Select Committee on Treasury Fifth Report

2  Northern Rock's business model

The importance of Northern Rock in the North East

8. Northern Rock plc is headquartered in Gosforth, Newcastle upon Tyne, and was, until its demotion, only one of two FTSE 100 headquartered in the North East. In its 2006 Annual Report, Northern Rock had recently reaffirmed the importance of the North East for its headquarters:

9. A geographical distribution of the branch network is outlined in Table 1, which shows the concentration of Northern Rock's branches in the North East.

Table 1: Geographical distribution of Northern Rock branches
Geographical area (as defined by Northern Rock website) Number of branches
North East21
North West10
South West6
West Midlands5
South East5
East Anglia3
Northern Ireland1

Source: Northern Rock website

10. At year-end 2006, Northern Rock had 4,811 full-time employees and 1,125 part-time employees.[34] A recently opened contact centre will have subsequently increased the number of employees at Northern Rock. The Northern Rock Community Report also notes that the majority of Northern Rock's staff were women.[35] The Northern Rock workforce, in general, have higher qualifications than average for the overall workforce in the North East. Such qualifications have been boosted by the introduction of a Modern Apprenticeship Scheme for trainee clerical staff.[36] Dr Matt Ridley, Chairman of Northern Rock, highlighted that 3,500 jobs had been created by Northern Rock since its demutualisation in 1997.[37] The regional development agency for the North East, One NorthEast, states that:

    Northern Rock is a substantial contributor to the £7.9bn financial and business services sector in the North East, which includes companies in banking, financial services, insurance, contact centres, accountancy and legal services.[38]

11. In 1997, at the time of its demutualisation, Northern Rock set up the Northern Rock Foundation. Northern Rock plc pays out 5% of its pre-tax profits to the Northern Rock Foundation through a Deed of Covenant.[39] According to Northern Rock's 2006 Annual Report, since 1997, the Northern Rock Foundation had received £175 million from Northern Rock Plc.[40] As with Northern Rock, the Northern Rock Foundation has remained rooted in the North East. The Northern Rock Foundation's trustees committed to a policy for 2006 of 'funding activities exclusively in the North-East and Cumbria'.[41] In 2006, the Northern Rock Foundation awarded £27.1 million over 352 grants.[42] In the same period, the Northern Rock Foundation also lent £1.1 million over 8 loans.[43] The importance of the Foundation is also reflected in the fact that should Northern Rock be taken over, it will have a 15% of the share capital at that time."[44] The Foundation is not the only reason for the strong support for the Northern Rock in the North East. Northern Rock has been a key sponsor of sporting clubs in the region, including Newcastle United Football Club and the Newcastle Falcons Rugby Union club.


12. Northern Rock plc was formerly a building society; it demutualised on 1 October 1997.[45] At the end of 1997, Northern Rock had assets on a consolidated basis of £15.8 billion.[46] By the end of 2006, its consolidated balance sheet had grown more than six-fold so that the value of its assets was £101.0 billion, comprised mainly of secured lending on residential properties.[47] Mr Adam Applegarth, the then Chief Executive of Northern Rock, told us that Northern Rock had been growing its assets "by 20% plus or minus 5% for the last 17 years".[48] This pace of growth led to Northern Rock entering the FTSE 100 in September 2001.[49]

13. Northern Rock described itself 2006 in its Community Report as "a specialised lender, whose core business is the provision of UK residential mortgages funded in both the retail and wholesale markets".[50] As of end 2006, 89.2% of its assets were residential mortgages.[51] This level of growth could have led to a weaker set of assets being held by Northern Rock. Mr Applegarth was keen to stress that such a weakening of asset quality had not occurred. He pointed out that Northern Rock's arrears for the last 15 years had consistently been around half the industry's average.[52] On top of this, he said that analysis undertaken as part of the Basel II process had shown that Northern Rock's "last 18 months lending is actually better quality than the previous two to three years".[53] Dr Matt Ridley, the then Chairman of Northern Rock, also told us that Northern Rock, while introducing sub-prime borrowers to a third party, did not hold such sub-prime loans on its balance sheet.[54] Mr Sants said that Northern Rock "had high quality assets—there is no suggestion here this is an organisation taking on poor quality assets".[55] The Governor of the Bank of England, Mervyn King, was also supportive of the quality of the asset book of Northern Rock, telling us that:

