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Term paper

Prepared For:

Prepared by: ID Muntazera Husain Papia Nury 081-442-030 073-392-030

North South University 22nd December, 2010

Background of Northern Rock PLC:

Northern Rock is a British bank, best known for becoming the first bank in 150 years to suffer a bank run after having had to approach the Bank of England for a loan facility, to replace money market funding, during the credit crisis in 2007. Having failed to find a commercial buyer for the business, it was taken into public ownership in 2008. It is based at Regent Centre in Newcastle upon Tyne, United Kingdom. Formerly the Northern Rock Building Society, the bank was formed in 1997 when the society floated on the London Stock Exchange. Northern Rock converted from a mutual-form building society to a stock-form UK bank on 1 October 1997. At the time of conversion it was a retail-funded lender, but from the second half of 1999 it embarked on a growth strategy which was increasingly dependent on securitization and other secured borrowing in a range of currencies and targeting investors in both UK and foreign capital markets. 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.

Reasons of the failure of Northern rock:

Northern Rock had a unique business model in that securitization (originate-anddistribute) was a central part of the banks overall business strategy. While many banks

securitized assets at the margin, the uniqueness of Northern Rock was that securitization, and a reliance on short-term market funding, was the central feature of its business model. An inherent property of this business model was that it exposed the bank to a lowprobability-high-impact (LPHI) risk. The bank became heavily dependent on short-term funding in the money and capital markets, while no-one predicted that liquidity in the markets would suddenly evaporate on a large scale. This was the nature of the LPHI risk. While the business model was successful for some years, the LPHI risk eventually emerged in the context of global financial turbulence focused initially on sub-prime mortgage lending in the US. As the Northern Rock had no part in this it might be claimed that it became an innocent victim of this turbulence. However, the chosen business model exposed the bank to a LPHI risk associated with a drying-up of liquidity in the London financial markets. The Northern Rock crisis was multi-dimensional and revealed several fault-lines with respect to: I. The implications of securitization and a consequent over-reliance on short-term market instruments, II. III. IV. V. VI. VII. VIII. The management of LPHI risks in banks, The deposit protection regime in the UK, Money market operations of the Bank of England, The institutional structure of financial regulation and supervision, Corporate governance arrangements in the bank, The arrangements for defining insolvency in banks, Resolution arrangements for failing banks.

Background on DBBL
Dutch-Bangla Bank Limited (the Bank) is a scheduled commercial bank. The Bank was established under the Bank Companies Act 1991 and incorporated as a public limited company under the Companies Act 1994 in Bangladesh with the primary objective to carry on all kinds of banking business in Bangladesh. The Bank is listed with Dhaka Stock Exchange Limited and Chittagong Stock Exchange Limited. DBBL- a Bangladesh European private joint venture scheduled commercial bank commenced formal operation from June 3, 1996. After instability and frequent management changes in its initial years, DBBL overcame these obstacles to establish rapid growth since the year 2000. The bank grew its reputation through social work rather than profits. The bank's conservative nature, long-term strategies, hefty social donations and technology investments have always led to modest but steady profits. DBBL has been known to be overly conservative in its banking practices. Despite being the largest corporate donor in Bangladesh, investor confidence was unhindered. In March 2008, DBBL share prices reached Tk. 14325.80 in the Dhaka Stock Exchange, setting the record for the highest stock price in the history of Bangladesh. It is also one of the few banks that do not participate in merchant/investment banking (which can lead to sporadic growth).

Comparison between Northern Rock bank and Bank Asia

Net Profit after tax:
Net profit after tax shows 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 Dabbles as follows:


1000 500 0 2004 -500 -1000 -1500 2005 2006 2007 2008 DBBL Northern rock

Fig: NET PROFIT AFTER TAX According to the graph, the net profit after tax for northern rock and DBBL was quite similar till the year 2006. After that there was a Sharpe fall of the net profit of the northern rock. The profit of the company was decreasing at a decreasing rate. Here the company actually incurred a huge amount of loss as it was generated negative amount of profit for consecutive two years. This actually reveal financial crisis for the company. In case of DBBL the net profit was quite stable till 2008. After 2007 the profit started to increase but it actually increased by a very stable rate. If we compare the net profit after tax of these two companies we can say that the trends of these two company for net profit after tax is not similar.

