Failed Stress Tests…in 2004

From the Financial Times:

Northern Rock risk revealed in 2004

By Norma Cohen and Chris Giles

Published: May 30 2009 00:03 | Last updated: May 30 2009 00:03

Banking regulators identified Northern Rock as the weak link in Britain’s banking system during secret “war games” held as long ago as 2004, the Financial Times has learned.

The risk simulation planning, conducted by the Financial Services Authority, the Bank of England and the Treasury, made clear the systemic risks posed by Northern Rock’s business model, and its domino effect on HBOS, then the UK’s largest mortgage lender.

The revelation is at odds with the notion that no one could have foreseen the September 2007 collapse of Northern Rock or the subsequent rescue of HBOS, which was sold to Lloyds Bank.

The FT has found the troubled lender and HBOS were at the centre of a 2004 war game that regulators held to test how banks would cope with sudden turmoil in mortgage markets and the withdrawal of the money from foreign banks on which Northern Rock’s business model relied.

Regulators chose that scenario because they were worried about the growing dependency of banks such as Northern Rock and HBOS on such funds rather than on stable retail deposits.

Even though the exercise revealed the banks’ vulnerability, the regulators concluded they could not force the lenders to change their practices, according to several people familiar with the matter.

It was felt that it was too hard to say Northern Rock’s business model was excessively risky, and in any case banks following that strategy were profitable and growing, though the Bank did warn of the growth in wholesale deposits repeatedly in its financial stability reports. However, as wholesale lending markets dried up in mid-2007, the war game’s findings proved eerily prescient.

Both banks sustained irreparable damage beginning in 2007 as wholesale lending markets seized up and mortgage-backed securities became unsaleable.

Regulators on Friday confirmed that Northern Rock and HBOS were central to the war game. But spokespeople for the FSA and the Bank of England said the exercise was focused on uncovering weak regulatory practices rather than predicting individual bank failure.

Mervyn King, Bank governor, alluded to the war games in a 2005 interview with the FT, saying the Bank had looked at a situation in which “there could be a problem in a particular institution which isn’t terribly big, which may for completely unpredictable reasons turn out to pose a liquidity problem to a very big institution”.

But until now no one has known the name of any banks used in the exercise. The Financial Times sought details in early April under the Freedom of Information Act from the Bank and the Treasury, but those requests have so far been unsuccessful.

Copyright The Financial Times Limited 2009

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