Regulator fiddled while Northern Rock burned
Long regarded as one of the leading and most well respected financial regulators in the world, the UK’s Financial Services Authority (FSA) has deservedly been criticised and come under the spotlight through supervisory failures regarding the oversight of the Northern Rock bank.
The UK Treasury Committee was scathing in its view of the supervision on Northern Rock, and considered the FSA systematically failed its regulatory duty to ensure Northern Rock would not pose a systemic risk. The supervisory framework of the UK financial system, based on a tripartite structure between the treasury, the Bank of England and the FSA, is also viewed as performing inadequately, particularly with regard to support operation of a problematic bank.
The UK supervisors failed in understanding the shift in risk profile of Northern Rock, particularly with regard to the bank’s liabilities. In the first half of 2007, Northern Rock expanded its business at a rapid rate, increasing loans by a net £10.7 billion (Dh77bn) and growing market share. To achieve a significant level of growth in assets, the firm had previously changed its structure of liabilities.
It began to borrow more money from the wholesale markets, adopting an ‘originate to distribute’ model of funding. In this funding model, banks no longer hold loans to maturity instead sell on loans to investors. Mortgages are parcelled up and used as collateral through securitisation.
Securitisation represented 50 per cent of Northern Rock’s funding. A further 10 per cent was covered bonds. Moreover, Northern Rock had inadequate liquidity insurance. Its business strategy was high risk, with a reliance on short- and medium-term wholesale funding and a failure to arrange standby facility or cover that risk. As a result, it was unable to cope with the liquidity pressures placed upon it by the freezing of international capital markets.
The FSA’s supervision of financial firms is based on its ‘Arrow’ framework. Northern Rock was treated as ‘a high impact bank, under close and continuous supervision’. The assessment is an intensive stock-take of a firm. However, Northern Rock, despite being a high-impact firm, was not scheduled to have another Arrow impact assessment until three years after its most recent assessment, which was January 2006. The three-year interval is clearly inadequate.
The FSA missed early potential warnings connected to the bank, including the rapid growth and reliance on short-end funding – in essence an extreme business model. Another potential warning signal was the fall in the bank’s share price. Northern Rock’s share price had been in steep decline since February 2007. The market had become increasingly aware there were issues concerning the bank’s business model.
In a profit warning in June, Northern Rock stated it was suffering from a structural mismatch between London Interbank Offered Rate and bank base rates. The FSA acknowledged these warning signals but it failed to tackle the fundamental weakness in the bank’s funding model and did nothing to prevent the problems that emerged fully from August 2007 onwards.
The United Kingdom’s treasury committee saw this as a ‘substantial failure of regulation.’
Arguably one of the main reasons why the FSA took its eye off the radar was its overriding focus on Basel II, particularly over the last three years. In this regard, the FSA missed the big risk picture while focusing on certain detail. A huge supervisory resource and time has been spent on the rules, regulation and management of the Basel II process. Much of the focus of Basel II is on credit risk.
As we have seen at Northern Rock, liquidity is the proximate cause of a bank’s failure. This has always been the case for banks around the world. However, the regulation of liquidity in respect to the FSA has been lacking, in part due to the concentration on Basel II, the FSA as a regulator has been too focussed on capital adequacy with not enough emphasis on liquidity issues.
The Governor of the Bank of England has accepted that liquidity regulation has to be taken more seriously. A robust liquidity regulatory environment would have shown Northern Rock’s weakness in respect to funding and liquidity, despite being sound on the capital adequacy side.
The FSA did not supervise Northern Rock properly, or monitor a business model appropriately. The select committee also considered the FSA failed in its duty as a regulator to ensure Northern Rock would not pose a systemic risk.
In response to the failures, the treasury committee has recommended that an Office of the Deputy Governor and Head of Financial Stability be created within the Bank of England, to support the supervision of financial institutions.
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