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Banking and Finance

Factors Influencing the Financial Institutions in the UK With Particular Reference to Credit Crunch

A Comparative Study between Barclays and Northern Rock Bank

I- Abstract

Banks acts as intermediaries between surplus units depositing funds and investors or individuals seeking capital for investments. Thus, banks role is important in maintaining the flow of fund between these different parties.

Banks like any other profit maximising firms are influenced by various factors that represent risks or opportunities. Therefore, banks business decisions are founded on aspects such as confidence in the market, the level of risks, the state of the economy, and their competitive strength. Regulation is essential for assuring compliance and integrity in the financial system, but rigid rules stifles the dynamicity of the banking industry and the financial sector as whole.

Moreover, Central Bank role as a lender of last resort can rise the issue moral hazard by helping imprudent banks, however because banks are financial intermediaries, the impact of bank failure can have a detrimental effect on the financial system (systemic risk), and also on clients and customers, therefore bank supervision is vital due to their sensitive important role and their extensive impact.

Furthermore, the development of events in the US financial market particularly the high default rate of subprime mortgage market led to a decrease in demand for tradable securities. This has affected confidence in the US and the global financial market, and consequently some financial institutions and banks such as northern rock in the UK faced difficulties in obtaining the necessary funds to maintain the business operation and remain solvent due to lack of short term liquidity. However, other banks faced similar difficulties but are using various methods to improve their balance sheets to overcome the current credit crisis. Moreover, governments and regulatory bodies are all taking the necessary measure to stimulate the market and tackle the core sources of the current credit crisis.

II- Introduction

Sustained economic development is often linked to efficient management of fund that is used to finance investments, which are projected to further create more wealth and opportunities for states, corporate and individual investors. Banks acts as intermediaries between surplus units depositing funds and investors seeking capital for investments. Thus, banks role is fundamental in maintaining the flow of fund between these different parties. Furthermore, the stability of financial and banking system is vital for the sustainability of economic growth and the preserve of investors' confidence. Banks like any other profit maximising firms are influenced by various factors, these includes internal and external factors, which represent risks or advantages.

Therefore, banks decisions are based on elements such as confidence in the market, the measurement and management of risks, the state of the economy, and their competitive power and market share. This study will look onto various factors influencing the financial institutions in the UK, with particular reference to Credit Crunch. This literature will comprise the banks management of risks, the role of authorities regulating and supervising the financial system, and explore the regulation of the banking industry and the financial system as a whole, in addition of the effect of regulation on banks performances.

The analysis will include a comparative study between Barclays and Northern Rock Bank, taking into accounts the differences in their structure, size, as well as their reaction to changes in global financial markets. Furthermore, the Research will examine the fast moving global effect of the credit crunch; discuss the two banks business model, and explore their activities and behaviours. The study will also investigate the two banks high exposure to credit risks arising from risky investments, highlight the consequences of the heavy reliance on money market, and the use of securitisation for liquidity sources.

IV- Methodology

The research objective is to investigate the various factors that influence financial institutions in the UK, notably the banking industry. This research was based mainly on secondary research, the gathered data and information was sufficient for this research topic. However, sensitive data regarding the value of risk were not disclosed in both banks publication, such data is useful for the researcher to scrutinise banks estimation of risk and how realistic are the projections. Nevertheless, information about estimation of risks may be obtained directly from banks for further analysis of this specified area of banks management of risk.

Research material relevant to the topic was collected from various academic sources; this is to explore issues and arguments regarding the regulation and supervision of the banking system. The two banks internet site was used to gather the background information along with the financial statements of the last six years, which were used in the research analysis to perform the comparison between Barclays and Northern Rock bank business strategies and financial performance. Publications from the Bank of England website were collected to study the central bank regulation and the management of the UK banking system, in addition to the historical data regarding interest, LOBOR, and inflation rate changes.

