Handle Northern Rock with care
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The government and Northern Rock recently set out how the lender is expected to develop in the next few years. The central proposal is that it should be split into two parts towards the end of this year.
A new banking arm would hold deposits and some of the lender's existing mortgages, and carry out new lending while an asset arm would hold the rest of the mortgages - those of lower quality - and be responsible for repaying outstanding elements of the government's loan.
Of course, the good bank, bad bank strategy is well known throughout the lending world as a way of dealing with poor quality assets held by failed banks during a period of recovery.
These ideas for Northern Rock were conveyed to the European Commission in June to allow it to assess whether they break European state aid rules.
We have also provided a commentary to the EC on the proposals, critical of the advantages the proposed banking arm might enjoy. In our submission we make the point that the restructure would give such an advantage to the institution that it would be likely to be viable in the medium to long term. But the limits imposed by Northern Rock's competitive framework are unlikely to be effective in reducing the negative effects on other private sector competitors such as societies.
There's a danger that the banking arm will be able to aggressively expand its mortgage lending because it will have a clean balance sheet and a large amount of funds.
This is despite the fact that North- ern Rock's tier 1 capital had fallen to -£110m by the end of 2008. Obviously, the lender's capital base is significantly below the minimum regulatory capital requirement even allowing for the waiver granted by the Financial Services Authority, enabling it to include all available tier 2 capital within its capital resources. This is not an option open to mutuals.
It seems likely that the banking arm will fund the additional lending that the lender has announced, predominantly if not entirely by retail savings.
The banking arm would hold about £20bn in retail savings balances - a target attained much more rapidly than expected.
In a business plan published in March 2008 Northern Rock said it intended to boost its retail balances from £10bn at the end of 2007 to £15bn at the end of 2009 and £20bn by 2011.
But because of the government guarantee covering deposits with the lender at a time of heightened consumer uncertainty balances grew to nearly £20bn by the end of 2008 - three years ahead of schedule.
This is a good example of a distortion in the market created by Northern Rock's present position.
And in October 2008 the lender had to withdraw a number of savings products and cut interest rates on other accounts so as not to reach 1.5% share of UK retail balances.
Northern Rock's commitment not to offer top-three savings rates or refer to the government guarantee in its marketing literature seem to have been ineffective in preventing at least a short-term distortion of the savings market.
We believe that the state guarantee covering deposits with Northern Rock should be removed as soon as possible. It will be particularly difficult to justify if the banking arm is established as a strongly capitalised bank freed from the majority of Northern Rock's loss-making assets.
The commitment that the lender will remain outside the top three savings accounts in the best buy tables should be reapplied until the state guarantee covering deposits is removed. If there are perceived to be financial stability dangers from the removal of that guarantee it is essential that its pricing should be credibly marked to market.
In the mortgage market it is particularly important that Northern Rock's lending does not harm the private sector's capacity to lend.
We have suggested that as long as it enjoys any semblance of state support it should operate in those areas of the mortgage market that purely private sector institutions find it difficult to support, such as first-time buyers and high LTV deals. The conflicting pressures on the government are appreciated by societies. They know it simultaneously wishes to maximise taxpayer return, revitalise the mortgage market, reduce guarantees for savers and give other lenders a far crack of the whip.
These objectives are not easily compatible but societies find it galling that an institution that was run in such an imprudent manner in the run-up to the recession that it required a state bailout could return to compete unfairly with lenders that ran themselves more prudently, did not require taxpayer support and, broadly speaking, sorted out their own difficulties.
Source:
Lending Strategy
