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Risk and Crisis Management: Northern Rock Case Study

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Introduction

            The global economic crisis has consistently formed a topic of discussion in the recent past with more companies feeling its effect. The credit squeeze that is currently being experienced in the banking and investment sector has been termed a crisis which has had major effects not only in the United States but in Europe as well. Northern Rock, which is one of Britain’s five largest mortgage lenders has already experienced the pressure caused by the credit squeeze. The bank which had previously been doing well started experiencing problems in the second half of 2007.

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The bank recorded a slow down in its profits due to difficulties in obtaining funds as banks tightened their lending capacity. The securitisation model and funding from covered bonds which made up for 75 percent of the bank’s funds started to deteriorate and these markets finally closed. The bank had to seek government bailout which resulted in temporary nationalisation. The bank of England stepped in to help Northern Rock get out of the mess that had threatened to ruin its otherwise bright future because of the fact that the bank was a high impact firm whose failure would have resulted to a serious mayhem in the economy.

The major concern is whether this credit crisis has been a wake up call for Northern Rock and other corporate bodies to come up with plans of dealing with such unexpected crises. Having a framework to manage a crisis by having alternatives and putting measures to cushion the company from the effects of such a crisis in future is what Northern Rock needs to give first priority. This paper will analyze the Northern Rock case study while utilising crisis management theory and frameworks to examine how Northern Rock dealt with the crisis and the areas in which it failed. The paper will show the importance of planning for a crisis in order to avoid losses caused by unforeseeable happenings and how Northern Rock and other companies would have survived the crisis had they been ready.

Analysis

            Northern Rock had been doing well and by the first half of 2007 taking nearly a 19 percent share of the mortgage market in Britain. Its rapid growth had been fuelled by an innovative model in which it used securitisation of mortgages, borrowing from other banks as well as use of capital-markets funding. Securitisation is a source of funding where the bank uses a pool of mortgages as collateral to obtain loans. As a result, the mortgage risk shifts to the investors leaving Northern Rock to only pay up the loan. Another model known as ‘originate to distribute’ was used whereby Northern Rock would borrow then sell the loan to investors before they matured. Ironically, this same innovation is what brought it down when it could not sustain its financial needs to meet market demand. The manner in which all funding strategies started shutting down on Northern Rock was a major crisis to hit the bank. Their inability to deal with the crisis can be attributed to inadequate crisis management plans. The bank was over-reliant on borrowing for its finances and actually operated more on borrowed finances than deposits. This model did not offer substantial alternatives for the bank should there be a shortage in funds as Northern Rock has witnessed. According to the Northern Rock chairman Dr. Ridley, they did not expect that their sources of funding could close simultaneously. Its CEO maintained that the belief taken by Northern Rock that high quality assets would maintain its liquidity had been wrong. The Northern Rock scenario comes as a precautionary measure that businesses ought to have crisis management frameworks that will shield the company from unexpected happenings (Regester et al, 2005: 196-198).

            Salter (1997: 60) defines risk management as the process that managers take to come up with policies and procedures to be used in identification, analysis, treatment and monitoring of risk. It also involves coming up with guidelines on how to deal with risks as they may present themselves and on how to guide the organization through recovery after a crisis (Pingeone, 2006: 37). According to Salter (1997: 61), preparedness helps a company to bear any crisis that is likely to face it. Response and recovery actually depends on the level of preparedness that the company has adopted. This can only be done by risk analysis to determine what kinds of threats are likely to face the firm (Robert and Lajtha, 2002: 184; Lee and Woeste, 2007: 334-335). Even though, determining the possibility of a crisis and detection of an emerging crisis could prove hard which is the reason why most companies are caught unawares (Lagadec, 25). A crisis may not announce its arrival and it is highly likely that its occurrence may be recognized when it’s already too late as in the case of Northern Rock. This is the reason as to why risk and crisis management are important for any company to undertake so as ensure crisis preparedness (McConnel and Drennan, 2006: 60).