Furthermore, articles from the Financial Services Authority (FSA) were gathered to study the role of the organisation and its contribution in supervising and stabilising the UK financial system. Recent publications from the Bank of International Settlement (BIS) were collected to study the role, the objectives and the effect of Basel directives on banks. Besides research the progress of current Basel II implementation along with the development of new requirements arising from the present credit crunch.

Recent newspaper articles and various other media sources were gathered to collect the latest information regarding the development of the present credit crunch and its effect on banking industry, these includes sources such as BBC business, yahoo finance and the Financial Times website, and follow recent actions of regulators and banks management of the current crisis. Moreover, data from the two banks financial statements was collected to perform the Gap Analysis using Microsoft excel package to conduct a series of calculations.

Other methods could have been used to assess bank risks such as value at risk (VaR) using regression analysis by utilising a computer package such as Microsoft Excel. The regression result will determine the degree of risk that the researched banks possess in their portfolio. However, the banks seldom disclose such sensitive information in published financial statements. This is to avoid adverse reaction by investors and credit rating agencies, which could therefore affect the banks stock prices, their reputation and confidence in the capital market.

V- Literature review (Part I): The nature of banking

The term bank can be applied to a wide range of financial institutions, from large banks to smallest mutually owned building society in the UK. The provision of deposit and loan distinguishes Banks from other financial institutions. Deposits products supply money on demand or following time notice. Deposits are liabilities for banks, thus must be well managed if banks want to make profit.

Similarly, banks manage assets created through lending. Therefore, Banks main activity is being an intermediary between depositors and borrowers. Other non banks financial institutions, such as building societies and stockbrokers, also act as intermediaries; however it is the provision of loans and taking of deposits that distinguishes banks, though many banks provide various other financial services.

1) Management of risks in banking

The fact is that bankers are in the business of managing risk. Pure and simple, that is the business of banking. (Walter Winston, former CEO of Citibank; the Economist, 10 April 1993). Banks, like all profit maximising firms, have to deal with macroeconomic risks, such as recession, inflation level, as well as other micro economic risks including political pressure, commercial breakdown of core customers or suppliers, natural disaster, in addition to the emergence of new competitive threats.

From a finance theory viewpoint, Bank risk management is primarily composed of four main balance sheet risks, which includes liquidity risk, interest rate risk, credit risk, and capital risk (Hempel et al, 1989). Credit risk has been recognised as the principal risk in its effect on bank performance (Sinkey, 1992, p. 279) and bank failure (Spadaford, 1988). The primary reason why the correct management of credit risk is essential is because banks have restricted ability to absorb loan losses. Generally, the ability of a bank to absorb a loan loss is originated firstly from generated income of other profitable loans, and secondly by bank own capital.

2) Factors influencing financial institutions

Banks and other profit maximising firms are influenced by various factors; financial institutions in particular are susceptible to a range of changes that may affect their projected growth. Some of these changes are internal changes, this occurs subsequent to restructuring program that a bank adopt following an expansion strategy such as in mergers and acquisitions or as a defensive strategy to remain competitive and maintain market share and fight competitive predators from acquiring the bank. Moreover, there are other external factors that can influence financial institutions, these includes a county's government monetary policy, the economic condition, the financial stability and the level of confidence in the market, the inflation rate, in addition to other risks such as credit and market risks.

There are a range of risks that a bank may encounter, these includes the followings:

a) Credit risk and counterparty risk: counterparty risk refers to the risks that after the creation of two parties' contract, one party will renege the terms of the contract, while credit risk is the risk that a loan or an asset becomes lost due to default.

b) Liquidity or funding risk: these are similar terms that refer to the risk of shortage of liquidity for maintaining operational commitments, that is the ability for the bank to cover its liabilities at due date. A shortage of sufficient liquid assets is often the trigger of financial distress, as it is increasingly difficult for the bank to obtain funds from the wholesale markets. Thus funding risk is the inability for the bank to maintain its daily operations.

