Page | 1

INTRODUCTION
For three days in August 2007, the UK experienced its first run on a bank since over
end and Gurney, the London wholesale discount bank in 1866. Around 3 billion of
deposils veie vilhdiavn (aiound 11 peicenl of lhe lanks lolaI ielaiI deposils) fion
a medium sized bank - Northern Rock (NR). The unedifying spectacle of widely-
publicized long queues oulside lhe lanks lianches leslified lo lhe lanks seiious
piolIens. The NR ciisis vas lhe fiisl line lhe ank of LngIand (OL), lhe UKs
central bank, had operated its new money market regime in conditions of acute
stress in financial markets, and it was the first time it had acted as a lender-of-last-
resort for many years.
Northern Rock (previously a UK mutual building society) converted to bank status
in 1997. Without the previous constraints on its operating permissions, it acquired
legal powers to conduct the full range of banking business. However, it remained
focused predominantly on the residential mortgage market. From the outset, it
adopted a securitization and funding strategy which was increasingly based on
secured wholesale money (by issuing mortgage-backed securities) and other capital
market funding.
Northern Rock is an extreme case of mismanagement in the banking sector. Its
spectacularly imprudent business strategy caused the first run on a British bank in
more than a century. The Treasury was forced to rescue and then nationalize the
bank to protect the wider financial system.
On 12 September 2007, Northern Rock asked the Bank of England, as lender of last
resort in the United Kingdom, for a liquidity support facility due to problems in
raising funds in the money market to replace maturing money market borrowings.
The problems arose from difficulties banks faced over the summer of 2007 in raising
funds in the money market. The bank's assets were always sufficient to cover its
liabilities, but it had a liquidity problem because institutional lenders became
nervous about lending to mortgage banks following the US sub-prime crisis. Bank of
England figures suggest that Northern Rock borrowed 3 billion from the Bank of
England in the first few days of this crisis.
Page | 2

FINANCIAL CRISIS OF 2007
The global financial crisis of 2007-2OO8 is vilhoul a piecedenl ly hisloiys accounl
even though economists tend to compare it to the Great Depression in 1929, the
Russian crisis of 1992 and the Asian one in 97-98, etc. There is almost universal
agreement that the fundamental cause of the crisis was the combination of a credit
boom and a housing bubble.
In the last five to seven years the ratio of debt to national income has gone up by
100% from 3.75 to 4.75 to one. During this same period, house prices grew at a record
rate of 11% per year. Since August 2007, financial markets and financial institutions
all over the world have been hit by shattering developments that had started earlier
with problems in the performance of sub-prime mortgages in the United States. A
housing boom followed by a bust led to defaults, the implosion of mortgages and
mortgage-related securities at financial institutions, and resulting financial turmoil.
Financial institutions have written off losses worth many billions of dollars and are
continuing to do so. Liquidity has virtually disappeared from important markets
and stock markets have plunged. Central banks have provided support with
hundreds of billions, intervening not only to support the markets and provide
liquidity but also to prevent the breakdown of individual institutions. Currently
governments in the United States and Europe are stepping in to support financial
institutions on a massive scale.
Globalization and financial innovation combined with the asymmetry of information
are effectively the main reasons for this financial crisis. The financial system would
have contained the effects from the housing bubble and there would be limited
repercussions if there were not as much systemic risk in the system. The need for a
new regulatory framework is the new paradigm which is being discussed across the
world and which will shape the financial system in the decades to come.
In the end, the financial regulation systems failed in predicting consequences of the
housing bubble. The effect from greater regulation is debatable and the chance for
the regulatory reform to improve financial system's robustness with as little damage
Page | 3

as possible to its efficiency and creativity is negligible. The crisis itself, however, has
made economic agents aware of the existence of black swans which will probably
rationalize expectations on a larger scale than the regulatory framework could ever
achieve. Human knowledge, however, has continued to suffer. My personal belief is
that the future of financial innovation lies in further research on how to measure and
learn more about the underlying systemic risk.

