The effects of the financial Crises on the banking industry and an evaluation of the measures for resolving the crises

Using evidence from the Great Depression and several other banking crises, Hoggarth and Reidhill (2003) concluded that banking crises can have a long term dramatic effect on the economy if left unresolved but the scale and character of any intervention should have as its prime objective to keep fiscal costs minimal and to prevent any future moral hazard. Moral Hazard in this case refers to the risk that bankers who are aware of the governments unwavering commitment to crop up dying banks may take too much unnecessary risk since they have a 'guarantee' that their banks will never go burst. This section discusses the effects of the recent 2007-2009 global financial crises on the banking industry. It further evaluates some of the measures put in place by the UK and US governments to alleviate the crises. At every point Hoggarth and Reidhill's 2003 conclusion will be my point of reference as I evaluate the Fiscal Cost and Moral Hazard issues related with the resolution of the crises. Finally, I will also discuss other view points and make recommendations on how the crises could have been tackled more effectively.

The United Kingdom and United States economies were the largest hit and probably the most affected by the crises. It is worth bearing in mind that even though this crisis began in the financial sector and real estate sectors of these economies, it rapidly spread to the manufacturing and retail sectors. Without much notice every sector of the economy had been affected by the downturn. A vicious cycle quickly develops where as companies lack credit, they slow manufacturing and layoff workers leading to high unemployment rates. As unemployment increases and consumer credit and purchasing power drops, the demand for goods and services plummets and the entire economy is further hit. At the end of the cycle, the main cause of the demise is soon forgotten and the problem actually becomes one of scepticism and mistrust widely termed consumer confidence and/or investor confidence.

It is popular opinion that such a crisis should not be left unresolved by country authorities even though it is caused by individual businesses and public companies. After all, a rapid decline in business profits and an increasing rate unemployment means a plunge in the state's tax revenue, a hike in unemployment benefit payouts, an increase in government debt and the crumbling of the economy. Politicians are therefore faced with the dilemma of whether or not to interfere with the free market economy, taking actions that will have serious implications on management and investor behaviour and spending public money to save private investors. As dreadful as this may sound, there appears to be no other viable way to resolve a banking crisis.

Banks in particular, are generally not stand alone institutions. One view point to resolving a banking crisis amidst a recession emphasises that any measures designed to ensure that banks survive in a sustainable way will be aimed at reviving and supporting bank stakeholders (Customers and investors). This view point advocates that the best way of resolving the crisis is by allowing more money in the pockets of households and companies, encouraging lending, reducing taxes, recapitalising and supporting banks and increasing consumer confidence in the financial system.


The UK bank Bailout Plan Summarised

The government continuously emphasized that these measures were not designed to protect banks but to protect the public from the failing banks

Northern Rock, one of the major mortgage lenders in the UK was the first casualty of the crises. The UK governments initial response (17 September 2007) response to the Northern Rock crises was to Guarantee all retail savings and certain wholesale liabilities of this bank. Their demise was attributed to the fact that they pursued a very risky business model that was solely or overly reliant on wholesale funding. Once the wholesale market crashed, they were bound to suffer from lack of liquidity.

By February 2008 the bank was taken into temporary public ownership. The government further strengthen the bank by converting some government debt into equity. The bank further pursued a rigorous restructuring program to make it more nibbler and ready for private ownership.

The FSA on September 28, 2008, realised the Bradford and Bingley was insolvent as it could not meet its credit commitments. Its demise was inevitable as it was heavily reliant on Buy-to-Let and Self-Certified Mortgages which are very vulnerable to an increase in the rate of arrears which is a characteristic of economic downturns.

The governments approach was to transfer its retail deposit business and branch network to Abbey National while nationalising its mortgage arm, personal loan arm, headquarters & staff, wholesale liabilities and treasury assets

The deterioration of the London Interbank Wholesale markets that resulted from the collapse of Lehmann Brothers had pushed HBOS into a very uncomfortable position. The risk of operating as a going concern became very high for HBOS as its source of finance became uncertain over night. This situation led to the Lloyds TSB and HBOS merger.

There is however much controversy on the motivations of Lloyds TSB to engage in such a merger. Many argue that its takeover of HBOS was a political rather than economic decision. The main criticism has been that proper or sufficient due diligence was not conducted before the takeover. The immediate consequence was the huge loss recorded by HBOS in 2008 of £10,825million whereas Lloyds TSB recorded a profit of £807million in the same period.

Again the merger was criticized on the grounds that competition rules were neglected. The new banking group, Lloyds Banking Group, is too big and thus transforms the UK banking system into an oligopoly.

