Banking Functions and Northern Rock
- Define and analyze the features that make large retail banks unique in the economy.
Large retail banks can be said to play a crucial role in any economy and they help ensure growth and smooth flow of commercial activity in a manner that few other rival institutions can. This importance of retail banks stems from some of the unique functions they perform in the economy. One of these is deposit mobilization. Banks encourage customers to deposit their savings with the institution which provides it a safe haven from theft and other physical dangers while allowing a rate of return to be had based on the type of account and maturity chosen.
This is then used to extend loans to investors and consumers for which an appropriate rate of return is charged based on a spread above the rate being paid to savers (Allman, 2005). Furthermore, investments are also made in securities and other assets which would provide a return to the bank, effectively making the funds available to further institutions and sectors of the economy where they may be put to productive use. Thus banks come in a position of being able to act as financial intermediaries, being able to generate funds from savers and channel them to investors who need the capital and consumers who need to borrow, via issue of loans (Pond, 2007).
Another function that they perform is creation of money. Since banks practice fractional reserve banking, at one time they only keep a fraction of the total deposits they are liable to return and the rest are loaned out, which results in an expansion in the money supply. This is a major source of money creation in any economy and is regulated by the central bank of the country as at any one time, little amount of money in the economy is that issued by the central bank itself.
Banks can naturally then expand money when the economy needs it and contract when production and output drops, avoiding deflationary pressures. Thus banks become importance vehicles in the monetary policy of a country (Pond, 2007).
Another function that banks can be said to perform is credit quality improvement. As savers usually will have to judge whether to provide loans to individuals or companies and will have huge exposures in certain sectors, banks can help reduce the risks by not only standardizing the process of loan processing and credit quality assessment but also can diversify, helping to absorb losses from multiple sectors.
This ensures that credit is extended to diverse sectors of the economy while overall risk to savers is reduced. Geographical spread of the savings in an economy is also achieved as funds do not remain bogged down at one place only but are in a position to be utilized in any productive location or market segment which benefits the economy as a whole (Allman, 2005). Apart from that, retail banks can also be said to play an important function in settlement of payments.
In this world of growing national and international level trade as well as sharp upturn in commercial activity, payments systems are needed to be in place as well as settlement mechanisms that allow money transfers to be made promptly with cash availability after a short amount of time as well. This can have high costs if carried out individually but banks reduce those costs in geographical settlement as well as payments netting off as its volumes in both directions tend to be huge which allows liabilities to be offset as well as clearance carried out promptly based on economization.
Banks not only engage in credit creation through deposit mobilization and channeling the savings of its customers however. It can also choose to acquire funding via borrowing from other markets such as the short term money market where funds are available at low cost of borrowing with low maturity as well (Allman, 2005). These sources can be tapped by banks if there is a need for excessive credit in the economy which can be used to advance loans to investors which may accelerate the rate of growth of the economy with a rapid rise in commercial activity. Banks are able to do this because of their size which improves credit rating and their expertise as handlers of funds and in channeling investments.
- Referring to your answer given in (a) in what ways did these features contribute to the recent financial crisis at Northern Rock?
The recent financial crisis hit the world economy very hard and the western countries were particularly hard hit due to their exposure to toxic sub-prime mortgages. Northern Rock was one of the worst hit in Britain, eventually requiring government intervention in order to keep it from failing to meet its obligations and closing down. Northern Rock engaged in the traditional business of deposit mobilization via advertisement of products that would entice customers (Brummer, 2008).
This was followed by the fractional reserve banking principle which meant the bank held only a fraction of its deposit liabilities at any one time, based on a probabilistic model. This was successful because customers trusted the institution and thought their money to be safe at the bank (Davies, 2010). However this feature of a bank contributed to the downfall of Northern Rock as when the financial crisis hit and the weakness of the management and financial model of the institution started to come into public knowledge, depositors immediately got cautious of their money and lined up outside the bank to draw their savings under threat of default of the bank.