Impairment losses on loans and advances for Northern rock plc:

0 -100 -200 -300 -400 -500 -600 -700 -800 -900 Impairment losses on loans and advances Impairment charges on unsecured investment loans 2004 2005 2006 2007 2008

The Group named impairment losses on loans and advances assess periodically and at each balance sheet date whether there is objective evidence that a financial asset or group of financial assets is impaired. In case of northern rock, the company suffered from impairment losses on loans and advances from 2005. Since then the company has been suffering from this serious problem. Till 2007 this damage was not that much serious but in 2008 it took a worst shape and the company lost almost 894.4 million. At the same time the company has suffered from impaired charges on unsecured investment loans. This situation occurred from year 2007. The impairment charges on unsecured investment loan are less than the impaired losses on loans and advances. These types of damage can affect a company at a high extend. As the bank was not able to collect the loan amount back so it faces huge illiquidity. This is one of the main reasons for the financial crisis faced by northern rock. In case of DBBL, the bank has reported small amount or charges on loan losses during the year 2007 and 2008. The amount was 4. 4% and 5.8% of their total revenue. So we can say that the trends practiced by Northern rock and DBBL is not Similar. In terms of this variable DBBL has less likely to face financial crisis.

Comparison of asset and liabilities of northern rock and DBBL: Northern Rock PLC:

100% 090% 080% 070% 060% 050% 040% 030% 020% 010% 000% -010% 2004 2005

Asset of northern rock

Cash and balances with central banks Derivative financial instruments Loans and advances to banks Loans and advances to customers Fair value adjustments of portfolio hedging Available for sale securities Debt securities Equity shares 2006 2007 2008 Intangible assets

FIG: Total asset of Northern rock plc In the nine years from June 1998 to June 2007, Northern Rocks total assets grew from 17.4 billion pounds to 113.5 billion pounds. This growth in assets corresponds to a constant equivalent annual growth rate of 23.2%, a very rapid rate of growth by any standards. After the crisis, in the year 2008 the total asset of the bank started to fall down. In order to sustain high growth in the banks asset, the bank changed the structure of its liabilities. In 1999, the bank adopted an originate and distribute model whereby the bank originates loans or purchase them from specialized brokers and transfer them to special purpose vehicle which then package them into collateralized debt obligation for sale to other investors. In the year 2004 the bank turned to covered bond in order to meet its growth funding needs. In this financial method the bank holds its asset and issue the covered bond which are secured against them. At the same time the counterpart of the rapid and huge growth in the whole sale funding was parallel decrease in the ratio retail deposit in its funding. Thus as a proportion of the total

liabilities and equity, retail deposits and funds declined from 62.7% in late 1997 to 22.4% at the end of 2006.

Northern Rock: balance sheet growth and liability structure June 1998-June 2007


080% 070% 060% 050% 040% 030% 020% 010% 000% 2004 2005

Asset of DBBL

Cash In hand Balance with Bangladesh Bank Total Balance with other banks Total with other banks and financial institutions Money at call and short notice Total Investments Total Loans and advances Lease receivables Other assets




Fig: Assets of DBBL In case of DBBL the average growth for total asset is 25.95% which is high. The total asset of the bank is increasing at an increasing rate. In order to sustain the growth of asset, the liability structure used by BDDL is quite secured than the structure used by northern rock. DBBL mostly use term deposit to finance their assets. At the same time they use current deposit and saving bank deposit to finance their liabilities. These sources of funding are less risky. Comparing the

liability source of these banks we can say that the trends of these two companies are not similar. As DBBL has no securitized bond or they do not borrow any money from the money market so its visible that DBBL is less likely to face financial crisis.

Northern rocks liability:

Northern rock plc used to heavily rely on the retail deposit. During 1998 60% of its liability was retail funding but gradually it decreased. Northern rock then mostly use non retail fund. By the summer of 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. The dating of the beginning of the credit crisis can be seen below in figure 1, which charts the weekly series on the outstanding amounts of asset backed commercial paper (ABCP), obtained from the Federal Reserves website. Asset backed commercial paper was the favored means for off-balance sheet vehicles to fund their holdings of long-dated mortgage-related assets, and as such served as the barometer for the appetite for short-term lending against mortgage assets. The weekly series shows a sharp break between the August 8th and August 15th.