Aside from the unique support provided to individual banks, the government on 8 October 2008 introduced certain measures to guarantee the stability of the UK's financial system and to protect savers, depositors, borrowers and businesses. The government's approach was based on the issues which it identified as the root causes of the crises; LIQUIDITY, CAPITAL and FUNDING.

A Special Liquidity Scheme (SLS) was introduced which housed £200Billion provided by the Bank of England. These funds were set aside to provide short term liquidity to financial institutions by swapping their illiquid assets (especially mortgaged backed securities) for highly liquid treasury bills.

The government also created the Bank Recapitalisation Fund which provided an alternative source of capital for banks with weakened balanced sheets. To ensure solvency, banks were required to maintain a higher tier 1 capital ratio in excess of 9% well above the international average. RBS for example, announced a 15Billion Capital raising program, offering ordinary shares underwritten by HM Treasury. Only 0.24% of the shares were taken up by the public leaving the HM Treasury to own over 58% of RBS. The HM Treasury further purchased 5Billion worth of Preference Shares which were subsequently converted to ordinary equity further strengthening the bank. The Lloyds Banking Group was able to obtain 17Billion worth of Capital from HM Treasury taking its holding interest in the group to 65%.

The Credit Guarantee Scheme was designed and introduced in a bid to tackle the funding problem. This scheme which exposed the tax payer to the tune of £250Billion was designed to unclog the interbank lending market by guaranteeing to refinance maturing debt of participating financial institutions.

In January 2009, after a persistence of the Crisis, the government introduced new measures and further extended existing measures in a bid to resolving the crises. Most notably the government introduced the Asset Protection Scheme wherein, in exchange for a fee, the government will provide participating institutions with protection against any future credit losses above a certain threshold on one or more portfolios of assets. RBS and Lloyds TSB were the first two banks to register for this scheme and they have been protected to the tune of £585Billion of assets. The two conditions imposed on participating banks were as regards lending and staff remuneration.

The downside of this bailout plan is that these actions may result in future moral hazard. As Hoggarth and Reidhill (2003) noted, if any protection offered to banks in a crisis is greater than they expected, this could increase their risk taking in the future. There therefore appears to be a trade off between maintaining today's financial stability and jeopardizing future financial stability. The issue of preventing future Moral Hazard has been the main concern of politicians as they design new fiscal and monetary policies to support banks in the recession. The fiscal costs associated with support packages cannot be underestimated. This huge national debt may stifle future growth and development and deprive future generations from the luxuries of affordable health, education, transport and communication infrastructure the nation enjoys today.

The government has bought into several high profile companies. Even though the government has every intension of privatising these institutions in the future one can never be too certain how long this will take. The government's interest of tightening financial regulations has taken only a subtle approach. This has mainly been through imposing terms and conditions before bailing out companies. The major area of interest has been through reducing bank bonus payouts & compensation schemes and re evaluating bank risk taking. The government has also used its position to encourage lending to companies and individuals. Other issues such as the role and functioning of credit rating agencies, mark-to-market valuations, securitisation, lending etc that were at the centre of the crises have received less attention to date. These issues have to be resolved on a global scale to ensure that institutions and countries can still remain competitive even with more stringent regulation.


The US Bank Bailout Plan Summarised – Troubled Asset Relief Program

In the case of the United States, the approach was similar. The government started by instituting a $700Billion bailout package designed to buy up bad assets from banks and in so doing recapitalise and make them stronger. The bill was supported by both the republican and the democratic political parties. The program was termed the Troubled Asset Relief Program (TARP). The program allowed the treasury to purchase illiquid, difficult-to-value assets including Collaterized Debt Obligations (CDO) from financial institutions, thereby providing them with liquidity, strengthening their balance sheets and stabilising the economy as a whole.

As Stiglitz (2009) testified the trouble with the program is that the government had assumed wrongly that the major issues that needed to be addressed was the lack of confidence and the absence of liquidity for banks. In his (Stiglitz, 2009) opinion, financial institution suffered from insolvency not illiquidity and thus merely pumping funds into such corporations might be a waste of tax payers funds. The government approach also left much room for future moral hazard. He advocated that investors and management should be punished just enough to prevent future moral hazard while supporting the banks to prevent long term economic instability.

It is worth noting that the bailout plans both in the UK and US have been designed to allow Tax payers to benefit immensely once the economy recovers.