c) Market or price risk: this type of risk refers to the risk linked to over the counter instruments or traded stocks in a non liquid market, such as equities and bonds. Thus if a bank hold these items in its portfolio, then it is vulnerable to market or price risk, this is the risk that the price of these items is unstable, which is caused by systematic (movement of prices in all traded market instruments, for instance due to changes in economic policy) or specific market risks (the movement of a particular instrument is opposite to the rest of similar instruments, for example, this may be caused by unfavourable information about the issuer of that instrument).

d) Interest rate risk: this is similar to price risk, because interest rate is price of money, it represent the opportunity cost of keeping money. This occurs because of interest rate mismatches between assets and liabilities, which differ in volume and maturity arising from the banks performing asset transformation.

e) Capital or gearing risk: because banks are highly leveraged firms, they have to set aside some capital to cover the losses. The size of capital is proportional to the level of risk taken by the banks. Basel risk asset ratio principle requires banks to hold up to 8%.

Besides, settlement or payments risk. This is when one party in the contract deliver assets or makes payment in advance, which creates exposure to potential loss. Furthermore, operational risk refers to risks from human capital, legal risks such as law suits, fraud, and physical capital. While sovereign and political risk refers to the risk that a government default on its debt obligation to a bank. Moreover, financial regulators has identified three main risks linked to banks, these includes market risks such as risks from exchange rates, interest rates, operational risk, commodity and equity prices.

3) The Asset-Liability Management (ALM) technique

Because the fundamental and the primary activity of a bank is intermediation between surplus units that makes deposits and those that seek capital, which acquire fund from the bank, thus this payment system gives the bank the role of intermediation , where the intermediation is key activity, risk management is founded principally on a sound asset liability management (ALM). Furthermore, the ALM is a technique practiced by banks to effectively manage their risks, which was largely utilised by banks in the post war period up to the 1980s.

The ALM method was the main tool used to manage banks books, it is essential that the bank maintain its assets and liabilities under control to minimise risks and remain solvent. Besides, banks are keeping their managers updated with newer techniques and skills to maintain their efficiency and competitiveness for the future, for instance, ALMA is an association that comprise around 40 financial institutions, which are international and local banking groups and building societies, mostly UK and Irish.

However it is growing its membership and links around Europe. Its objective is to offer an informal and inclusive forum regarding the balance sheet management issues (Byrne, J. 2004). Due to the development of banking activities, innovative instrument became increasingly used by banks to manage their assets such as off balance sheet instruments, where banks moved from interest earning income products to non-interest income sources, thus this required that banks risk management should adopt newer techniques other then just the ALM to includes the risks originating from the off balance sheet instruments. Moreover, one of the new methods included in managing market and then credit risks is the Value at Risk (VaR), which involves giving an estimate of losses arising from the volatility of banks assets.

4) Credit Culture

A recent research conducted by the Australian institute of bankers on the issue of "Improving Asset Quality" (Brice, 1992), which focused on the significance of 'credit culture'. The great emphasis on credit culture was due to its influence on bank performance and in some occurrences bank failure ( Spadaford (1988) and Brice (1992)).

Spadaford (1988) stated in his study of 162 bank failures in the United States that the analysis showed that 98% of bank failure occurred due to asset quality problems, among these problems are poor management of loan policy, inadequate systems to ensure compliance with internal rules and procedures, and the lack of supervision on senior and key management members in the organisation.

McKinley (1991) has defined four main cultures that influence bank performance. predominantly the immediate performance-driven, which emphasis on earnings targets, followed by Market share/production-driven that focuses on being the biggest with greater production volume, along with Values-driven that balances between credit quality and generated income. In addition to the Unfocused (current priority-driven) bank, such bank lacks vision and appropriate strategy often set short term targets which consequently lead to unsuccessful ventures.