    What I would say about Northern Rock (and this is the tragedy of Northern Rock) is that most of the staff that worked in Northern Rock on the lending side, all the evidence shows, did an excellent job in appraising the loans that they were making, and that they monitored very carefully and they did not lend money to people who should not be borrowing from them. The lending side was handled extremely well.[56]


14. However, in order to achieve this level of growth in assets, the company changed the structure of its liabilities. Northern Rock began to borrow more money from the wholesale markets, adopting an 'originate to distribute' model of funding. In the 'originate to distribute' model banks no longer hold loans to maturity but instead sell on loans to investors. In our Report on Financial Stability and Transparency we will consider further the transition from the 'originate to hold' model of banking to the 'originate to distribute' model.

15. In 1999, Northern Rock adopted an 'originate to distribute' model and began to parcel up mortgages and use them as collateral for further funds, a process known as "securitisation".[57] As part of this process, a separate entity was created called Granite, which was based in Jersey. Granite was carried on Northern Rock's balance sheet and set out in its accounts. Mr Applegarth explained Granite's role to us:

    Granite is our securitisation vehicle and accounts for roughly 50% of our funding. The way securitisation works is you borrow against a pool of mortgages. The bond holders, the people who are lending the money against it, they carry the risk and therefore there can be no risk from those loans to [Northern Rock]'s balance sheet, so even though it is shown in our balance sheet, it has to be a separate legal entity. The separate legal entity is a master trust.[58]

The Financial Services Authority stated that "The structure of the Granite securitisation meets industry norms and there is nothing to suggest that the Granite structure is not functioning as intended".[59] We will consider whether there is any significance to the position of Granite as an entity based offshore when we report shortly on Financial Stability and Transparency.

16. Another funding strategy introduced by Northern Rock in 2004 was the use of 'covered bonds'.[60] The Bank of England provided the following explanation of a covered bond:

    In recent years, UK banks and building societies have increasingly chosen to use limited liability partnerships (LLPs) for funding and risk transfer of assets. The main difference between securitisations through SPVs [special purpose vehicles] and LLPs is that, in the latter structure, the banks themselves (rather than the SPVs) continue to hold the assets and issue the so-called covered bonds which are secured against them. The LLP effectively only comes into operation in case the issuing bank defaults, thereby providing additional security to investors in the bonds.[61]

Mr Applegarth outlined the overall funding of Northern Rock:

    50% was securitisation, which had an average life of three and a half years; 10% was covered bonds, which had an average life of about seven years; and of our wholesale borrowings, which is 25%, half of that had a duration longer than one year and the other half was less than one year's duration.[62]

17. While wholesale funding to Northern Rock grew markedly, there was no correspondingly rapid growth in its retail funding. On a group basis, retail deposits and funds made up £9.9 billion of the liabilities of Northern Rock at the end of 1997.[63] By the end of 2006, retail deposits and funds had only grown to £22.6 billion, compared with the six-fold increase in Northern Rock's assets.[64]This means that, as a proportion of the total liabilities and equity of Northern Rock, retail deposits and funds had fallen from 62.7% at end-1997 to 22.4% at end-2006. This figure is low when compared to other banks that were previously building societies: at the end of 2006, Alliance & Leicester's proportion was 43% and Bradford & Bingley's was 49%, for example.[65]" Dr Ridley confirmed Northern Rock's position in relation to its retail funding, stating that "we had a smaller retail deposit book than many other institutions, although there are many like us overseas".[66]

