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Macroeconomic Factors And Stability Of The Banking System Finance Essay

The current global economic crisis has lead to an increasing clamor for the study of macroeconomic factors that affect the stability of the banking system. Many governments pursue autonomous financial, microeconomic and monetary stability policies. The relationship is termed as a procyclicality of banks’ operations. Scholars have always pinpointed that the status of macroeconomic conditions are the predominant causes that determines the state of health of banks. Researchers have always aimed to determine the extent of how macroeconomic factors impacts a banks’ performance. Many studies have been made on the procyclicality of banks including the measurement of how banks affect the macroeconomy as well. Research has shown the cyclical fluctuations of banks are indeed directly proportional and distinctly procyclical. It is important to note that how banks reacts to macroeconomic factors do not have models but rather the analysis is based only on shortened analysis of the relationship between micro and macro variables (Bikker & all, 86).

Studies emphasize on the used of regressors to study bank behavior often placing estimates on macroeconomic conditions. There is little research done on how macroeconomic uncertainty impacts banking behavior. Few studies are made on understanding of other macroeconomic variables. Thus the study of the cyclical relationship is limited since few efforts are made in order to determine how the management of banks reacts and changes to the macroeconomic conditions. Furthermore there is less review of the impact of macroeconomic uncertainty. This paper is an effort to contribute to lack of study in these areas. The goal of this paper will study the factors that affect how the management of banks determine whether to invest in risky loans and risk-free assets. This paper will evaluate if macroeconomic uncertainty affects how banks choose between the said two through the use of Baum & all’s portfolio model. This model links how banks manage their portfolio between of loans versus uncertainty. In particular, this paper will evaluate how United Kingdom’s banks decide between risk-free assets and loans during higher levels of macroeconomic uncertainty. This paper hopes to deliver a better understanding of the model used as a reliable point of reference. This paper will further highlight the significance of the study of idiosyncratic factors that impact how banks make their portfolio management decision. This paper will add to the many studies made on the cyclical relationship of macroeconomic factors and bank operations. This paper will also test whether the model is valid using varying degrees of aggregation. The final result of this paper will confirm that macroeconomic uncertainty have indeed impacted United Kingdom’s bank performance in relation to its portfolio management decisions. In higher levels of uncertainty banks have a tendency to react narcissistically by protecting itself through a decrease of loan-to-asset ratio across all operations. The study of the idiosyncratic uncertainty will help banks make informed decisions in terms of portfolio management decisions, allowing banks to hedge over uncertainties in a volatile market (Pesola, 6). This paper includes a literature review and methodology.

II. Literature Review

Many studies have been made that links macroeconomic factors to the performance of banks. However, a wide array of these researches does not evaluate the impact caused by macroeconomic uncertainty. A great emphasis has been made on the empirical effect of macroeconomic factors on the balance sheets of banks. During a economic crises the percentage of bad loans increases creating losses for banks while bull markets illustrate a greater liquidity and subsequently banks increase their lending activities. In the study of banks in the United Kingdom, it has become prevalent that the rate of losses in loan activities is greater when macroeconomic uncertainty abounds. There is a direct link between lower Gross Domestic Product rates and higher levels of bad loans amongst corporations and individuals, which inherently has caused the current banking financial crises. Researchers study geographical activities of bank proving that small macroeconomic variables allow for accurate forecasting of bad loans such as the case of the United States banking sector. In a study made in the economy of the United Kingdom this is also prevalent as a slower economy increases bank losses in loan activity. (Hoggarth & all, 282)

A gap exists in the study of macroeconomic uncertainty versus the bank management decisions. The glaring disparity gap fails to emphasize the role of banks in macroeconomic conditions since banks themselves are a large industry significantly impacting the health of the economy as a whole. In Baum & all’s model he gave an extensive review of banks in the United States. This can be used as well to study the performance of United Kingdom’s banks. In his research as macroeconomic uncertainty increases in rate, banks react by contracting loan activity this negatively affects the bank’s decision making failing to realize opportunity investments in the long run. This negatively affects a bank’s performance has uncertainty forces banks to rebalance their sheets based on incorrect credit market signals. This results in a poor allocation of a bank’s financial resources. In this type of scenario banks place increased protective measures contributing to narcissistic behavior. Baum & all’s study includes the analysis of many macroeconomic variables and through a thorough analysis of the bank’s balance sheet. This behavior is not unique to the United States because many studies have shown this is a global behavior of banks. Many studies indicate that the higher the macroeconomic uncertainty the more that bank management acts narcissistically and protectively through the decreasing of its loan to asset ratio (Baum & all, 521).

Baum, Caglayan and Ozkan’s study shows that there is a way for banks to maximize itself during macroeconomic uncertainty. Their study suggests that in levels of fluctuating macroeconomic uncertainty its is best for the company to invest periodically in loans and bonds. The suggestion to invest in bonds is mainly because these are mainly risk-free other than carrying the risk of possible default of governments. However, in all likelihood bond investing is predictable which is a necessary factor in bank performance. It is also necessary for banks to be able to manage its risks in order to hedge adverse market conditions. The second suggestion is for banks to invest in loans allowing itself to open up to market and default risk. The default risk is a idiosyncratic variable however a bank does need to provide loans in order to profit. As such, loans will enable banks to perform better however, it is in this way that banks expose themselves to macroeconomic uncertainties. Many studies have shown that an economic crisis increases the rate of corporations and individuals to discontinue loan payments (Baum & all, 521).

