Did the Market Signal Impending Problems at Northern Rock? An Analysis of Four Financial Instruments


  • Previous versions of this paper have been presented at research seminars at Imperial College London, May 2008, the IBEFA session on NR, WEAI 83rd Annual Conference, June 2008 and the EFMA Symposium on Risk Management in Financial Institutions, April 2009. The authors would like to thank discussants and attendees for their constructive comments, which have been incorporated into this version, as well as the anonymous referees.


The academic literature has regularly argued that market discipline can support regulatory authority mechanisms in ensuring banking sector stability. This includes, amongst other things, using forward-looking market prices to identify those credit institutions that are most at risk of failure. The paper's key aim is to analyse whether market investors signalled potential problems at Northern Rock in advance of the bank announcing that it had negotiated emergency lending facilities at the Bank of England in September 2007. A further aim of the paper is to examine the signalling qualities of four financial market instruments (credit default swap spreads, subordinated debt spreads, implied volatility from options prices and equity measures of bank risk) so as to explore both the relative and individual qualities of each. The paper's findings, therefore, contribute to the market discipline literature on using market data to identify bank risk-taking and enhancing supervisory monitoring. Our analysis suggests that private market participants did signal impending financial problems at Northern Rock. These findings lend some empirical support to proposals for the supervisory authorities to use market information more extensively to improve the identification of troubled banks. The paper identifies equities as providing the timeliest and clearest signals of bank condition, whilst structural factors appear to hamper the signalling qualities of subordinated debt spreads and credit default swap spreads. The paper also introduces idiosyncratic implied volatility as a potentially useful early warning metric for supervisory authorities to observe.