VI- Literature review (Part II): Banks regulation

The base of regulating financial institutions is founded on three broad frameworks. Primarily, the consumer protection argument, this is based on the notion that investors and depositors cannot be demanded to perform risk assessment of financial institutions they deal with, nor monitor standard of service or performance of these institutions. The consumer protection underlying principle is based on three types of regulation; firstly, compensation schemes created to repay all or part of losses caused by the insolvency of financial institutions; secondly, rules and regulations such as capital adequacy requirements designed to prevent insolvency; and lastly promote fairness in business or market practices by setting rules and standards.

The latter regulation reveals market imperfections arising from principle agent problems, asymmetric information, and the issue of determining the true value of financial products or services, which are established well after the transaction or contract was formed (Dale, R and Wolfe, S. 1998). Furthermore, there are other concerns associated with consumer protection rationale. The provision of compensation to depositors and investors for losses sustained from the insolvency of financial institutions will further encourage these institutions to pursue risky investment decisions, thus there will be minimal or no incentive for prudence.

This indicates that risky firms will be able to attract trade with identical terms and ease as prudent institutions, thus affecting financial market standards and discipline, and rising potential insolvency incidences. Therefore, the resulting losses must be covered by the deposit insurance scheme, investor protection fund, or in some cases by the tax payer.

Thus, prudential controls on financial institutions are essential to minimise losses and to balance the regulatory incentives with the excessive risk-taking.

The third aim of financial regulation is to promote integrity of markets, encompassing various issues such as market manipulation, fraud, transparency, and fairness; market integrity emphasis on organising the market as whole beyond just the relationship between financial firms and their consumers. Supervisors implementing the financial regulation consider systematic risk as the factor that causes great concerns. That is the risk that failure of one or more distressed financial institution could spread and cause a contagion effect, which could cause the collapse of other prudent institutions. It is their vulnerability to the contagion effect that single out financial institutions from other non financial firms.

1) Targets of regulation

The major objectives of Financial regulation is to set guidelines for the activities of Banks, insurance companies, investment firms, exchanges, and fund management companies.

The diverse principles for financial regulation mentioned above vary in their relation to these various institutions of the financial services sector.

Banks are distinguished by what is referred to as short- term and unsecured value certain liabilities (deposits) and illiquid value-uncertain assets (loans). Banks conforms to deposits insurance and other type of consumer protection, partly because banks' balance sheet consists of a variety of complex instruments and depositors are not capable to measure the riskiness of their deposits. However, depositor protection creates moral hazard problem.

Furthermore, banks regulation focuses more on systemic risk. That is the possibility of a bank run that can spread to a number of banks and trigger a wider instability in the financial system. According to this notion, bank runs are the result of action by depositors retrieving their funds in response to amounting fear and uncertainty of the bank future arising from bank asset losses that could render it insolvent. Due to potential risk of losing all or some of their assets, depositors tend to make a run when initial signs indicate some troubles.

Moreover, recent research found that the occurrence of a bank run can not be entirety explained by the decline of bank's underlying assets (LaWare, J.1991.p34), (Diamond and Dybvig, 1983).The emphasis is on a bank's maturity transformation notably the transfer of illiquid assets (bank loans) into liquid claims (bank deposits), taking into account that the bank's loan portfolio substantially decline in value in an event of liquidation than on going concern. What triggers a rational bank run is that the uncertainty and the higher probability that the loan portfolio liquid value is less than the value of liquid deposits. This notion demonstrates how bank runs can possibly arise and affect even healthy banks. Thus distressed bank have to liberate its assets at liquidation value, therefore leading to possible insolvency.

2) Techniques of regulation

While procedures of conduct of business regulation do not differ among various types of institutions, but in terms of prudential regulation there are fundamental differences that reveal the distinctive risk features of banks, insurance firms, and investment companies. Because bank failure has a greater effect on the whole market, and can create systemic crisis, governments and central banks have set bank regulation for creating extra protection in provision of extra fund by setting the lender of last resorts facilities, and deposit protection, however, these facilities creates moral hazard.