FEW SALIENT POINTS OF CRISIS
The particularly significant aspect of the NR episode is that it was multi-dimensional
in that several issues came together in a single case study. Several key dimensions
are identified:
1. As has been argued, the NR had a particular business model that exposed it to a
low-probability risk (that liquidity would dry-up in the inter-bank and commercial
paper market) but one that would have a high-impact (inability to continue to fund
its business operations).
2. NR had a particularly hazardous business model, which seems not to have been
sufficiently monitored by the supervisory authority. Northern Rock was the only
major UK bank to have securitization as the centerpiece of its business strategy.
3. Solvency v. Liquidity. A distinction is conventionally made between the
solvency and liquidity of a bank. This distinction is more difficult to make in practice
than in theory. At the time of writing (October, 2007) NR remained legally solvent
and yet was dependent on BOE funding because it could not fund its operations in
the markets. However, there must be a question about this concept of solvency when
applied to a bank which:
(a) has serious funding problems in the open market,
(b) Where the cost of funding exceeds the average rate of inteiesl on lhe lanks
assets,
(c) When it is dependent on support from the BOE.
Page | 4

4. Major fault-lines were revealed in the British deposit protection scheme.
5. The government intervened in an ad hoc manner by arbitrarily guaranteeing all
deposits held at NR (and, by implication, all banks in similar circumstances) which
was contrary to the well-established deposit protection scheme. This raises issues of
credibility regarding whatever deposit guarantee system is in place.
6. Serious moral hazard issues have been created with respect to depositor
pioleclion and lhe ioIe of lhe OLs noney naikel opeialions.
7. The NR episode raises important issues regarding corporate governance. In
particular, did the Board of the bank exercise due care with respect to the risk profile
of the bank? What is the responsibility of the Board of a bank in this crucially
important dimension? This raises the question of the practical ability of a Board
(most especially the non-executive directors) to monitor the risk-taking activities of
the management of a bank and, by extension, the interests of the depositors.

SHARE PRICE OF NORTHERN ROCK AFTER THE FINANCIAL
CRISIS




As the figure depicts, in only four months after the global financial crisis, the share
price of Northern Rock decreased from 1200 pence to 450 pence. The reason behind
this decrease was the sudden run on the bank after the subprime crisis in US.
Northern Rock bank had already liquidity problems and after the run on the bank its
share price started decreasing drastically, which led to its nationalization.
Page | 5

COMPARISON BETWEEN NORTHERN ROCK BANK AND
PRIME BANK LTD
We have looked into the unusual figures of Northern Rock bank, which are mainly
affected by the dismissal of the bank. Then we have compared those items to those
of Prime Bank Ltd. This comparison will give us some idea on whether Prime Bank
Ltd. is going to follow the same trend as Northern Rock Bank followed before the
credit crunch.
NET PROFIT AFTER TAX
Net profit after tax tells us whether the organization is making profit or not. This is
an item that many people use to make assumptions about the profitability of the
organization. Net profit after tax of Northern rock and Prime Bank Ltd. is as follows:






Northern Rock Bank: Northern Rock had constant net profit after tax during 2004-
2006. During 2007 and 2008, Northern rock had faced severe decrease in their net
profit after tax. This decrease was caused by the increase in the interest expense and
similar other charges (49% increase in 2007) and increase in Impairment charges on
loans and advances (195% increase in 2007 and 273% increase in 2008). This increase
in expenses drastically reduces the profit of Northern Rock Bank and caused after
tax loss in year 2007 and 2008.Impairment losses on loans and advances increased
very shapely year during 2007 and 2008.
Northern Rock
2004 2005 2006 2007 2008
Prime Bank
2006 2007 2008
Page | 6



Prime Bank Ltd.: as we can see in the graph, Prime Bank Ltd. did not have any
decreasing Net profit after tax. Instead, it had increased it after tax profit in the year
2007 and in year 2008, the profit level is stable. The net profit after tax of Prime Bank
Ltd. increased because its interest income increased in year 2007 and 2008.










Northern Rock
Impairment losses on loans and advances
Impairment charges on unsecured investment loans
Page | 7

INVESTMENT SECURITIES AS A PERCENT OF TOTAL ASSET
Northern Rock Bank: If depositors know that the bank is illiquid they may be
induced to withdraw deposits, which, in turn, force the bank to sell assets at a
discount in order to pay out depositors. In September, 2007, customers of Northern
Rock rushed to the bank branches to withdraw their cash from deposit. Within a
day, 5% of total bank asset was withdrawn by the customers. In such situation,
Northern Rock needed assets that are very liquid.
Northern rock had investment securities for sale, which were very liquid but risky in
terms of price. So, when it faced urgency of money, it had to sell its investment
securities in loss.


