Northern Rock Strategies and Leadership - Case Study Example

Background information Northern Rock a building society that was formed on 1 July 1965 as a result of the merger of Northern Counties Permanent Building Society (established in 1850) and Rock Building Society (established in 1865), and a number of small local building societies making an amalgamation of 53 societies became a public limited company in October 1997. Listed on the London Stock Exchange and authorised under the Banking Act 1987, the Northern Rock Foundation, an independent charitable body was also established with objectives to tackle disadvantage and to improve quality of life in the North East and Cumbria. In 2007, when due to sub prime loans from the USA caused credit markets to shrink, Northern Rock became unable to meet the repay of the loans she had taken. It became apparent that to keep the bank afloat and protect private money saved in the bank, the bank of England in February 2008, Northern Rock was taken into temporary public ownership using some £13 billion of public money guaranteeing The Northern Rock Foundation a minimum income of £15 million per year in 2008, 2009 and 2010. Before facing the crises, Northern Rock had established itself as the top securitisation bank making £6,1 billion in January 2007 and £10,7 billion in the first half of May 2007. She was the fifth biggest British bank and made a pre-tax profit of £627 million in 2006 1. Northern Rock strategies from 1997 Northern Rock main strategy was borrowing cheap funds when available on the whole sale market and lending to her customers world wide at more attractive rates than her competitors. Cheap market funds are the most risky loans since they are not secured and lack any legal backing such as government backing. When credit markets get frozen, this means there will no more funds available on the market and the bank will be unable to generate the required money for repayments. Therefore, Northern rock should now concentrate on funding her loans from retail deposits since they are secured and most often based on savings and deposits from clients. In such a way, the bank knows that they are sufficient funds before making any loans. Securitisation by all means is a good idea since it presents a better way of risk management since the risk of funding is diversified. But pooling the loans from people to put everything on give to lenders, the process works well if there is enough money circulating on the market. But when the credit dries off, it becomes difficult to raise the get back the money given out to investors especially as they too may have invested the money in other market assets. In this case therefore, it will be of great importance if not all loans are sold in form of securitised loans. Management had failed to take note of all market indicators such as the fall in share price and company profit which was cut from 17% to 15%. In such instances management should have understood that there should be something going on with the world economic system and should tighten credit. But instead management went ahead to issue more loans at lower rates than what it will pay to finance. Another factor that was ignored by the bank was the cut in interest rate by the Bank of England. When interest rates are cut, it instead discourages savings and increases consumption and investment. In such instances investors will obviously run to the market to buy more funds for their investment further pushing up the interest rate. Thus giving loans at rates higher than what was on the market was a bad strategy. It will be more prudent for management to take good care of market indicators before making loans. Northern rock had failed to strictly implement stress tests and create avenues for lending from the Central Bank in case of illiquidity. The bank since it was mostly based in England failed to exploit her Irish outlet to get funds from the Central Bank due to negligence from management since it thought that the wholesale market was to exist for ever. Stress tests that would have been used to test the faith of the bank in case where the credit market dries up were not strictly implemented. Therefore, it will be prudent for management now to exploit all relevant avenues to tap in cash into the bank should there be a credit crisis and at same time keep a close look at the functioning of her branches. 2. Leadership at Northern Rock up to February 2008 Leadership at Northern Rock was very ambitious, but lacked the foresight. The decision to unnecessarily take high risk without putting in place adequate measures to counter any problems is a case in hand. Management under Applegrath had involved the bank into excessive risk taking that pushed the bank to the brink of bankruptcy. Leadership blunders never ended within the bank. The decision to reduce interest rates on customer’s deposit accounts without a prior notification was a blunder on management and Applegarth as identified by the Daily Telegraph. Such decisions may cause a stampede on the bank and seriously weaken customers trust on the bank. Management under Applegarth had concentrated on borrowing huge sums of money to fund mortgages to an extend that it had loaned out six times more money than it had in their coffers. In such situations, when the credit markets from which management based as source of funding dried up and when inter bank lending stopped, they had no deposits to cover the loans, therefore exposing the bank to credit risks. This was really a management flaw and lack of foresight. With increasing interest rates, Appelgrath due to lack of foresight who should have stopped borrowing money from the cheap wholesale market, went further to borrow more. A major instrument that should protect the bank in case of rising interest rates such as the insurance policy was sold as a means to raise further cash to meet their targeted growth rate of 20% per year. This act alone further exposed the bank to problems as when this was done, interest rates effectively increased. Applegrath had concentrated power in his hands so much that, the department that was in charge to monitor risks had no functions to perform. Rather than reporting to Finance Director who was in charge of managing risks, the Treasury department was now made to report directly to Applegrath. From all indications, Applegrath was shown as a banker with no banking idea, but someone who wanted power especially as no one was allowed to question his management style or disagree with him. It really proved that he was acting not because he knew what he was doing, but because he tried a business model which he never really understood and thought it was just the best to help him meet the target growth the bank had set. This is proof of why no one really cared to test the stress test. 3. Issues faced by the change agent 3.1 Background information of Mr Sandler The change agent, Ron Sandler was called in to salvage the bank after the bank was nationalised in February 2008 by the Bank of England using taxpayer’s money. Ron Sandler, a 55-year-old Zimbabwean is well known for his reputation as a trouble –shooter who has taken on tough jobs and succeeded. Northern Rock being the highest employer in the region, with some 6,000 employees will have to work with someone who has carried up such daunting tasks and succeeded. Some of Mr. Sandlers successful projects include; As Chief