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Northern Rock - illiquid or insolvent?

Date: 15th September, 2007   |   Author: Chris Laughton   |   Comments: 3

Was the Bank of England's bail-out of Nothern Rock, Britain's 5th largest mortgage lender justified on the grounds that it met Mervyn King's parameters explained recently in a letter to the Treasury Select Committee?

". . .central banks, in their traditional lender of last resort (LOLR) role, can lend
“against good collateral at a penalty rate” to an individual bank facing temporary
liquidity problems, but that is otherwise regarded as solvent."

Professor Willem Buiter of the LSE, formerly a member of the MPC, believes the Bank is proven to be a paper tiger. Firstly his blog notes (here) Northern Rock's "extremely agressive and high risk" business strategy and that its share price was declining steeply well before the credit crunch in recognition of an absence of long term viability.

Adam Applegarth, Northern Rock's chief executive is quoted by the Times on 15 September 2007acknowledging a flawed model (here): “Is the model flawed looking foward? Of course it is. Is it flawed looking back? I think the answer is no because of the markets that we were operating in prior to August 9".

Mervyn King's letter also stated:

"The moral hazard of an increase in risk-taking resulting from the provision of LOLR lending is reduced by making liquidity available only at a penalty rate. Such operations in this country are covered by the tripartite arrangements set out in the MOU between the Treasury, Financial Services Authority and the Bank of England."

Professor Buiter quotes the Memorandum of Understanding:

"Such a support operation is expected to happen very rarely and would normally only be undertaken in the case of a genuine threat to the stability of the financial system to avoid a serious disturbance to the UK economy.”

and argues that if Northern Rock were to fail it would neither threaten the stability of the UK financial system nor seriously disturb the economy.

According to the Times article, two white knights have walked away from rescuing Northern Rock.

But despite reports of savers queing to withdraw £1bn today, the BBC's story "What if Northern Rock goes bust?" shouldn't become reality. The Old Lady of Threadneedle Street has stepped in as Lender of Last Resort.


Discussion and Comments

By wonkotsane on Sunday 16th September, 2007

I can’t see that they’re insolvent - that would mean they didn’t have assets to cover their liabilities.  They have investments, assets and cash as well as future income from loans and mortages.  No bank has enough cash to cover its liabilities, not even the Bank of England but if Northern Rock can stop people withdrawing their savings and depriving them of capital they should be ok.  I have no doubt that on paper they are not only solvent but well and truly in the black but that doesn’t translate into liquidity which is, of course, readily-available cash.

By Chris Laughton on Monday 17th September, 2007

I agree, Northern Rock is unlikely to be insolvent on a balance sheet basis just now.

But it can only meet its liabilities as they fall due - and many deposits are both repayable on demand and being demanded - by virtue of the Bank of England bail-out.

By Louis on Thursday 1st May, 2008

Ok, now I was trying to think this out. NRB having a lot of fixed assets wont do them good paying their liabilities. This is what causes insolvency. Your current assets cant pay your current liabilities. All the people were asking for their money, and at the same time because of the global credit crunch, NRB couldnt borrow more money to pay their liabs. So this caused insolvency problem, and it shows on their balance sheet that they dont have enough current or short term assets to cover their short term liabs.

But I have some other question. We know that the FSA nad Bank of England made some mistakes and they admitted them, and that the regulatory system in the UK has some flaws and gaps. But I was trying to find some more details on the regulations applicable to the NRB, to find some material gaps in the system. Could anyone help me in this?


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