Reflections on the Failure of Northern Rock

As the anniversary of the failure of Northern Rock attracts some media attention it prompts us to reflect on the lessons this example holds for directors. A local councillor reflected on the crisis at the bank, saying, "Nobody saw this coming".

The real question is why not? 

Consider this: Northern Rock had a distinctly different funding model from a traditional mortgage lender, they did not reply on deposits to expand their mortgage book, but the wholesale money markets. This was a strategic choice. No doubt this strategic choice carried some apparent advantages - possibly lower financing costs and more rapid growth among them. 

But inevitably this choice also carried distinct risks from the traditional model. The board should have also been asking "What if the wholesale market fails - what does that do to us?" The point is not that such an event is unlikely or improbable; the point is that had anyone asked that question the consequences to Northern Rock would have become very apparent.

The second follow up question the board should have asked is "What set of circumstances might lead to a failure in the wholesale market?" and having considered these it should then have asked "what tell-tales signs and signals can we monitor that would give us some warning that these set of circumstances are, in fact, happening?" Finally they should have asked "If we see the signs that this event is happening, how much time will we have to react?." 

These questions illustrate the fundamental difference in the nature of strategic risk compared with quantifiable and transferable risks. The existential threats that arise from strategic risks are rarely, if ever, amenable to quantification and cannot be transferred. 

Governing strategic risk is a fundamental accountability of the board. Only by asking the right questions and adopting the right tools to answer them can boards and directors avoid the familiarity with imperfect information that creates the blindspots that "nobody can see coming".

The board of Northern Rock was blind to the risk of a failure in the wholesale market. Probably they thought it so improbable that it was not worth consideration. But improbable is not the same as impossible.

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