Executive of Lloyd’s of London in 1990, he helped bring back the insurance market that was almost at the brink of collapse. In 1999, he tried to fend off a take over bid of NatWest by the Royal Bank of Scotland, even though failed. But this gave him accreditation from his admirers who saw the issues a hard fought battle. He has served as Chairman of Paternoster (an insurance firm), Financial Education Charity Pfeg among others. Successfully in 2001 took charge with overseeing a review on how the UK’s long term saving industry (stakeholder pension and investment products) could be developed as to help those on the low income bracket save for retirement. A task he carried out with respect. His educational background and ability to take on difficult tasks has given him a good reference from Justin Urquhart of Seven Asset Management as someone with “a reputation for taking on difficult issues. He is someone who demands respect and can deal with difficult people”. He can therefore be considered as someone who is vest with the financial industry and can handle the crisis at Northern Rock. 3.2 Issues faced by Mr Sandler Mr. Ron Sandler is joining the Northern Rock at a time when the more than 6.000 employees working with the bank and who want to see a turn about change so as to protect their jobs, customers in some 204 bank branches who have their money blocked in the bank, the Bank of England who has pumped in taxpayers money to the tune of some £25 billion to salvage the bank and the confidence the Treasury has given creditors (worth some £30 billion). Shareholders, who in the past have enjoyed a good place but recently saw the fate of their investments in jeopardy especially with the nationalisation, are also keen to see some change happen in the bank so that they may once more be the owners of their investment. Shareholders had been used to see their investment at a growth rate of 20% as target and for some time had enjoyed a favourable market position. It is incumbent on new management to work out a favourable strategy to keep the bank afloat rather than pursue a strategy that will not work such as setting standards when the bank is in crisis. 4. New strategies that can be followed New management has to know here that they are taking on an institution that has given a poor image to her shareholders, the government, and the customers. Mr. Sandler so far has two options; either turn the bank to a profit making institution and get the taxpayers money paid back, or fail completely and the assets of the bank be sold to reclaim any money pumped in the bank to save it from collapse. The question now is, will Mr. Sandler be able to use their competitive advantage on the mortgage market and outplay the other British banks? The advantage here is that Mr. Sandler is dealing with a bank in which he can use the fact that depositor’s accounts are backed by the government and attract more deposits from where they can give out loans at more attractive rates than other mortgage institutions on the mortgage market. But at the same time, he should be prepared for strong competition from other banks. New management should avoid in the very fist place what caused the failure of their predecessors. The idea of backing loans with cheap money from the wholesale market was a risky investment. Therefore, new management should base on using retail market funds such as deposits and savings from their customers to fund any loans. Loan securitisation should be an absolute area where the bank should not fully engage all available funds. Securitisation is considered to be part of hedging the loans which are given out. But when all loans are bundled and given out to an investor, the bank should know that in times of lack of liquidity and when the investor fails to pay the loans, then the bank will be in serious problems. The bank has to use more hedging techniques such as buying insurance policies on loans. The fact that the old management team sold the insurance policy that could cover the bank in times of crisis should be avoided. The best thing to often do is to make sure that loans are often covered with an insurance policy or at least a collateral security so that if the client fails to repay the loan, the insurance policy or collateral can cover the loan. New management should be able to increase their bank outlets and make use of them in times of crisis to borrow from the European Central bank. As was the case with the former management, who failed to use their Irish outlet to seek help from the European Central Bank when other banks in Europe did, was a failure that exposed the bank when the credit markets dried up. Stress tests should be strictly applied and at all times to all factors, while keeping a keen eye on the credit market. All market signals such as increase or cuts in interest rates be watched carefully and at every stage, the management should analyse the impact of any small change on the market on the bank. Stress tests are obviously of great importance since they show the bank management what may be going wrong and the effect on the bank assets. Market indicators such as falling company share price, fall in company profits should not be ignored at any one moment. It is just a matter of keeping a good loan book, but trying to see how the bank is fairing on the stock market. A fall in stock price is an indication that bank activities may not be moving well and needs change. But when this factor is ignored and instead the bank pushes further to increase the number of loans, then it is just a bad signal to the market and the share price will obviously continue to fall thereby fall in customer confidence on the bank. Lending should be based on a certain benchmark such as the London Inter Bank Offered Rate (LIBOR). LIBOR is a common of benchmark interest rate indexes used by banks, securities houses and investors to fix the cost of borrowing in the money, derivatives and capital markets around the world and also to make adjustments to adjustable mortgage rates. An increase in LIBOR rates should reflect to management that there is increasingly liquidity pressure in funding markets internationally. Therefore, the new management should take LIBOR rates important and not ignore them as did the Applegrath team. Functions should be decentralised, giving each person that ability to function where it is necessary and only report to the Director (in this case Mr. Sandler) if absolutely needed. When powers are usurped from relevant departments and crowded on the Director, then it leaves room for mistakes especially as the Director shall now have much to do at the same time. Conclusion Change is a good thing, be it at the level of a state or any institution. But what matters most is continuity. When a person is given the confidence, then that person is willing to face the challenge. Therefore, Northern Rock had in the past done many errors in their banking transactions, but with the coming of a new team into the dance floor, certainly changes will come and hopefully positively. Therefore, with the credentials of a man like Ron Sandler, there should be reason for hope that Northern Rock is once more on the right footing. References Course handouts (extracts from the Economists newspaper, and Daily Telegraph). Web site consulted http://companyinfo.northernrock.co.uk/investorRelations/corporateProfile/, retrieved on 07-04-2008 at 20,05pm Read More