Political views to the Resolution Strategies

The strategies and measures used in reviving banks were designed and instituted by decision makers with a political agenda. Through out the crises, different political parties advocated the use of contrasting measures to resolve the situation. One thing that both countries (UK and US) had in common was the fierce opposition and criticism of the measures that were proposed to resolve the crises. This however appears to be a political rather than an economic debate. The UK Opposition Parties for example have heavily criticized the heavy fiscal spending, the Lloyds TSB and HBOS merger, the tax cuts and the nationalisation of banks. These critics have however provided no viable solution to resolving the crises. Most strategies employed in resolving the current crises are academically sound but have never been tested to such an extent. The results although might not be felt today will certainly have a long term impact on the economy. One can therefore expect that some strategies will seem wasteful at first sight but must not be criticized on the grounds that their impact was not immediately felt. The main concern has been the astronomical rise in the national debt since the onset of the crises. Supporters have argued that without the fiscal stimulus the situation could have been a lot worse. Without the benefit of hindsight, it is difficult to evaluate if the fiscal spending is worthwhile.


Recommendations and evaluation of other view points

As a direct consequence of the subprime mortgage crisis, companies were unable to meet their immediate debt commitment (an indication of insolvency). Prominent economists such as Stiglitz (2009) and Sachs (2009) who were called to testify before the US congress proposed that the best way of resolving the insolvency issues, credit market liquidity problems and restore confidence in the financial system was to restructure corporate debt by converting debt into equity- Debt-for-Equity Swaps or Bondholder Haircuts. This conversion reduces the institutions' commitments while increasing its equity. Again, the problem of future moral hazard and the fiscal cost of a massive cash injection are mitigated. Ultimately, investors rather than tax payers will be punished for their bad investment decisions.

Many will agree that the cheapest way of resolving a banking crisis is to prevent it in the first place. The government decided to stand behind many banks because they were considered 'too big to fail'. This sends a message to management that the best way of ensuring future sustainability is by attaining a size that matters to the government. Financial crisis and the failure of banks is not uncommon in these countries. Caprio and Klingebiel (2003) recorded 168 cases of systemic and non-systemic banking crises in both developed and emerging economies since 1970. The government must therefore be proactive rather than reactive in its prevention and resolution of crises of such a nature. Stiglitz (2009) emphasises that markets only work well when there are well designed incentives, a high level of transparency and effective competition. All three of these are absent in the American financial markets and many other leading markets. He realises that incentives are important but when they are poorly structure, they will encourage distorted behaviour. Today's incentive structure encourages short-sightedness and unruly risk taking.

Stiglitz (2009) testified that the lack of transparency in financial markets played a key role in kick-starting the crisis. Information asymmetry was largely common as financial institutions hide assets and commitments in the form of off-balance sheet elements. The boom in the complicated world of over the counter derivatives did not help to solve the problem. To create and/or restore consumer confidence and to ensure long term sustainable stability in financial markets transparency and simplicity in reporting must thus be advocated.

The third dimension was the absence of effective competition as stated by Stiglitz (2009). Banks and other financial institutions have become so big and have attained the status of 'too big to fail'. Management is aware that a failure of their banks will mean the collapse of the entire economy and this motivates them to engage in the practice of excessive risk taking. The worse that can happen is that the Government backed by the tax payer will run to their aid in case of any misfortunes. If a future crisis is to be prevented these mega institutions must be broken down into smaller, nimble and more manageable institutions. This will allow for effective competition which will advocate for good management and prudence.

Reidhill and Hoggarth (2003) advocate that private sector solutions such as asking existing shareholders to increase their capital contribution are more preferable to public sector solutions. The advantage here is that this method attempts to keep the bank solvent while punishing those who have the most to benefit from it. A take over by a stronger bank will also punish incumbent management and shareholders.

Reidhill and Hoggarth (2003) also propose that in a case where the government has no choice but to crop up such institutions, strict losses should be imposed on management and shareholders. This could be in the form of restrictions to severance payments for failed managers, banning failed managers from taking further work in public companies, imposing losses on uninsured creditors etc. These methods have the potential of reducing the immediate fiscal costs of resolving the crisis while discouraging long term unproductive behaviour.

As proposed by Reidhill and Hoggarth (2003), the design of deposit protection schemes may be used in preventing moral hazard. Limited protection schemes[1] will ensure that smaller depositors[2] are fully protected while larger depositors such as other banks are still exposed. These bigger depositors have a higher monitoring ability on banks. This supports the findings of Hoggarth, Jackson and Nier (2003) and Caprio and Levine (2001) that schemes with unlimited protection or a generous deposit insurance are more highly associated with banking crises.