Prime Bank Ltd.: On the other hand, Prime Bank Ltd. has higher percentage of
investment in securities, but mostly in Government securities. Government securities
are second most liquid asset after the cash and have very low price risk. If Prime
Bank Ltd. faces high liquid emergency, it can sell the government securities very
quickly without making any loss.

Northern Rock Bank
Year 2005 2006 2007 2008
Page | 8





LOANS AND ADVANCES
Northern Rock Bank: One of the most criticized initiatives taken by the Northern
Bank was the aggressive mortgage lending. The bank started giving out loans to
customers with bad credit rating. Customers, who were not eligible for loans, were
approved for loans which were about 7 times of their salary or 125% of their total
asset. Northern Rock increased its investment in loans and advances over years,
which is shown below:
Prime Bank Ltd.
Year 2004 2005 2006 2007 2008
Prime Bank Ltd.
Government securities Others
Page | 9



Prime Bank Ltd.: Prime Bank Ltd. also has increased its loans and advanced over the
years, but it is mainly to expand its business and not an aggressive approach, which
does not lend money to non-qualified customers.



Northern Rock Bank
Loans and advances to customers Loans and advances to banks
Prime Bank Ltd.
2004
2005
2006
2007
2008
Page | 10

NORTHERN ROCK LIABILITIES
Retail deposit funding is perhaps the most stable form of funding available to a
bank. Although retail deposits can be withdrawn on demand, their effective
duration is much longer. Indeed, a stable deposit base figures prominently when
valuing banks in terms of their franchise value. By 2007, only 23 percent of its
liabilities were in the form of retail deposits. The rest of its funding came from short-
term borrowing in the capital markets, or through securitized notes and other
longer-term funding sources.
















Page | 11

RETAIL DEPOSITS
The fiisl nolalIe fealuie is hov quickIy Noilhein Rocks lolaI laIance sheel size
outstripped its traditional funding base of retail deposits. Even as total assets grew
by a factor of 6.5 in this period, retail deposits only grew from 10.4 billion pounds to
24 billion pounds. As a result, retail funding fell to 23% of total liabilities on the eve
of the crisis (and much further after the run)
.











The bulk of the retail deposits were non-branch based deposits such as postal and
telephone accounts. It was these non-branch retail deposits that proved most
vulnerable to withdrawal in the aftermath of the run on Northern Rock.



Page | 12

SECURITISED LOAN
The role played by securitized notes has received considerable scrutiny in the
Northern Rock collapse. It has become the received wisdom that such securitized
noles nade Noilhein Rocks lusiness nodeI unusuaI, ils laIance sheel Iess
liadilionaI, and lhal secuiilizalion vas iesponsilIe sonehov in Noilhein Rocks
downfall. Northern Rocks secuiilized noles veie of nediun lo Iong-term maturity,
with average maturity of over one year.
The notes were due to be issued in September of 2007, but the crisis intervened
before the notes could be sold. None of the notes were placed with investors, and the
whole issue of notes - around 5 billion pounds face value - were taken back on to
Noilhein Rocks laIance sheel. In lhis inslance, lhe piolIen vas lhal lhe pIanned
sale of notes did not proceed, depriving Northern Rock of cash, rather than a
problem with the rolling over of existing liabilities.

