure, what's changed?

10 years on from Northern Rock's failure, what's changed?

10 years ago the global financial crisis reached UK shores via the unlikely route of a relatively small mortgage bank based in Newcastle upon Tyne.

That bank was Northern Rock and it had run out of money. How, you may ask, does a bank run out of money? The traditional model of banking is to take deposits in from customers, and then lend that money out to borrowers.

Northern Rock, and indeed many other banks, found that demand for loans exceeded the available supply of deposits. More money was needed to feed the demand.

Other sources of funding included borrowing money on wholesale markets and selling existing mortgages, packaged up into securitisations, to investors. At its peak in late 2006, only a third of Northern Rock’s loans were funded from its deposits.

Northern Rock’s model was problematic because mortgages have a long lifetime, whereas deposits and wholesale funding do not. If depositors ask for their money back, the bank cannot ask its mortgage customers to repay their loans.

This does not matter if the wholesale money markets are open and funding is cheap. But when the US sub-prime crisis erupted in 2007, fear spread into the wholesale money markets.

Nobody knew which banks held subprime loans packaged into securitisations. If these securities were valueless, the banks holding them could be in trouble. Who would lend to a bank under such conditions?

So, when Northern Rock’s wholesale funding came up for renewal, it found the markets shut. It had to repay the wholesale funding, but could not replace it with new borrowings.

Unable to meet its funding needs, Northern Rock went, cap in hand, to the Bank of England (BoE) and with the Chancellor’s authorisation liquidity assistance was granted on 14 September 2007.

For the first time in living memory, the UK suffered a run on a bank where depositors queued to withdraw their money. The additional costs of accessing the BoE’s facilities, and the requirement to post high-quality collateral to receive the funds, drove Northern Rock to failure and it was taken into state ownership in February 2008.

As the crisis deepened, further failures followed: HBOS was rescued by Lloyds, which itself needed state aid, as it was unable to support HBOS’s balance sheet problems. RBS collapsed under the weight of its ill-judged ABN Amro acquisition and was almost entirely nationalised. Alliance and Leicester, and Bradford and Bingley both disappeared.

The regulatory response around the world was dramatic. Regulators moved from a light touch model, which assumed banks would regulate themselves, to a far more rigorous system of capital and liquidity requirements.

At the same time, central banks greatly increased the provision of liquidity to the banking system. This has successfully removed the stigma of a bank taking money from its lender of last resort.

The new rules demand far higher capital levels, and far more onerous ways of measuring risk. As a result, the banks hoarded profits and shrunk balance sheets. The structured assets that caused so much angst were unwound, never to be seen again.

Across Europe, €600 billion of fresh equity has been raised from shareholders. The effects are dramatic. Banks that entered the crisis with core equity tier 1 (CET1) ratios (their amount of equity relative to risks) of 5-7%, are today sitting on ratios of 13-15%.

All other forms of capital, including tier 2 bonds, and even senior bonds, will be available in the future to absorb losses if the bank gets into trouble. This will allow a failing bank to be resolved without infecting the rest of the system, avoiding the contagion effect characteristic of the crisis.

The effects are dramatic. Banks that entered the crisis with core equity tier 1 (CET1) ratios (their amount of equity relative to risks) of 5-7%, are today sitting on ratios of 13-15%. All other forms of capital, including tier 2 bonds, and even senior bonds, will be available in the future to absorb losses if the bank gets into trouble. This will allow a failing bank to be resolved without infecting the rest of the system, avoiding the contagion effect characteristic of the crisis.

The BoE’s annual UK stress tests provide more evidence of recovery. In the 2016 test, banks were subjected to severe conditions that included house prices falling by 31%, commercial property prices by 42%, and UK GDP by 4.3%.

The net result of this stress was that the banks across the UK would lose £44bn. To put that figure into context, it is five times as high as the same banks lost during the crisis.

What is truly staggering about this result is that the weakest of the banks in the test, RBS, ended with a CET1 ratio of 5.9%, significantly higher than the 4.5% at which HBOS entered the last crisis.

So, in my view, today’s UK banking system is almost unrecognisable from that of a decade ago. Balance sheets are cleaner and smaller, capital and liquidity levels far higher, regulation far tighter, and backstops more encompassing.

The returns that banks can earn on this higher level of capital will almost certainly be lower than previously, but in many ways, those returns were illusory, just a function of leverage. With more stable, albeit lower, returns on equity, banks ought to enjoy a lower cost of equity. It will take time for this to be proven and accepted, but there, in my view, is the investment opportunity.

Robert James is an equity analyst at Old Mutual Global Investors

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