            It is unfortunate that quite a considerable number of companies do not have plans set aside to counter unexpected crises. McConnell and Drennan (2006: 62) suggest that the reason for this is the low probability of the occurrence of crises. As a result, the need to have a plan is ignored when firms consider that their resources will be spent in planning for an even that may never happen. This is probably what happened to Northern Rock before it was hit by the credit crisis and it is only after the crisis that the company began to think of alternatives. Disaster may strike any time and what is needed is for the company form contingency plans to cater for unforeseeable occurrences (Nudel and Antokol, 1988: 32-36). One such way is by investing in insurance policies which shield a company from losses by indemnifying it when the event that it is insured against happens (Gottschalk, 2002: 96; Fink, 1986: 36-39). The fact that Northern Rock had not invested in adequate liquidity insurance shows that it had not committed enough efforts to cater for such a crisis. When the Bank of England Governor compared Northern Rock to Countrywide, a U.S bank, he meant to say that had Northern Rock been more keen on the possibility of suffering from a liquidity crisis then it would have been easier to obtain funds from insurance.

            When managers think about crises, they are more likely to focus on physical disasters such as fires, floods, hurricanes, terrorist attacks and other disasters that are likely to impact on the firm (Smith, 2001: 12). Few however put into consideration external and economic forces that could lead to an impact on the firm’s source of resources so that most companies find themselves relying on one source. When a crisis sweeps away this source, the company is left destitute and has to undergo rigorous procedures to obtain another one. In the mean time, the company makes huge losses as a result of a problem that could be avoided (Alexander, 205: 169-171). Crisis management theory requires that you do not over-rely on one source of supply because its failure could lead to the company’s downfall (Pingeone, 2006: 49). This is exactly what happened to Northern Rock in 2007 as a result of the credit crunch that led banks to tighten their lending to fellow banks. Northern Rock which was relying heavily on borrowed funds to finance client’s mortgages found itself in a fix when its money supply reduced drastically. Those who were willing to lend hedged their interest rates such that it became too expensive for Northern Rock to acquire funds. Northern Rock is said to be the most reliant on capital markets getting 77 percent of all it’s funding from non-retail borrowing.

            Northern Rock was not well prepared to face this crisis which came as a surprise leading to its sudden downfall. Northern Rock seemed to have reached their edge with the closure of medium term markets and securitisation and the management had to think of a way to get some funds for the institution. It was after this that they approached the Bank of England for a helping hand. Their appeal to the bank of England signifies that companies may have act fast in the event of a crisis so as to reduce the chances of collapse (Nicol, 2001). This is considering the effect that a crisis is likely to have on the company’s ability to sustain itself (Pingeone, 2006: 98). When the news on Northern Rock’s downfall hit the headlines, every customer rushed to withdraw his money and this is bound to have caused a great loss to business. Borrowing from the Bank of England was done as a last resort yet Northern Rock had few options to turn to. It would therefore be right to say that if the Bank of England had not approved Northern Rock’s appeal then the bank would have come crumbling down.

            Northern Rock failed to forecast which is one method used in crisis management to predict the possibility of occurrence of a certain event (Gottschalk, 2002: 77). It also ignored the signs that could have acted as early warning for the company to change strategy and reduce its lending rate. Northern Rock continued with its expansionary lending policy when there were indications in the market that funds were likely to be threatened in the future. Furthermore, the Bank of England had warned through its Financial Stability Report in April 2007 that the increased whole sale funding that was being witnessed in the market could pose a potential danger if liquidity in the financial market reduced. Other similar studies had given the same kind of warning. Risk analysis is taken to be an important aspect of crisis management and should therefore not be undermined (Robert and Lajtha, 2002: 184).