OTHER LIABILITIES
The gap in funding was made up by securitized notes and other forms of non-retail
funding, such as interbank deposits and covered bonds. Covered bonds are long-
term liabilities written against segregated mortgage assets. As such, they are illiquid
and long-term in nature and other short-run wholesale funding was more closely
implicated in the run on Northern Rock






Page | 13

PRIME BANK LTD. LIABILITIES
From 2004 - 2008

Prime Bank Ltd.s najoiily Ioans cones fion lhe deposils and olhei accounls, il
constitutes of 45% of the overall liabilities. Fixed deposits consist of 36% followed by
5% borrowings from other banks, financial institutions and agents. Current deposit
and saving bank deposits are 5% and 3% respectively with a mere of 1% of bills
payable.
COMPARISON
While comparing Prime Bank Ltd. and Northern Rock, we can see that 23% of
northern rock liabilities came from retail deposits whereas 80% of the liabilities of
Prime Bank Ltd. are from deposits. Retail deposits are considered as the most stable
liabilities for a bank as the bank is aware of its maturity and interest charges. Any
other liabilities such as securities are most likely to be volatile with the market
changes
Series1,
Borrowings
from other
banks,financia
l institutions,
and agents,
1,490,000,000
, 5%
Series1,
Deposits and
other
accounts,
13,470,981,84
9, 45%
Series1,
Current
deposits and
other
accounts,
1,362,942,877
, 5%
Bills payable
1%
Series1,
Savings bank
deposits,
999,076,129,
3%
Series1, Fixed
deposits/Ter
m deposits,
10,981,260,32
0, 36%
Series1, Other
liabilities,
1,666,080,989
, 6%
Page | 14

NORTHERN ROCK ASSETS
2007












Northern Rocks 83% came from residential mortgages which are resulted in
subprime mortgage crisis and nationalisation. In 2007, northern rock was hoping to
recover this loan over the next two to three years and the balance sheet to contract
significantly as Northern Rock customers coming to the end of their mortgage
product redeem and they will continue to restrict new lending volumes. Other
advances viII aIso le ieduce foIIoving lhe decision lo cease offeiing nev Togelhei
products to customers and the withdrawal from new standalone unsecured lending.



Page | 15

PRIME BANK LTD. ASSETS
2007

Loan and advances were the major source of assets for Prime Bank Ltd.. It is
constitutes of 74% of the total assets. Investment is 11% and money with bangladesh
bank and its agent bank (including foreign currency) is 5%.

COMPARISON
Majoiily of Noilhein Rocks assels cone fion ResidenliaI Moilgages.
Loan and advances is the major source of assets for Prime Bank Ltd.
Due to the global demand from investors for securitised mortgages dropped,
Northern Rock faced a heavy downfall


2007, Cash
In hand ,
219,714,704
, 1%
With
Bangladesh
Bank and its
agent bank(s)
(including
foreign
currencies)
5%
2007,
Balance
with other
banks and
financial
institutions,
1132464146
, 3%
2007,
Money at
call and on
short
notice,
335,151,342
, 1%
2007,
Investments
,
4203135875
, 11%
2007, Loans
and
advances,
2845694413
7, 74%
2007, Fixed
assets
including
assets
taken on
lease,
498,428,68
2, 1%
2007, Other
assets,
1,591,194,5
74, 4%
Page | 16

Capacity Ratio(%)
LIQUIDITY ANALYSIS
One of lhe ieasons Ieading lo Noilhein Rocks ank ciisis is Liquidity mismatch, to
tide over the excessive lending over and above their deposit base; Northern Rock
bank took money from the money market. Therefore here is the liquidity analysis
which will give us a comparison between Northern Rock and Prime Bank Ltd..
3 types of ratios have been discussed under Liquidity analysis. They are:-
Capacity Ratio
Cash Position Indicator
Liquidity Securities Indicator

1. CAPACITY RATIO:-
Capacity ratio=

Capacity Ratio indicates the most loans and advances a bank can give out with the
overall size of its asset portfolio.
Year Northern Rock (%) Prime Bank Ltd.(%)
2007 91.61 73.02
2008 88.6 74.05
2009 78.42 74.9


Page | 17

Graph Description: - The graph shows that from 2004 to 2006 the capacity ratio of
Northern Rock has increased, after 2006 it started to decline and decreased more in
2008 whereas the capacity ratio of Prime Bank Ltd. has increased more from 2004 to
2005 and then it increased up to 2008 more or less consistently.
Analysis:- In 2007, the loans and advances of Northern Rock fall drastically due to
the financial crisis, hence their total asset fell too, whereas in Prime Bank Ltd. after
the rise in 2005 it maintained a consistent capacity ratio with their loans and
advances increasing over the years but the total assets increased more
proportionately over the next years. Every time the ratio of Prime Bank Ltd. is lower
than Northern Rock, which indicates that Prime Bank Ltd. is more liquid than
Northern Rock.