The events of 2007

The increase in Northern Rock's market share in the first half of 2007

18. In the first half of 2007, Northern Rock continued to expand its business at a rapid rate. In that period, its loans to customers underwent a net increase of £10.7 billion.[67] The Chancellor of the Exchequer characterised this period as one in which Northern Rock "had aggressively expanded its market share".[68] Professor Willem Buiter of the London School of Economics was critical of this expansion:

    I like healthy growth but it is hard to believe that the quality of the asset portfolio and the ability to vet the credit-worthiness of your borrowers does not suffer when you take 20% of the net increase and 40% to 50% of the gross increase in activity in this half year period, so I think they were an organisation that was clearly engaged in high-risk behaviour.[69]

19. Dr Ridley denied that the expansion of Northern Rock's mortgage lending activities in the first half of 2007 was a departure from the trend of the preceding decade.[70] Sir Derek Wanless, Chair of the Risk Committee of the Board of Northern Rock, also contested the notion that this period of continued expansion saw an aggressive approach. He claimed Northern Rock had only 10% of the market in new lending, but conceded that this was 19% of new lending after repayments.[71]


20. Northern Rock's continued expansionary lending policy required the continued success of its funding strategy at a time when there were indications of potential problems on the funding side. In its April 2007 Financial Stability Report, Sir John Gieve told us that the Bank of England had "identified the increasing wholesale funding of banks as a potential risk if markets became less liquid".[72] When questioned as to whether Northern Rock had acknowledged those warnings, Dr Ridley told us that both the FSR and similar warnings in the Financial Service Authority's Financial Risk Outlook had influenced Northern Rock's board decisions.[73] Mr Applegarth also told us that in March 2007 the company had "picked up the warning signs that the US sub-prime position was meaning a tightening in pricing and therefore we slowed down the rate of growth and we gave new guidance against our profits for the year, recognising the tightening in pricing".[74] Mr Applegarth then outlined to us the change in strategy being adopted by Northern Rock in the first half of 2007, and announced in its 2007 interim report. On the asset side, Mr Applegarth stated that the company was seeking to sell its commercial lending, unsecured lending and commercial buy-to-let operations.[75]

21. On changes to Northern Rock's funding side, Sir Derek Wanless pointed out that the company had started obtaining retail funding from Denmark, and that Northern Rock "had [retail funding] products in the UK, too, which were being successful".[76] Mr Applegarth told us that Northern Rock had "increased [its] liquidity by £2.3 billion at the half-year stage",[77] in other words by 30 June 2007.

22. Mr Applegarth also outlined the changes over the last decade that Northern Rock had carried out to try and strengthen its funding platform:

    we have worked very hard over the previous decade to try and diversify our funding platform by geography and product. That is why we moved to having four funding platforms—retail cash deposits, covered bonds, securitisation and traditional wholesale—and it is why in each of those markets we look to diversify by geography. So for securitisation for example not only did we tap the UK but we tapped Europe, the Far East and America. If you look at traditional wholesale, we tapped American, European, Asian and Australian markets. [For] cash deposits … we moved across to Ireland and across to Denmark, so we broadened our funding platform to try and increase stability.[78]


23. In the middle of this change of strategy, on 9 August 2007, Northern Rock's traders noted a "dislocation in the market" for its funding.[79] This dislocation was the result of a global shock to the financial system, with the American sub-prime mortgage market as its centre. We will examine the causes of this dislocation, and its wider effects beyond the direct impact on Northern Rock, in our forthcoming Report on Financial Stability and Transparency.