As the bank obviously did not have the liquidity to meet all the obligations at once, it had to wait for the government to bail it out. This was the first bank run in the United Kingdom for over a century. Another feature that contributed to this was the ability of the bank to borrow from the inter bank market or the money market (The Sunday Times, 2009). This is known as liability management and it allowed the bank to carry fractional reserves as it could borrow from the markets if something akin to a bank run started, provided it was solvent.
However, the financial crisis took that option out of the question just when it was needed the most as the credit crunch that ensued resulted in institutions and lenders not wanting to extend credit which led to Northern Rock not being in a position to satisfy its liabilities (Telegraph, 2007).
Another problem emerged in the model of Northern Rock due to one of the features of a bank. These institutions are supposed to extend credit to the different sectors of the economy in order to gain returns. Asset quality assessment thus needs to remain a crucial feature of the banks as they should be putting themselves in a position whereby they can get good returns while simultaneously avoiding the risk of default in particular sectors through diversification, allowing losses to be absorbed (Schiller, 2008). Northern Rock however decided to follow the money making way by heavily relying on mortgage sales and betting on the housing market which was beginning to over heat.
As deposits are only limited, the bank borrowed heavily from the money market at cheap rates as credit was plentiful and then extended mortgages to customers. This is to be carried out with due diligence in order to ensure good asset quality through standardization and these standards should be up to par. However, in the case of Northern Rock, mortgages were sold at high levels and with little concern for credit risk as their model consisted of following mortgage sales with securitization, which basically packaged these mortgages into vehicles, chunks of which were then sold off to investors, effectively making a huge profit for the bank and transferring the risks forward (Schiller, 2008).
This however was only going to work as long as the credit from the money market was available. With the financial crisis, this kind of borrowing became acute and the payments of a short term nature from the money market came due without extension of new credit. The situation was worsened by downfall in customer confidence in the bank and an abrupt liquidity crisis swept through Northern Rock, leading it to demand a line of credit from the Bank of England and eventually nationalization as the government stepped in to save the institution.
The situation was further complicated as the bank failed in its role to improve asset quality which resulted in mortgages being sold to those who were potentially not going to pay up on their obligations. These were packaged and sold further to investors, touting the benefits of diversification would reduce the risks. While the spread of geographic investors may have been achieved through this, the sector diversification was still a problem which produced risk not accounted for and the credit ratings provided by the ratings agencies also did not serve to highlight this fact (Telegrph, 2007).
However, when the ground reality struck that the liabilities would not be paid off; the securitized products were no longer in demand and the source of the heavy profits and growth of the institution abruptly stalled. As the bank had not figured a credit freeze in the money market in its models or accounted for the heavy exposure to one sector, that is the housing market, it failed in many of its functions and obligations which resulted in the failure of a nature not recorded in a while century in the country.
Allman, B, 2005. Banking. 1st ed. London: Lerner Publications.
Allman, B, 2005. Banking. 1st ed. London: Lerner Publications.
Brummer, A, 2008. The crunch: the scandal of Northern Rock and the escalating credit crisis. 1st ed. Michigan: Random House Business Books.
Davies, H, 2010. The Financial Crisis. 1st ed. London: Polity.
Pond, K, 2007. Retail Banking. 3rd ed. London: Lessons Professional Publishing.
Schiller, R, 2008. The subprime solution: how today’s global financial crisis happened, and what to do about it. 1st ed. New Jersey: Princeton University Press.
The Sunday Times. 2009. Northern Rock – a catalogue of failure. [ONLINE] Available at: http://www.timesonline.co.uk/tol/comment/leading_article/article5941261.ece. [Accessed 17 August 10].
Telegraph. 2007. Why Northern Rock was doomed to fail. [ONLINE] Available at: http://www.telegraph.co.uk/finance/markets/2815859/Why-Northern-Rock-was-doomed-to-fail.html. [Accessed 17 August 10].
Allman, B, 2005. Banking. 1st ed. London: Lerner Publications.Allman, B, 2005. Banking. 1st ed. London: Lerner Publications.
Allman, B, 2005. Banking
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