2. CASH POSITION INDICATOR:-
Cash Position Indicator =

Year Northern Rock (%) Prime Bank Ltd. (%)
2006 0.95 5.85
2007 0.17 5.75
2008 9.62 5.56


Figure-Northern Rock
Series1,
2004, 0.1
Series1,
2005, 0.08
Series1,
2006, 0.95
Series1,
2007, 0.17
Series1,
2008, 9.62
Cash Position Indicator(%)
Page | 18


Figure: -Prime Bank Ltd.
Graph Description:-
Northern Rock- From 2004 to 2006 the cash position indicator increased after which
it decreased in 2007 and again increased in 2008 by a substantial amount.
Prime Bank Ltd.- From 2004 to 2005 it slightly decreased and in 2006 it again
increased well. After that it started to decrease but by a very small amount.
Analysis:-
A great portion of cash implies that the institution is in a stronger position to handle
immediate cash need. After 2007 when Northern Rock was nationalized its cash
position indicator increased that means it became capable of handling immediate
cash need. In 2008 there was more infusion of money from the government. Before
nationalizing it had high leverage that means it must have enough cash need. For
Prime Bank Ltd. the change was not so drastic and increased or decreased by a small
amount.
Initially, Prime Bank Ltd. was in a good position to handle cash need than Northern
Rock.



Series1,
2004, 3.61
Series1,
2005, 3.25
Series1,
2006, 5.85
Series1,
2007, 5.75
Series1,
2008, 5.56
Cash Position Indicator(%)
Page | 19

Series1, 2004,
17.47
Series1, 2005,
9.21
Series1, 2006,
10.24
Series1, 2007,
10.77
Series1, 2008,
10.62
Liquidity Services Indicator(%)
3. LIQUIDITY SECURITIES INDICATOR:-
Liquidity securities indicator (LSI) =

Year Prime Bank Ltd. (%)
2004 17.47
2005 9.21
2006 10.24
2007 10.77
2008 10.62

Figure: -Prime Bank Ltd.
Graph Description: - It compares the most marketable securities an institution can
hold with the overall size of its asset portfolio.
From 2004 to 2005 Prime Bank Ltd.s Liquidily Secuiilies Indicaloi has decieased a
lot from 17.47% to 9.21%. But then it started to increase consistently.
Northern Rock has no marketable or government securities for which there is no
liquidity Securities indicator.
Page | 20

Analysis:- In 2005, Prime Bank Ltd. was in need of cash which is why they sold their
major government securities, which is the most liquid marketable securities. Hence
there was a sudden fall in liquidity securities indicator, after that government
security were increasing that caused LSI to increase consistently.


LEVERAGE RATIOS
Leverage ratios are used to calculate how much debt is present in the capital
structure of a company. Hence, the calculation of leverage ratios will indicate the
impact of excessive loans on that company. For leverage ratios, we calculated the
equity multiplier of the company. We know that, equity multiplier is calculated by:
Equity multiplier=

,
since total asset is made up of debt and equity if there is any debt at all the figure
will be higher than 1 and if there is no debt then the figure for equity multiplier will
be equal to 1. Hence, the higher the number the more leveraged the company is.
It is common knowledge that Northern Rock had a lot of loans due to the fact that
they were incapable of paying off their short term debts and had to resort to taking
loans. The equity multiplier figures for Northern Rock and Prime Bank Ltd. are
given below:

2004 2005 2006 2007 2008
Northern Rock 47.17 33.22 32.75 45.19 155.12
Prime Bank Ltd. 15.05 14.92 15.63 14.91 16.01

