UK regulators propose remedies for future mortgage bank recoveries

As a result of the fallout from the crisis at Northern Rock, the UK Treasury, Bank of England and Financial Services Authority have produced consultation papers with recommendations on how to deal with similar episodes in future.

Newcastle-based mortgage lender Northern Rock had to be nationalised in February, when an evaporation of liquidity in both the wholesale and short-term money markets shook investor confidence and led to a bank run on the firm.

The results of the consultation between the UK's Treasury, central bank and primary regulator for the financial sector, which began in January, include the papers Financial stability and depositor protection: further consultation, published on July 1 and Financial stability and depositor protection: special resolution regime, released on July 22.

“The authorities recognise that it is vitally important to have in place regulatory and supervisory arrangements to minimise the risk of banks experiencing difficulties that bring them close to failure. However, in the rare cases in which there is a significant risk of a bank failing, it is also important that the authorities have access to appropriate tools for dealing with the situation at the appropriate time,” said the latter report with respect to a suggested special resolution regime to deal with troubled banks.

The report included proposals for giving authorities powers for “stabilisation”, to avoid reaching the position where a financial firm becomes insolvent and needs to be taken into public ownership. Suggested actions include forced part-private ownership, which could be facilitated through property and share transfers to a private sector purchaser or a bridge bank. In the case of using a bridge bank, it would only operate until a private sector solution could be arranged or the possibility has been thoroughly explored. A time frame of up to 12 months in which to find such a solution is suggested.

The consultation stated the UK government intends to bring forward legislation for it to take temporary public ownership of a failing bank as a last resort. The chancellor of the exchequer would have the final decision on whether to nationalise affected institutions. For public ownership to occur, the government would take control of an ailing bank’s shares, with the Bank of England and Treasury responsible for temporary public ownership. However, these actions would only be taken if it was felt there was a serious threat to the stability of the UK’s financial system or it was deemed to be in the public interest.

Temporary public ownership is considered appropriate where a significant amount of public money has been made available to a failing bank in order to stabilise it; when wholesale and long-term restructuring is required to return the bank to the private sector; and where the bank is subject to an extremely fast-burn or complex failure, such that there is insufficient time or means to effect a property transfer or share transfer to a private sector purchaser without significant risk.

The UK’s financial authorities are still attempting to resolve the issues that affected Northern Rock, with the intention of returning it to the private sector eventually.

Northern Rock announced its first half results on August 5, reporting a £585.4 million loss. The bank had reduced its borrowings from the Bank of England by 35% (£9.4 billion) to £17.5 billion from £26.9 billion at the end of December 2007. However, the Treasury committed to swap £3 billion of the outstanding debt into equity and to convert $400 million of its preference shares into ordinary shares.

“It is successfully reducing the size of its mortgage book and paying down the Bank of England loan ahead of plan… It is also attracting new retail deposits. However, in common with other banks across the world, Northern Rock is facing a challenging external environment,” wrote Alistair Darling, chancellor of the exchequer in a letter to the Treasury dated August 5.

Arrears on mortgages over three months had more than doubled since the start of 2008 to 1.18% from 0.45% at the end of 2007. This compares with the benchmark average provided by the Council of Mortgage of Lenders of 1.21% at March 31, 2008.

“This increase in arrears and expected loan losses is partly attributable to the company tightening the application of its arrears capitalisation policy and to the reduction in size of the mortgage book. But it has also been driven by wider economic factors affecting many other UK banks, who are reporting increase in arrears in their half-year results,” said Darling.

This increase could also have a negative impact on the bank’s balance sheet.

“The increase in arrears is likely to have an impact on Northern Rock’s profit and loss. Some people who start to fall behind on their payments eventually default, which means the bank is likely to see increases in impairment losses later this year,” said Richard Barnes, credit analyst at rating agency Standard & Poor's in London.

It might be several years before it can be determined whether Northern Rock is an example of how nationalisation of a troubled bank can work.

“It’s a too early to tell whether the nationalisation of Northern Rock has worked. It is in the process of a long-term restructuring up to 2011, and its success will partly depend on how the housing market develops,” added Barnes.

See also: Northern Rock appoints CRO
Northern Rock fallout continues
Northern Rock’s CEO departs