24. Two aspects of this worldwide liquidity squeeze appeared to surprise Northern Rock, and overcome the attempts highlighted above to combat the tightening in credit markets. One was the absence of a so-called "flight to quality". Dr Ridley told us that:

    What we did not expect was that there would be no flight to quality in that process [of a tightening in credit markets]. In other words, we expected that as markets became tighter and as pricing for risk changed that low-risk prime UK mortgages (and we have below half the industry average of arrears on our mortgage book) and such a low-risk book would remain easier to fund than sub-prime mortgages elsewhere. That is why we were very determined to keep the credit quality of our book high, in order to be able to attract funding.[80]

Mr Applegarth told us that Northern Rock had wrongly "believed that high-quality assets and transparency [were] the way to maintain liquidity".[81] Sir Derek Wanless told us that Northern Rock's "first line of defence [was] good credit quality".[82]

25. Secondly, Northern Rock had not foreseen all its funding markets closing simultaneously, as happened after 9 August. Dr Ridley explained:

    We deliberately diversified our funding platform so that we would have … three different types of funding and indeed a diversified programme within the wholesale funding, and geographically we had programmes in the United States, Europe, the Far East, Canada and Australia. That was deliberately so that if one market closed we would still have access to others. The idea that all markets would close simultaneously was unforeseen by any major authority.[83]

The idea of all markets closing to Northern Rock was repeatedly characterised to us by Northern Rock officials as "unforeseeable".[84]

26. One aspect of Northern Rock's financing raised by the Governor of the Bank of England in a speech was Northern Rock's lack of insurance against the troubles it faced. He referred to Countrywide, a bank in the United States that had faced difficulties due to the United States sub-prime crisis:

    Countrywide had paid millions of dollars each year to big banks as a liquidity insurance policy so that, in the event of difficulty, they would provide it with long-term loans. So on August 17 Countrywide was able to claim on that insurance and draw down $11.5bn of committed credit lines. Northern Rock had not taken out anything like that level of liquidity insurance. So when it came to the Bank of England for support, it was important that liquidity was not provided free.[85].

Mr Applegarth explained that Northern Rock had taken out insurance, but that he felt its wide funding base did not merit purchasing too much insurance:

    I think the first thing to say is that our funding platform is broader than Countrywide's in that we have the four funding vehicles. We did have some insurance in place but clearly it was inadequate to cope with the retail run. It was not the same volume of insurance as Countrywide had put in place but we did have swing-line and standby facilities put in place. They were smaller because we have a more diverse funding platform.[86]

And in his written evidence, Mr Applegarth went on to outline the size of the insurance taken out by Northern Rock:

    Northern Rock had a standby loan facility of £750 million and a $775 million bilateral swingline facility in place to support its US Commercial Paper programme—making a total of $2.3 billion. This was proportionately slightly greater cover than Countrywide in the US, given relative size of both lending programmes and balance sheets, including securitisation.[87]

27. Northern Rock continued to find some funding, even after 9 August. Mr Applegarth told us that "we were actually still funding—not fully funding, and duration was noticeably shorter, but we were still funding until 13 September".[88] In fact, Mr Applegarth told us that Northern Rock had, before 13 September, "two or three months' worth of liquidity".[89] Despite this, on 16 August, the possibility of the Bank of England giving emergency support was first discussed as a "theoretical" possibility by the Governor of the Bank of England in conversation with Dr Ridley.[90] At this point, the intention of Northern Rock was not to use such a Bank of England facility, but to have it as a "backstop".[91] Mr Applegarth explained that "The problem we had was you could not tell how long the markets were going to be closed and it was a reasonable and proper thing to do to put a backstop facility in place".[92] We consider later the negotiations on the support facility "backstop" and the attempts to find a "safe haven" or buyer which were made at the same time. We also consider later the causes of the retail run on the bank, but one consequence of that run was set out by Mr Applegarth: "Ironically, it was the announcements and the leaking of the backstop that caused the retail run and it was the retail run that reduced our liquidity".[93] The run thus created a situation in which State support for Northern Rock was not a backstop, but an everyday necessity, and where Northern Rock had become reliant on exceptional, State-backed financing.