DBBL liabilities:
070% 060% 050% 040% 030% 020% 010% 000% 2004 2005 2006 2007 Term deposits Other liabilites Long term liability Subordinated debt Borrowings from other banks, financial institutions Current deposits Bills payable Savings bank deposits


Fig: DBBLs liabilities from 2004-2008 In case of DBBL we can see that the firm mostly uses term deposit for funding. Term deposit is a deposit which held at a financial institution that has a fixed term. These are generally short-term with maturities ranging anywhere from a month to a few years. Term deposits are an extremely safe investment and are therefore very appealing to conservative, low-risk investors. By having the money tied up you'll generally get a higher rate with a term deposit compared with a demand deposit. Almost 60% of DBBL liabilities are term deposit. At the same time the bank is increasingly using saving bank deposit, current deposit and other deposit for funding. These are

very secure source of funding so DBBL is less likely to face a financial crisis like northern rock. At the same time we can say that the trends of these two banks are not similar. Investment of DBBL:

Investment of DBBL
014% 012% 010% 008% 006% 004% 002% 000% 2004 2005 2006 Government Others 2007 2008

DBBL mostly invest in government securities. DBBL invest in both Treasury bill and bonds. They invest in several government bonds with different maturity period. At the same time DBBL uses REPO with other bank and financial institution. At the same DBBL also invest in some debenture. They actually invest a very small amount in other investment instrument. We know that the risk associated with government securities is very small and most of the time these risks can be avoided. So investing in government securities actually minimize the business risk and at the same time firm specific risk is also eliminated. According to the graph we can see that DBBLs investment in government securities is not stable. From the year 2004 the investment of DBBL was increasing. The highest investment of DBBL was made in the year 2006 which is almost 13% of their total assets. After that the investment in government securities is decreasing very slowly. DBBLs investment in other securities is very small that the risk associated with these types of investment is actually very insignificant. So it is assumed that DBBL is not likely to face any financial crisis because of the structure of their investment which is mostly consists of government securities

Derivative financial instruments of Northern rock

Derivative financial instruments of northern rock

014% 012% 010% 008% 006% 004% 002% 000% 2004 2005 2006 2007 2008 Derivative financial instruments

Derivative financial instrument is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Northern rock uses the derivative instruments for the purpose of supporting the strategic and operational business activities of the Group and reducing the risk of loss arising from changes in interest rates and exchange rates. All use of derivative instruments within the Group is to hedge risk exposure, and the Group takes no trading positions in derivatives. From 2005 to 2007 the company has almost 2% derivative financial instrument of their asset. In the year 2008 there was a Sharpe increase of using this instrument which was almost 12% of their total assets. The objective of using derivative instrument is to ensure that the risk to reward profile of any transaction is optimized. The intention is to only use derivatives to create economically effective hedges. DBBL does not use any derivative financial instrument in order to hedge their operational and business activities.

Loans and advances to customers

Loans and advances to customers

100% 080% 060% 040% 020% 000% 2004 2005 2006 2007 2008 Total Loans and advances of DBBL loans and advances of northern rock plc

FIG: Loans and advances of Northern Rock and DBBL The amount of loan and advances to customer of northern rock is higher than the DBBL. According to the graph we can see that total loan and advances to customers of northern bank was very high from 2004 to 2007 which is almost 90% of the total asset of the bank. Then in the year 2008 after the financial crisis the amount of loan and advances to customer decreased which was almost 70% of the total asset of Northern Rock. These loans and advances include Advances secured on residential property, Commercial secured advances, unsecured loans, and unsecured investment loans etc which are mostly mortgages. These all loans and advances are not secured and some of them are not backed by any asset. So the risk of those is high.

Debt securities of Northern bank

50000,000 40000,000 30000,000 20000,000 10000,000 ,000 2004 2005 2006 2007 2008 Securitised notes Covered bonds Other

Northern rock used various methods to raise funds for mortgages. These include using the money held in deposit accounts, borrowing from the wholesale markets, where banks lend to each other, and selling existing mortgage debts on to other institutions to raise funds for new home loans this is a process known as securitization. In this situation the financial crisis of US mortgage market take place. This actually decrease the Demand for mortgage-backed securities also pretty much evaporated because of worries that other borrowers, and not just those in the US, would slip into arrears. This affected northern rock very badly. Northern Rock, had a business plan which involved borrowing heavily in the UK and international money markets, extending mortgages to customers based on this funding, and then to re-sell these mortgages on international capital markets, a process known as securitization. When the global demand from investors for securitized mortgages dropped in August 2007, Northern Rock became unable to repay loans from the money market with money which should have been raised from securitization. The problems were anticipated by the financial markets which made the issue more public. On 14 September 2007, the bank sought and received a liquidity support facility from the Bank of England, to replace funds it was unable to raise from the money market. This led to panic among individual depositors fearing that their savings might not be available. This led to a bank run and the bank faced a huge financial crisis. In case of DBBL they make fewer amounts of loan and advances to their customers comparing to Northern bank. On an average the loan and advances to customers of DBBL is 65% of their total asset. In Bangladesh their loans and advance to customers included secured overdraft, cash credit, export cans credit, transport loan, house building loan, loan against trust receipt, term loan industrial, staff loan etc. most of the loans and advances to customers of DBBL are secured against asset. So theses are less risky. At the same time DBBL mostly use current deposit, bills payable, saving bank deposit and term deposit to raise the fund to make loans and advances to customers. These funds are less risky compare to those of northern rock. In this case it is easy to conclude that practices for loans and advances to customers of DBBL and Northern rock are different. At the same time it can be noticed that DBBL is less likely to face financial crisis like Northern Rock.

