THE NORTHERN ROCK AFFAIR: AN ANALYSIS OF THE ‘TEASER RATE’ STRATEGY

THE NORTHERN ROCK AFFAIR: AN ANALYSIS OF THE ‘TEASER RATE’ STRATEGY

Av. Nihal YURT, Attorney at Law

Northern Rock was a British Bank and originally it was a building society. It converted from a building society to a bank on 1 October 1997. With the aim of ambitious growth, in the early 2000s, the company borrowed significant loans to finance mortgages. In addition, the company donated large amounts to charities and communities directly and through sponsorship. The global banking crisis, which started in 2007–08, meant that it could not generate revenue from its loans as expected. And the company was at risk of not being able to repay the money it had borrowed. The news that the government supports the bank's liquidity within 24 hours has led to a lack of public confidence and concerns that savings are at risk. And the bank failed. So, it was the first British bank in 150 years to fail due to a bank run.

The rapid growth of Northern Rock from 1997 to 2007 owed much to marketing, especially as a so-called teaser rate strategy. The essence of the strategy was to offer mortgages at rates slightly different from the funding costs of banks to get business from competing organizations, while offering remuneration and other add-ons to Northern Rock that made a reasonable profit. It can be said that credit spreads of North Rock, even for wages and add-ons, are low compared to most of the competition. One of the problems raised by the Northern Rock issue is "How are banks' credit margins determined?"

How are banks’ loan margins determined?

Bank loans are risky and costly to organize and they are financed by deposits for which at least part of the interest is payable. Revenues should be at least sufficient to cover the following list of substances:

- Allowance for possible credit losses,

- Costs of banks to collect deposits, organize loans and maintain money transmission infrastructure,

- Cost of funds to the lending bank in terms of interest paid on deposits or other financing.

Trends in bank liquidity: the run-up to the Northern Rock crisis

Reluctance against banks' vulnerability in a run was reflected in various developments over the decade that led to the Northern Rock crisis. The traditional understanding had been that the cash reserves of the banks with the Bank of England had a definite functional logic for the deposit banks themselves. Both of their cash reserves were accounts in which banks solved their imbalances at the end of the day and cash reserves were the a backstop for vault cash when vault cash were attacked due to loss of confidence and retail run. Also, by opening an account at the Bank of England, a bank initiated a relationship with the central bank of England and this included the possibility of borrowing on favorable terms.

In the first 35 years after World War II, UK banks made big claims about the government, which was ideal for open market operations. However - until August 2007 (when King insisted that government securities were the appropriate instrument for open market transactions) - the net assets of government securities of the banks in the UK were small compared to total assets.

Basel Rules

Northern Rock was subject to Basel rules during reciprocation. Indeed, reference to compliance with recent developments in the framework of Basel legislation were included in their last published account as a listed PLC. Perhaps it is too early for international banks to try to bypass the Basel constraints in their decisions over the last decade to manipulate their asset and debt structures. However, even a review of banks' annual reports shows that for many institutions, the ratio of equity to assets has remained below 3 percent for several institutions over the last few years. Nevertheless, they followed the Basel rules because they allow zero weight (in terms of capital use) for claims, with the exception of interbank risks and other state-related exceptions.

In the early stage of modern industrialism, banks typically had a capital / asset ratio of more than 30 percent, but in the mid-current decade the effective ratio was less than 3 percent. Probably a significant increase of 5 percent and the decline in the ratio of interbank demand to total assets are likely to be two medium-term responses to the current crisis.

The liquidity proposal submitted by the Basel Committee is based on three main principles:

i) The liquidity coverage ratio (LCR) is a ratio aimed at ensuring that a bank possesses high quality assets without any restrictions on its sufficient amount. It is aimed to meet the liquidity need within 30 days period under stress scenarios related to liquidity determined by supervisory authorities with such assets;

ii) Net stable funding ratio (NSFR) is aimed at funding activities with assets longer than 1 year in order to eliminate longer-term structural liquidity mismatches;

iii) A number of common metrics are often referred to as control instruments. This refers to the minimum information bundle that banks should report to supervisors. This information should be used by the relevant authorities to monitor the liquidity risk profile of the bank in question. Although the link between diversification and liquidity risk is well known, many banks have overlooked how this relationship could lead to liquidity shortages in the past. Northern Rock is the best example of this. Just two months before the Bank of England recovered it in August 2007, the Bank said it was doing well in its calculations for capital requirements. However, the Bank underwent a low level of diversification in terms of both its assets and liabilities and did not consider the factors that would affect the liquidity situation in the short term.

Basel III represents a fundamental shift in how we will be conducting banking regulation and supervision in the future. It fixes many of the shortcomings of micro-level supervision. But it also incorporates the broader system wide lessons and introduces a macro-prudential overlay to the regulatory framework. Taken together, these measures should make the system more stable over the long run, thus raising economic growth over the cycle.

What do the trends in liquidity and solvency imply for loan margins?

The regulatory continuation of the Northern Rock crisis has contributed to the rise in capital / asset ratios in UK banking as part of a wider campaign to improve deposit security. Since their envisions in August 2007, the Bank of England has continued to address the type of assets that the state government can easily buy from banks, even if the state government has insisted that only government papers constitute valid collateral, although King has been allocated to a degree that he would initially insist on. Meanwhile, banks reduced interbank risks and tried to improve the quality of securities in their portfolios. Therefore, long-term pattern for banks to use their economies and leverage on cash and low-yield liquid assets have been reversed. This return could only be cyclical, but sooner or later the secular tendency towards low-rate banking was over. The Northern Rock crisis once again showed that the expansion in banking was able to follow up very quickly after excessive purchases. In any case, Northern Rock’s customers and many other British households serving the mortgage or buying home have been the increase in the cost of mortgage financing, reversing the long-term trend into low-rate banking.