Responsibility for the problems at Northern Rock

Responsibility of the Board of Northern Rock

28. In its evidence to us, the Board of Northern Rock acknowledged that the company's funding strategy had been looked at and discussed by the Board. Part of the oversight of the liquidity strategy of Northern Rock was conducted by its Risk Committee, chaired at the time by Sir Derek Wanless, a non-executive member of the Board of Northern Rock.[94] Sir Derek Wanless told us that "We looked as a Board at the issues of our funding strategy and what the risks were".[95] He went on to defend the role of the Board and the Risk Committee, telling us "The Risk Committee and the Board did [their] job, in my view, properly through this period".[96]

29. However, several witnesses highlighted to us the responsibility of the Board of Northern Rock for the events which engulfed Northern Rock in August and September 2007. The Governor of the Bank of England told us that "it was the business strategy that was fatally flawed in this episode where, once those markets had closed in mortgage backed securities, they were absolutely unable to finance their wholly illiquid assets".[97] And Professor Buiter noted in his written evidence that given that Northern Rock knew the Bank of England's collateral policies—which we consider later in this report—"its funding policies were reckless".[98]

30. On 30 August 2007, Sir Ian Gibson, senior independent director at Northern Rock, asked for, and received, agreement by each member of the Board of Northern Rock to resign should such resignations be needed.[99] These were not used at the time, according to Dr Gibson because stakeholders in Northern Rock felt that it was more important to weather the immediate crisis.[100]Dr Ridley announced his resignation on 19 October 2007 and was replaced by Mr Bryan Sanderson CBE who joined the Board as Chairman.[101] Then on 16 November 2007, four non-executive directors, including Sir Derek Wanless, retired from the Board of Northern Rock.[102] At the same time, three other directors of the company—David Baker, Keith Currie and Andy Kuipers—stood down as Board members, although they remained as officers of the company.[103] Mr Applegarth's resignation was also announced, but he was not then expected to leave the company until January 2008.[104] However, on 13 December 2007, it was announced that Mr Applegarth had left Northern Rock, and that Mr Kuipers, who had stood down from the Board on 16 November 2007, was to replace Mr Applegarth as Chief Executive.[105]

31. The directors of Northern Rock were the principal authors of the difficulties that the company has faced since August 2007. It is right that members of the Board of Northern Rock have been replaced, though haphazardly, since the company became dependent on liquidity support from the Bank of England. The high-risk, reckless business strategy of Northern Rock, with its reliance on short- and medium-term wholesale funding and an absence of sufficient insurance and a failure to arrange standby facility or cover that risk, meant that it was unable to cope with the liquidity pressures placed upon it by the freezing of international capital markets in August 2007. Given that the formulation of that strategy was a fundamental role of the Board of Northern Rock, overseen by some directors who had been there since its demutualisation, the failure of that strategy must also be attributed to the Board. The non-executive members of the Board, and in particular the Chairman of the Board, the Chairman of the Risk Committee and the senior non-executive director, failed in the case of Northern Rock to ensure that it remained liquid as well as solvent, to provide against the risks that it was taking and to act as an effective restraining force on the strategy of the executive members.

Responsibility of the shareholders

32. The shareholder base of Northern Rock reflects Northern Rock's demutualisation in October 1997. At that time, 500 "free shares" were issued to both 'borrower' and 'saver' members of Northern Rock.[106] A significant number of Northern Rock's employees were also represented in the shareholder base of Northern Rock: Dr Ridley told us that around 75% of employees at Northern Rock were also shareholders.[107]

33. The Board of Northern Rock emphasised to us that the business model of Northern Rock had been transparent to shareholders. Sir Ian Gibson told us that:

    the risk information about [Northern Rock's] model was very clearly in the market and has been for a very long time. It is a very clear presentation of the company that is given in our annual report. It is a very straightforward business. It is essentially a UK mortgage-only business, which some would see as a weakness, others would see as a strength. It depends on your point of view. The data surrounding that has been transparent to all for a considerable period, not just this year but year on year. [108]

34. When questioned as to whether there should have been an earlier announcement from Northern Rock on the state of its business model, Sir Ian Gibson was swift to point out that Northern Rock had taken advice both from the FSA as the UK Listing Authority and from Northern Rock's own legal advisers, and that Northern Rock was "fully satisfied that we did follow the best advice and follow[ed] it to the letter".[109] The business model of the Board of Northern Rock was clearly stated. It is unfortunate that the shareholders who acquired their shares as part of demutualisation and the staff of Northern Rock have suffered significantly from the fall in the value of Northern Rock shares. However, it is not possible to make a distinction between types of shareholders in the circumstances of Northern Rock. In a market environment shareholders as a whole must be viewed as taking a risk from which they sought a reward and for which they are now paying a price.

