LESSONS FROM THE NORTHERN ROCK EPISODE David Mayes & Geoffrey Wood David T Llewellyn Loughborough University,

2 AREAS OF LESSONS Business models Financial innovation: risk-shifting characteristics Institutional architecture: two dimensions Role of central bank Role of government

3 NEW MODELS Bank assets relative to deposits: funding gap Bank loans relative to sum of RWA Investments and trading relative to balance sheet Money market funding and securitisation Credit derivatives

4 Major UK banks’ customer funding gap(a) Sources: Dealogic, published accounts and Bank calculations. (a) Data exclude Nationwide. (b) Customer funding gap less securitised debt. Where not available, stocks of securitisations are estimated from issuance data.

5 BANK MODELS TraditionalSecuritisationCDS (1) Accept deposits ( ) (2) Originate loans (3) Utilise comparative advantage:  Information  Risk analysis  Monitoring (4) Transform into loans (5) Accept risk (6) Hold on balance sheet (7) Capital Backing (8) InsuranceInternalShiftInsure Traditional: Originate and hold Securitisation:Originate and sell CDS: Originate and insure

6 WHAT REVEALED Not fully understand risk-shifting characteristics in new banking models Importance of liquidity in market-centric systems Credit risk v. liquidity risk v. funding risk Under-estimate and under-price risk

7 KEY STRUCTURAL FAULT- LINES INDEPENDENT OF NR (1)Inconsistency in deposit protection regime (2)No special insolvency regime for banks (3)No ex ante Resolution strategy (4) No PCA (5) Crisis management structure (6) [Institutional structure?]

8 INSOLVENCY REGIME PROBLEMS Very protracted Need to freeze deposits Unique systemic dimension: externalities Banks are “special”: depositors as creditors No prompt payment Banks vulnerable to losses of confidence Continuation of business

9 RESOLUTION CRITERIA Minimal loss and/or risk to the tax-payer. Predictable resolution arrangements Resolution based on a viable business model. Continuous business Shareholders not be protected. Not create moral hazard for the future. Sustain financial stability. Resolution model not infringe EU competition law. Competitive neutrality Avoid bargaining for economic rents.

10 SQUARING THE CIRCLE: AN HOLISTIC STRATEGY Deposit protection - 100% of X - risk-based pricing - immediate compensation - funded scheme Insolvency arrangements for banks - clear/credible/predictable/continuous services Resolution strategy: SRR PCA Crisis management

11 PRE-INSOLVENCY INTERVENTION What are shareholder rights? Pecuniary v. governance rights Are SH rights absolute? ECHR Legal challenge: e.g. NR case Private v. public interest What is the “public interest”? Who decides? Proportionality

12 SRR FEATURES Allow resolution with positive capital New insolvency procedures Continuity of business Power to transfer business to 3 rd parties Power to create a Bridge Bank: authority to take control Fast pay-out Covert emergency funding Further assistance measures

13 THE BRIDGE BANK Continuous services Enables re-sale Buys time Avoids asset sales Reduces DP claims Control Restructuring Franchise value maintained: if any!

14 CRISIS MANAGEMENT “There were clearly some problems….of these various agencies playing their roles as the others would feel appropriate” “5. Some designated institution needs to be in charge of intervention in failing banks to ensure rapid and concerted action.”

15 REFORM AGENDA Complete reform of institutional architecture V Minimalist

16 DESIGNATED INSTITUTION Institutions v. systemic LLR to FSA or Supervision to B/E

17 A CATHARTIC EXPERIENCE “The NR experience has been a fortunate opportunity to focus attention on an area that governments in particular have not thought in need of serious attention, for it has done so without causing important losses”