Once a crisis has started the speed of resolution becomes an important factor. A delayance in the restructuring process may give decision makers enough time to carefully analyse the situation and put through an appropriate and full proof resolution package. A poorly devised strategy may only lead to a higher fiscal cost with little or no results. If the intervention is too little its impact might rather be negative thereby increasing the depth of the crises. If it is too much, the current fiscal cost and the future moral hazard might be too great for the nation to bear. Research by the OECD (2002) and Dziobek & Pazarbasioglu (1997) however concluded that prompt intervention (intervention within one year of the onset of the crisis) reduces the fiscal cost of intervention and increases the efficiency of the intervention process. This therefore means that the government should not be too quick to respond but should not allow the situation to deteriorate before it intervenes.

For so long supporters of the concept of market efficient have argued that financial markets are self regulatory. It is widely accepted that politicians lack the expertise to pass suitable laws that will adequately regulate the market yet allow for innovation, growth, stability and global competitiveness. The assumption of self regulation was centred on the role of rating agencies and on the concept of mark-to-market valuations (De Grauwe, 2008). Rating agencies however suffered from a conflict of interest as they advised financial institutions on which products to create then later rated the riskiness of these products. Mark-to-market valuation rules were responsible for the recording of exorbitant profit margins during the boom and the massive write downs that were experienced during the gloom. The market has therefore failed to regulate itself and thus the government should take full responsibility for market regulation.

Another somewhat pro-traditional or conservative proposal has been made by De Grauwe (2008). He argues that today's risk assessment and mitigation procedures are solely based on the assumption that stock markets are efficient. He finds that the Basel Approach to stabilising the banking system or the practice of setting capital ratios for universal banks is inherently flawed as these ratios are based on the assumption of market efficiency. The assumption of 'efficient markets' helps management to mathematically compute the level of risks their banks take at any one time. De Grauwe (2008) shows that the risks that matter for universal banks are tailed risks associated with bubbles and crashes and not systematic and unsystematic risks proposed by the theory of market efficiency. These risks (Tailed Risks) cannot be computed and mitigated by the use of appropriate capital ratios. The only way forward i.e. the mitigation of future bubbles and crashes, is a return to the Glass-Steagall Act approach (De Grauwe, 2008). This approach advocates for narrow banking where bank activities are restricted and universal banks are non existent. Investment banks must be totally separate from commercial banks i.e. banks that collect depositors' funds cannot invest in equities, derivatives or complex structured products. Investment banks must therefore raise funds from investors and not savers. This proposition means the end of the practice of securitisation which played a contributory role to the global financial crises of 2007-2009. Securitisation in itself leads to the build up of huge credit mount linking banks, institutions and individuals. Although it may seem like a transfer of risk in the first instance, these liabilities quickly reappear on the originators balance sheet once there is a default in the chain. The risk of the whole process is always absorbed by the central bank which acts as a 'lender of last resort'. This approach has been heavily criticized by firms such as RBS and Barclays. The Bank Of England Governor, Melvin King, acknowledged the advantages of the Glass-Steagall approach but did not think the practice was sustainable. Others argued that non-hybrid retail banks such as Northern Rock and Bradford & Bingley and Investments Banks such as Bear Stearns, Merrill Lynch, Morgan Stanley and Goldman Sachs had suffered more than Universal Banks such as HSBC and Standard Chartered Bank. Even though there is a huge potential for conflict of interest in these Universal Banks, the synergies obtained from housing the different arms under one roof are very significant. None the less, the approach seems to be useful if it is applied in a global scale otherwise UK banks will become uncompetitive in the global banking market.


Bibliography

Treasury Committee, House of Commons (2009), Banking Crisis: Dealing with the future of UK Banks, Seventh Report of Session 2008-2009

Grauwe D P (2008), The banking Crisis; Causes, Consequences and Remedies, Centre for European Plolicy Studies CEPS, No 178

Reidhill J. and Hoggart G. (2003) Resolution of Banking Crisis; A review, Financial Stability Review

Caprio, G., and Klingebiel, D., (2003). Episodes of systemic and borderline financial crises. World Bank Database.

Dziobek, C., and Pazarbasioglu, C., (1997). Lessons From Systemic Bank Restructuring: A Survey Of 24 Countries. IMF Working Paper 97/161.

Hoggarth, G., Jackson, P., and Nier, E., (2003). Banking Crises and The Design Of The Safety Net. Paper Presented At The Ninth Dubrovnik Economic Conference,

Dubrovnik, 26–28 June 2003.

OECD, (2002). Experience With The Resolution Of Weak Financial Institutions In The OECD Area. June. Chapter IV. Financial Market Trends, No. 82.

Stiglitz J.E. (2009). Testimony Before The Congressional Oversight Panel Regulatory Reform Hearing, US Congress


[1] schemes that protect depositors up to a certain maximum amount

[2] Household and Small and Medium Size enterprises

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