Page | 21


Graph description: ve can see lhal Noilhein Rock anks figuie iose diaslicaIIy in
2008 which indicates the amount of loan they took in that year. In 2004, the figure
was 47.17 but it declined in the next two years and started rising again from 2007
and it 2008 it reached an astronomically high figure of 155.12. Prime Bank Ltd. on the
other had pretty consistent figures throughout the five-year period. It was initially
15.05 in 2004 then dropped to 14.92 in 2005 then rose again in 2006 and then fell to
14.91 in 2007 and then finally became 16.01 in 2008 exhibiting a stable pattern.
Graph analysis: though the numbers are very high for both the banks, it must be
noted that banks usually have high figures when it comes to equity multiplier ratio.
Since, banks are in the business of taking deposits and then lending to borrowers,
they end up having a lot of liabilities as their assets are financed by debts. However,
the figures for Northern Rock bank are way too high indicating a huge amount of
debt. Prime Bank Ltd. on the other hand has manageable amount of debt and figures
like that are quite common for banks. Therefore, we can conclude that Northern
Rock Bank is more leveraged than Prime Bank Ltd.
We also calculated the times interest earned ratio of both the companies. As we
know times interest earned ratio indicates whether there is enough operating profit
to cover the interest expenses of the company which is calculated by:


Page | 22

Times Interest Earned Ratio=

,
The figure that we get indicates the number of times interest expense can be paid
with the operating profit.
2004 2005 2006 2007 2008
Northern Rock 1.17 1.15 1.15 0.97 0.76
Prime Bank Ltd. 0.5 0.44 0.44 0.5 0.38


Graph description: The graph above indicates that Northern Rock experienced a
drop in the ratio from 2007 and onwards. For the first three years the figures were
pretty consistent. It started with 1.17 in 2004, remained 1.15 for the next two years
and fell in 2007 to 0.97 and dropped to 0.76 in 2008. Prime Bank Ltd.s figuies veie
less than 1 throughout the five-year period. It was 0.5 in 2004 and was 0.44 for the
next two years and became 0.5 in 2007 and fell to 0.38 in 2008.
Graph analysis: The graph clearly points out that Northern Bank had difficulty
paying their interest expense from 2007 and onwards, before that they could at least
pay their interest expense once. This obviously is owing to their huge debts which
resulted in high amount of interest expense which they were unable to pay off.
Prime Bank Ltd. on the other hand has low figures due to their low operating profit.
However, since they have low debt and low interest expense they ended up having
high net income.

Page | 23

Z-SCORE CALCULATION
The Z-score is generally applied to the large manufacturing companies. The
foinuIa lo caIcuIale lhe Z-score is as follows:
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 0.999 X5
Where:

Assets Total
Capital Working
X
1


Assets Total
Earnings tained
X
Re
2

Assets Total
Taxes and Interest Before Earnings
X
3


s Liabilitie Total
Equity
X
4


Assets Total
Sales
X
5


7KHLQWHUSUHWDWLRQVRI=score are as follows:
x A score higher than 3 indicates a Low Risk.
x A score under 3 indicates further investigation is necessary.
x A score under 1.81 implies an inherent weakness and the probability of
company failure within 2 years.
x A consistent downward trend requires investigation even when the score is
satisfactory.

Page | 24

Year Northern Rock Prime Bank Ltd
2006 5.46 2.71
2007 3.02 1.29
2008 1.48 1.03


We can see from the figure above, before the financial crisis, Northern Rock had a
healthy Z-score of 5.46. This indicates a sound financial position. The value of Z-
score fell down to an abysmal 1.48, when the recession was at its peak. Northern
Rocks figure was 3.02 in 2007, which reflects the gradual decline in their financial
performance as the financial crisis was right around the corner.

Northern Rock
2006
2007
2008
Prime Bank
2006
2007
2008
Page | 25


Prime Bank on the other hand, is at an even worse condition in 2008, as the Z-score
value is way below the cut-off point of 1.81. Even before the recession back in 2006,
their score was 2.71, which does not indicate a crisis but shows Northern Rock was
financially much better off than Prime Bank.


CONCLUSION
Northern Bank has issued a note of caution to the investors. Investors must know the
internal and external strengths before depositing their hard earned money in the
banks otherwise they will be putting themselves in a lot of trouble. Northern Bank
on the other hand must not have dealt with subprime borrowers, as default risk
becomes very high then.
However, if we have to compare we can conclude by saying that Prime Bank Ltd.
has performed better when it comes to liquidity securities indicator, cash position
indicator and capacity ratio. Northern Rock as expected is more leveraged than
Prime Bank Ltd. and which eventually led to its bankruptcy.