33   Northern Rock, Annual Report 2006, p 31 Back

34   Northern Rock, Annual Report 2006, p 72 Back

35   Northern Rock, Community Report 2006 Back

36   Northern Rock, Annual Report 2006, p 31 Back

37   Q 531 Back

38   One NorthEast, News Article, 18 September 2007 Back

39   Northern Rock Foundation, Accounts of the Trustees, p 9 Back

40   Northern Rock, Annual Report 2006, p 33 Back

41   Northern Rock, Annual Report 2006, p 33 Back

42   Northern Rock Foundation, Accounts of the Trustees, p 6 Back

43   Northern Rock Foundation, Accounts of the Trustees, p 7 Back

44   Qq 716-717, Northern Rock, Annual Report 2006, p 93 Back

45   Northern Rock Annual Report 1998, p 25 Back

46   Northern Rock Annual Report 1998, p 31 Back

47   Northern Rock Annual Report 2006, p 59 Back

48   Q 684 Back

49   FTSE Press Release, 'FTSE confirms Regular Reshuffle',12 September 2001 Back

50   Northern Rock, Community Report 2006 p 9 Back

51   Northern Rock, Annual Report 2006 p 82 Back

52   Q 423 Back

53   Q 424 Back

54   Q 393 Back

55   Q 195 Back

56   Q 1696 Back

57   Q 524 Back

58   Q 694 Back

59   Ev 223 Back

60   Q 524 Back

61   Bank of England, 'Proposals to modify the measurement of broad money in the United Kingdom: a user consultation' Stephen Burgess and Norbert Janssen, Quarterly Bulletin, Q3 2007, pp 409, 411  Back

62   Q 516 Back

63   Northern Rock Annual Report 1998, p 48 Back

64   Northern Rock Annual Report 2006, p 91 Back

65   Alliance & Leicester 2006 Annual Report and Accounts, page 49 and Bradford and Bingley 2006 Annual Report and Accounts, page 43 Back

66   Q 401 Back

67   Q 244 Back

68   Q 749 Back

69   Q 854 Back

70   Q 445 Back

71   Qq 465-471 Back

72   Q 37 Back

73   Qq 412-413 Back

74   Q 427 Back

75   Qq 690-692 Back

76   Q 447 Back

77   Q 491 Back

78   Q 463 Back

79   Q 429 Back

80   Q 402 Back

81   Q 693 Back

82   Q 656 Back

83   Q 403 Back

84   Q 648, 656 Back

85   Speech by Mervyn King, Governor of the Bank of England at the Northern Ireland Chamber of Commerce and Industry, Belfast on Tuesday 9 October 2007 Back

86   Q 501 Back

87   Ev 232 Back

88   Q 585 Back

89   Q 488 Back

90   Qq 574-575 Back

91   Q 585 Back

92   Q 490 Back

93   Q 529 Back

94   Q 631 Back

95   Q 633 Back

96   Q 650 Back

97   Q 1696 Back

98   Ev 329 Back

99   Q 536 Back

100   Q 536 Back

101   Northern Rock Press Release, 19 October 2007 Back

102   Northern Rock Press Release, 16 November 2007 Back

103   Northern Rock Press Release, 16 November 2007 Back

104   Northern Rock Press Release, 16 November 2007 Back

105   Northern Rock Press Release, 13 December 2007 Back

106   Northern Rock website, Back

107   Q 605 Back

108   Q 744 Back

109   Q 744 Back

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Prepared 26 January 2008