HOW NORTHERN ROCK’S BUSINESS MODEL AFFECTS THEIR PERFORMANCE DURING FINANCIAL CRISIS

In 1990s the business model for banks has reformed to an equity culture with the main focus on faster share price growth and earnings expansion. The strategy has changed to activity based on trading income and fees through securitization which let the banks to grow earnings while economizing on capital at the same period. Northern Rock largely pursued the recently popular “originate and distribute” business model right before their collapse. They commenced mortgage loans, securitized and sold most of them to other parties and in return they are collecting fees for these services. Hazardous business model had been operated by Northern Rock and supervisory authority did not sufficiently monitor their business model, and it was proved by their business model where short-term funding could be rolled-over on normal terms applicable in that bank for several years. A tremendous disruption of financial intermediation leads to colossal economic and social costs, hence to preserve financial stability is one of the priorities of authority and central banks throughout the world.

A change in strategy from a traditional bank’s policy of possessing the loans that it comes from its balance sheet until maturity was involved in securitization. In addition, asset-backed securities that were formed by packaging loans and other assets were sold by bank to investors in securitization. Because of most investors prefer assets with short maturities, off balance sheet has been created by the commercial bank to be vehicles that shorten the maturity of long term structure products. To invest in long-term assets and borrowing using short-term paper discloses them to funding liquidity risk were the strategy of the off-balance sheet vehicles because the commercial paper market might suddenly become dwindle.

Northern Rock put securitization as the central part of bank’s overall business strategy and their reliance on short-term market funding was the central feature of their business model . Northern Rock’s business model left them vulnerable to the eagerness of the market to continue to buy its securitized bonds and to lend to it. When the market began to distrust the quality of the mortgages that serve as collateral for these securities, first in the United States, Northern Rock’s source of funding, and its cash flow, dried up. Securitization has been viewed as an efficient form of financial innovation since long time ago, it increases economic efficiency, with positive impact for borrower and lender, and spreads risk, by that reducing banking fragility, only now are policymakers waking up the problems caused by lack of transparency and complexity in securitization. On Observers point of view regulation should be made to prevent banks like Northern Rock, which acquires liquid liabilities and illiquid assets, from undergoing such a risky business model; shortly, regulators should demand such banks to maintain a proportion of their investments in liquid assets, where that portion is a function of their funding strategy.

The innate frailty of Northern Rock’s balance sheet could not combat the market’s deviation from lending to or purchasing from mortgage lenders after the revelation of difficulties in the American sub-prime mortgage market. The role taken by securitized notes has received substantial analysis in the Northern Rock episode. It has become the received knowledge that such securitized notes made Northern Rock’s business model abnormal, its balance sheet less traditional, and there is the way that securitization was responsible somehow in Northern Rock’s downfall