The Hindu Business Line : Northern Rock bailout — ‘Back-to-basics’ message for banks globally

Northern Rock’s travails are the result of some weaknesses in its balance sheet which have been exposed in a global market crisis. This holds important lessons for Indian banks even though a similar crisis may appear somewhat remote in the overall business environment.

T. B. Kapali

These are extremely abnormal and stressful times in global banking. Apparently well-honed concepts and practices are breaking down in the face of a financial markets crisis to manage which such practices/concepts were devised in the first place.

Stress testing, for instance, is a concept which has been “stressed” both by regulators and by the regulated in recent times, to assess the impact of extreme movements in market variables/conditions on the very integrity of a bank’s business and its balance sheet.

One is not sure how many banks and financial institutions have actually incorporated stress tests into their overall risk management programmes already and also how many have run simulated stress tests.

More importantly, one is not sure if those simulations factored in central bank bailouts if stress levels rose very high. If it had been factored, then what is happening in global financial markets currently is playing according to the textbook. If not, then on-going developments in financial markets just show that more the complexity of markets, instruments and products in banking, more is the need to not forget the basics in banking.

Liquidity risk to the fore

One such basic postulate in banking is to provide liquidity or sources of liquidity on the balance sheet adequate to the levels and nature of the business an institution is handling. This could mean, for instance, that funding sources should be diverse to take care of particular patterns or structuring of the assets portfolio. More unique or illiquid the assets portfolio (or if the assets portfolio is vulnerable to becoming illiquid in a stress scenario), more should be the diversity of the funding base.

Where the funding base is concentrated in a few markets/instruments given a certain level of illiquidity on the asset side of the balance sheet, the whole balance sheet becomes extremely vulnerable to systematic risks. The balance sheet then, even if the bank’s business is otherwise sound and financially viable, is a fit case for a central bank bailout.

That is, liquidity risk can sink the bank while the business remains financially solvent.

Northern Rock plc, one of the leading UK banks specialising in residential mortgages, seems to have suffered the above fate of liquidity drying up completely on both sides of its balance sheet. The bank consequently has been forced into seeking a bailout from the Bank of England.

The news of the bank being bailed out of a liquidity crisis in the wholesale markets sparked a run on the retail deposits of the bank (whatever low share of retail deposits in the overall funding base of the bank) compelling the UK Government to announce an unconditional sovereign guarantee for the full repayment of retail deposits.

A central bank bail out and a sovereign guarantee on deposits are very significant developments in advanced banking markets and point to how vulnerable established systems, procedures and products can be in a crisis even in such countries. For instance, with its guarantee, the UK Government has turned the deposit insurance concept itself on its head.

Northern Rock’s balance sheet structure

The uniqueness in Northern Rock’s balance sheet lies in the fact that while the bank was able to lay off interest rate risk, in large measure, through a high proportion of floating rate lending as well as by hedging (fixed rate loans) through interest rate derivatives, the door to liquidity risk on the balance sheet was kept wide open.

For a bank of its size — around £17 billion in loans ( $35 billion or Rs 1,50,000 crore which is the size of many mid-size public sector banks and some of the top private banks in India) — and also given the fact that the bank was into residential mortgage lending in a big way ( 90-95 per cent of its total loans), the bank relied to a significant extent on wholesale markets funding.

Northern Rock’s balance sheet as of June 2007 shows that wholesale funding accounted for as much as 80 per cent of its total funding base. The wholesale markets which the bank tapped for generating funding and liquidity were both on the asset and liability sides of its balance sheet. Securitisation of mortgage receivables dominated the wholesale funding profile with the bank generating around 60 per cent of its total wholesale funding through this route. Other medium and long-term debt instruments as well as inter-bank borrowings on the liability side were the other main funding sources.

To Northern Rock’s misfortune, the wholesale markets which it was operating in were precisely the segments most affected by the crisis originating from the US sub-prime residential mortgage markets.

The entire asset-backed securities market — both mortgage backed as well as other assets — has come under a huge cloud following the blow out of these markets in the US.

For Northern Rock, therefore, the asset side of its balance sheet suddenly became more illiquid than it normally is given the very nature of its medium/long tenor residential assets portfolio. Adding to the misfortune was the fact that the inter-bank markets for wholesale lending/borrowing (the LIBOR market) also went into a tailspin with credit spreads over central banks’ reference rates rising to as much as 100-150 bps for most major currencies. The bank was thus squeezed for liquidity on both its liability sides and asset sides.

These were arguably developments and eventualities which even the most rigorous stress tests may possibly not capture. And in Northern Rock’s case, the fact that the bank possessed a balance sheet which otherwise provided comfort — non-performing assets of less than 0.5 per cent, approval from the regulator to adopt IRB methods for computing the level of risk-weighted assets/regulatory capital — was of no avail and was also not something which retail depositors could appreciate.

Relevance for Indian banking

There are significant implications for Indian banking — both for the regulated as well as the regulator — from all these global developments. Residential mortgage lending and, more generally, real estate lending have grown the fastest in banks’ assets portfolios in recent times.

This segment is also slated for further exponential growth as the economy grows and if the history of banking growth in comparable countries is any indication. But India does not have yet a deep, liquid and efficient market for securitisation of loan receivables. As on date, only around 5 per cent of total residential mortgage assets of around Rs 1,80,000 crore has been securitised, NHB statistics show.

Banks therefore carry significant liquidity risks on the asset side of their balance sheets. These risks get compounded when such an asset profile is combined with high reliance on wholesale markets funding. Public sector banks with their widespread branch network have a natural liquidity cushion (provided the network is tapped vigorously).

Some private sector banks though run a business model which relies predominantly on wholesale/bulk liabilities funding. Northern Rock’s and the BoE’s travails are clear warning messages to such private sector banks as well as the Reserve Bank of India.

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