the northern rock crisis explained

The Northern Rock crisis

explained

Northern Rock fell victim to the so called credit crunch in the latter half of 2007. The main reason for it'd troubles was it business model. Compared to other mortgage lenders and banks Northern Rock had a very low amount of customers depositing money with them in the form of savings and a high proportion borrowing off them in the form of mortgages.

This low capital base meant that in order to offer large volumes of mortgages to consumers was much of it had to borrow money on the LIBOR money markets. This is the London International Bank Overnight Rate (LIBOR), which is the published rate at which banks lend money to each. This lending is typically done over fairly short period (usually about 3 months). Also traditionally the Libor interest rate is slightly lower than the Bank of England Base rates meaning that they could usually borrow money from Libor, then sell mortgages to you and I at say Base Rates and make a nice profit.

The above model changed dramatically as the sub prime crisis unfolded. As more and more banks and financial institutions announced heavy losses through their investments in sub prime securities, the large banks became very suspicious of each other and became reluctant to lend each other money. As a result a result the Libor rate shot up.

This increased Libor rate meant that the Northern Rock was borrowing expensively in the short term and lending out cheaply in the long term. Obviously this situation was unsustainable. Within a short period of time the Rock had to approach the Bank of England and ask to borrow more capital as a 'lender of last resort'. This approach to the BoE was very rare, with the last suspected loan made in the 1970's. Though the exact number are unknown the Bank of England is suspected to have leant the Northern Rock over £25bn.

In a recent report the House of Commons Treasury Committee criticized the Financial Services Authority (FSA), who regulates the banking industry in the UK, for not identifying and acting upon the flaw in the Northern Rocks business model sooner.

The future still remains uncertain for the Northern Rock as a number of institutions and companies seek to put together a re-financing plan to save the company.