            Risk communication plays a big role in the effect of a crisis on a firm’s stakeholders (Nelkin, 1988: 349). Nelkin (1998: 347-348) notes that media may bring panic after a crisis by the way the news is conveyed. The media played a big role in the downfall of Northern Rock because the news about the bank borrowing funds gave the impression of a collapsing company leading to numerous withdrawals not to mention the jammed networks at Northern Rock and website malfunction.

            We cannot however rule out Northern Rock’s attempt in trying to manage risk. We note that Northern Rock had tried to secure a hedge against possible liquidity by investing in different countries. Northern Rock had diversified its funding sources to ensure that in case some failed then they could make use of the others. The geographical diversification seemed to provide a substantial backup for any shortages in the domestic market. Dr Ridley notes that the company had diversified its funding activities to other countries like the United states, Canada, Australia, Europe and Far East yet it was shocking how the liquidity crisis came crashing down on Northern Rock. The fact that all markets closed simultaneously left the company with the question as to whether their diversification program was effective in hedging against risk. The company was apparently well prepared to handle the problem of liquidity should a crisis happen in Britain yet its strategy did not work when all markets collapsed. Such an occurrence suggests that a company should always come up with a business continuity plan which will guarantee that major activities in the business continue to thrive even when unexpected disasters happen (Yemen, 2001: 65). There should always be an allowance for that happening that the businesses cannot even predict or think about. The company had also taken insurance even though the effect of the crisis was too severe for the insurance to cover for the bank’s liquidity requirements.

            A good crisis framework must incorporate the post crisis actions that will be followed to help the company recover from the crisis. Smith (2001: 65) notes that these may involve changing of company policy and the adoption of new strategies of doing things. Salter (1997: 30) notes that there is the possibility of a shift in crisis management as the company tries to avoid a similar incident. A crisis should act as an opportunity for the company to learn and to progress (Lagadec 1997: 28; Shrivatsava, 1988: 284). Gauging this from the Northern Rock’s example, the bank had to change its operations to accommodate the changes in the system. Their “Together” loans which the bank used for first time buyers comprising of a combined secured and unsecured loan were withdrawn. Personal unsecured lending was also stopped with an aim of managing the available funds. They also did this with an intention of concentrating on secured residential lending which is the bank’s core business. This strategy according to the management was supposed to help the bank in the repayment of the debt they had obtained from the Bank of England. At the same time, the bank put forth an intention to contract its balance sheet in the next three years to facilitate the repayment of the debt. It is also notable that Northern Rock realised the level of risk it had put itself in by relying mostly on borrowing, securitisation and covered bonds while only using a small percentage of the customers’ deposits for their mortgage lending. By 2008, this had changed and the bank intended to use 50 percent of its finances from retail deposits and 50 percent from non-retail funding. This was to be used for at least three to four years while the retail balances were recovering.

Conclusions and Recommendations

            Crisis management has become an inevitable practice in all companies that desire to ensure continuity even in the face of a disaster. Numerous banks and other companies are facing a challenge in the ongoing credit and global economic crisis yet this could have been as a result of failing in crisis management. Northern Rock could have been in a better position had the management been keen on preparedness and response to the crisis. As indicated by the analysis, Northern Rock could have been effectively saved by proper forecasting using the available information about the liquidity market which had been made available by research bodies. Insurance which is one way shielding a company from the effects of a crisis was not taken seriously and the company over-relied on their geographical diversity to assume that there was no way they were going to suffer from a liquidity problem. It is worth noting that even when a crisis occurs, a company’s management should take this as a learning opportunity to handle similar crises in future. A crisis may mean change of strategies within the company so as to help in the recovery process. In conclusion, preparedness and the ability to recover from a crisis should be the core focus when coming up a crisis framework for any company.

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Cite this Risk and Crisis Management: Northern Rock Case Study

Risk and Crisis Management: Northern Rock Case Study. (2016, Dec 02). Retrieved from https://graduateway.com/risk-and-crisis-management-northern-rock-case-study/

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