The Bank of the United Kingdom receives accounting data from all banks and financial institutions. In the 1990’s, the country experienced a liberalizations of its credit market and subsequent competitive incentives were given by the central bank to improve market conditions. During the same period the security bonding was yielding smaller interest rates as a result many banks continuously had less profit in the bond market. In terms of measuring macroeconomic uncertainty two methods can be applied such as the use of a survey based approach and a model based approach. The first will measure the cross section dispersion forecast and the latter measures the time conditional volatility (Beaudry & all, 3).

A survey approach does an analysis of which macroeconomic variables are relevant and measures uncertainty as the dispersion of expectations, which is only an estimate or educated guess. In cases of making accurate forecast past data is used which makes this approach limited since it does not give an accurate figure of the level of uncertainty. A model based approach uses realized values of macroeconomic variables to get a statistical value of variability. The most commonly used model to make such estimations is the GARCH model wherein the conditional variance of a variable is estimated. However, even if this model is widely used many scholars have argued that this actually measures volatility instead of uncertainty. The model based approach calculates how much of the volatility affects the final outcome and measures volatility equal to uncertainty (Grier & all, 1).

The current performance of United Kingdom’s banks indicates how it has been impacted by macroeconomic uncertainty. This has lead the government to intervene with the implementation of the Asset Protection Scheme in January of 2009. The scheme will assists banks to rebalance their internal sheets in order to increase lending activity for corporations and individuals. The main challenge that United Kingdom’s banks are facing today is the crises of confidence in wake of a global financial crises. This has lead to decreased perception value on the abilities of United Kingdom’s banks to manage their own assets. The behavior of United Kingdom’s banks is the continuance to hold cash by limiting the supply of loans and mortgages to the public in order to protect its balance sheets. Many of the country’s largest financial centers are eligible for the Asset Protection Scheme including Barclays and Hong Kong and Shanghai Banking Corporation. However, both did not do so because both have larger assets and stable balance sheets so far. Both have less bad debt exposure and the sentiment is that neither would like an intervention from the United Kingdom government equity. In the mean time, Royal Bank of Scotland and Lloyds Group have both agreed to the Asset Protection Scheme. The scheme will lead both banks to pay tax fees for their participation. Under the scheme, both will be legally complied to increase lending to corporations and individuals to better help the ailing economy. Both banks were not liquid enough internally to hedge the current global financial crises. Both tried to raise capital but were unable to do so, making it necessary for both banks to apply for the Asset Protection Scheme. It is in the hopes the through the government’s intervention both banks can work in rebuilding their balance sheets through the infusion of new capital and increase lending activity (Kaufman, 2009).

The government intervention for banks is occurring globally as it has been necessary for them to save these banks from bankruptcy in order to save their internal economies as well. However, as other countries have improved significantly, United Kingdom’s banks continue to suffer from macroeconomic uncertainty. The European Commission has also demanded that the Royal Bank of Scotland and Lloyds Group to continue to open branches nation wide in order to maintain a competitive banking environment in the United Kingdom. The Royal Bank of Scotland will in turn issue more than twenty five billion pounds of shares to the United Kingdom government. As a result the reputation of the Royal Bank of Scotland has suffered immensely because of the large figures included in the bail out. The bank is also required to sell more than three hundred of its branches costing about fifteen percent of its operational facilities. The total bail out amount is more than two hundred eighty billion pounds. This will give the United Kingdom government more than eighty percent stake at the company. Furthermore, the government will provide an additional contingent funding of eight billion pounds. The scheme will require the Royal Bank of Scotland to pay taxpayers a fee of point seven billion pounds for the initial three years. The bank will also increase its network in England, Wales and Scotland to accommodate loan activities for small to medium enterprises as mandated by the European Commission. The bank will also sell its insurance branch and global merchant serves. The scheme will help the bank most especially in the first four years as it will hope to increase value by increasing customer sales and profits from initial public offerings (Kaufman, 2009).

The Lloyds Group also has to do the same procedure which means they will to sell six hundred of its branches. The bank will receive nearly six billion pounds from the scheme. Lloyds Group will also have to sell most of its assets in four years. The bank initially agreed to get more than two hundred six billion pounds from the scheme but the bank has expressed a desire to exit early, which means they will have to pay another fee of two point five billion pounds to the United Kingdom government. Analysts agree that Lloyds Group fares better than Royal Bank of Scotland as it is more likely to earn profits from selling its assets such as

Cheltenham & Gloucester, Lloyds TSB Scotland and Intelligent Finance (Kaufman, 2009).

Most notably, both of the bank’s employees and to management will not receive any bonuses since applying for the scheme as a way to show their commitment to their long-term goals. Both banks are required to increase lending activity by as much as thirty nine billion pounds. The manner in which the government is acting forcing the cyclical relationship of banking operations demonstrates how macroeconomic uncertainty determines bank performance. In this scheme, the benefits can only be computed regressively and the manner in which the government valued the uncertainties is unknown. In the wider scheme of things, governments want banks to increase loans to make the economy more viable and competitive. This scenario also as the government views it a better management of risks. In the banking side however, the same narcissistic behavior prevails as the continually choose to withhold cash. The rate of success of these moves is yet to be determined but more importantly the question remains are the United Kingdom’s banks making informed decisions in calculating and assessing the manner in which it conducts itself versus macroeconomic uncertainty (Carruth & all, 2).

This paper will use Baum, Caglayan and Ozkan’s model to determine the gap between macroeconomic uncertainty versus the bank management decisions. This paper will also use the model’s based approach to calculate macroeconomic uncertainty and further studies will be made on the idiosyncratic factors that impact bank’s portfolio management decision. The results of both will help achieve said objectives. This paper will also evaluate the role of the United Kingdom government relative to the procyclical relationship of bank operations.

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