Ratio Analysis for Northern Rock:

Ratios: 1.Current Ratio: (Current Assets/ Current Liabilities) 1.044373 2. Total Debt/ Total Asset 3. Times Interest Earned (EBIT/Interest expense) 4. Return on Equity(Net Income/Total Owner's Equity) 5.Net profit Margin(Net Profit/ Sales) 41.89% 42.34% 43.57% -27.55% -514.82% 0.976301 0.274895 19.91% 1.035081 0.968426 0.149558 13.38% 1.061126 0.968215 0.151994 13.80% 1.030364 0.975308 -0.02727 -7.37% 0.89286 0.993928 -0.23973 -206.71% 2004 2005 2006 2007 2008

Current Ratio
1,044372791 1,035080872 1,061126185 1,030363699







As we can see from the above diagram that the current ratio of Northern Rock has considerably gone down after the year 2007. It had become only 0.89 times higher than their current liability which is obviously due to the financial crisis it had to face during the end of 2007.

Total Debt to Total Asset Ratio


0,976301192 0,968426462 0,968215217







The total debt to total equity ratio has also gone up between the years 2006 to 2008.

Times Interest Earned Ratio:

0,3 0,2 0,1 0 -0,1 -0,2 -0,3






Times Interest Earned ratio has fallen drastically over the years, especially after the year 2007 because, the interest expense has risen over the years. And after the year 2008 the Earnings before interest and taxes in a negative figure which gave a negative result for the times interest earned ration. It indicates the worsening ability of Northern Rock to afford loans.

Return on Equity
050% 000% 2004 -050% -100% -150% -200% -250% 2005 2006 2007 2008

The return on Equity for Northern Rock has also fallen after the year 2007. The most probable cause is the negative profit after taxes in the year 2007 and following.

Net Profit Margin

100% 000% -100% -200% -300% -400% -500% -600%






The net Profit margin also shows a negative figure after the year 2007. Even the income from interest and other sources could not cover the negative net income figure. For the ratio calculations, we considered the following: Current assets Cash and balances with central banks Loans and advances to banks

Loans and advances to customers Debt securities Prepayments and accrued income Current tax asset Available for sale securities

Current Liabilities considered: Loans from central bank Deposits by banks Customer accounts Debt securities issued: (Securitized notes, Covered bonds, other) Current taxation liabilities Accruals and deferred income Retirement benefit obligations Deferred income tax liability Provisions for liabilities and charges

Historical Prices for DUTCH BANGLA BANK LIMITED:

16000 14000 12000 10000 8000 6000 4000 2000 0 average daily price of DBBL shares 2005-2010 February time

The prices were at its highest during the year 2008.

Historical Price of Northern Rock

As we can see from the graph above that the share prices of Northern Rock fell drastically after reaching its peak in mid or before mid 2007. However, Northern Rocks Share price crashed by 30% on September 14th 2007 as the mortgage bank sought emergency funds from the Bank of England due to the credit freeze in the interbank money market which Northern Rock heavily relies upon. Panic gripped savers forming long lines outside Northern Rock Branches throughout the UK to withdraw funds. Investors dumping the stock on the market open where even unsubstantiated rumors of takeovers and white knights failed to halt the crash in the banks share price.

http://www.economist.com/node/9832838?story_id=9832838 http://en.wikipedia.org/wiki/Northern_rock#Subprime_mortgage_crisis_and_nationalisati on http://books.global-investor.com www.bankofengland.co.uk www.britannica.com http://www.thisismoney.co.uk www.dutchbanglabank.com www.wikipedia.com