Moreover, the deposit protection fund may exceeds the available protection from deposits insurance schemes, demonstrating policymakers' greater emphasis for protecting the banking institutions rather then just depositors, as well showing the regulatory objectives of sustaining the banking system, while preventive regulation focuses more on tackling excessive risk taking by setting capital adequacy requirements for assets.

Institutional regulation varies between states; in the UK for instance there was a single mega regulator, all regulation is institutional, each group/ institution have a diversified activity which all work under a single agency that overlook the supervision. Alternatively, in a system of multiple regulatory agencies specialised by duty, a fixed institutional regulation is unattainable due to the fact that these agencies are divers in functions, which calls for the appointment of a 'lead regulator' for diversified groups (Taylor, M. 1995).

3) Regulation of the financial system

By tradition banks are providers of loans among other services to firms and individual investors, temporary banks falls in deficits when their expenditure exceeds receipts; however banks generally adjust their liquidity position by using capital or wholesale market.

Problems occur when banks capital is misused in funding high risk investments; this is often the consequences of bad governance by senior management in controlling the banks assets or it is the outcome of a contagion effect resulting from systemic risk. Moreover, the central bank controls and monitor commercial banks activities and set rules to regulate the banking system. This is to create stability and to promote confidence in financial market, which are vital elements in maintaining steady economic growth.

4) Bank failure

Regulation of banks must be explored in context of bank failure. As any substantial problem produces the need for the introduction of changes in the regulatory framework, because the regulators attempt to correct any loophole in the system.

Major bank failures in the history of banking occurred in the US in the year 1929. At that period there were 25,000 operating banks, however by 1934 the number had reduced to 14,000. These incidences consequently led to the implementation of more restrictive bank rules, such as single state operations, which until recently remained the feature of the US banking system. The subsequent major bank failure was the fringe banking crisis in the UK in the year 1973.

5) Reasons for regulating banks

The principle reason is the systemic risk, because the financial system is susceptible to level of confidence, therefore external regulation is essential in maintaining the stability and reduces further volatility. The second reason represents the social cost that a failure of bank causes, which have a greater impact then a failure an ordinary firm. The insolvency of a firm affects the shareholders, while the failure of a bank will have a greater number of affected customers (depositors), which could also be spread across larger geographical locations. As well as the effect it will have on providing savings for potential investors which will have a detrimental impact on the economic growth.

The third reason is the possible lack of knowledge by the public, it is suggested that they lack the necessary background information to distinguish between safe and risky investments partly due to asymmetric information because depositors do not have access to the same information available for banks. Thus comprehensive risk assessments necessitate additional information to that included in financial reports. Hence for this particular reason regulators had introduced depositor protection. Although the above arguments support regulation, however there should be some caution on the use of excessive control over banks. It is primarily the issue of sustained cost in terms of resources on banks and the regulators.

Because the central bank has to set teams of experts to perform the prudential control, likewise banks have to employ skilled resources capable to produce the necessary required returns to the regulator. Such costs can be large, thus it is a matter of cost benefit analysis to establish whether the gain of applying prudential control exceeds the incurred costs. Other possible dangers of excessive regulation are the fall of competition, increase in costs and the diminishing pace of financial innovation and development.

Furthermore, heavy regulation on a particular centre may lead to the migration of the activities to locations that have lenient regulation, which has been the principle factor in the development of offshore banking centres that led to the need for a global regulation system for international banks, which is known as a 'level playing field'.

6) The supervision of the financial system in the UK

The above arguments about prudential regulation are based on banks but it can also be applied on various other financial institutions. Furthermore, the current UK financial regulation system utilise the same measures in authorising and supervising financial institutions without a distinction between insurance firms, building societies, or banks.

The FSA is the principle regulator of the financial system in the UK. The FSA was established in 1997, succeeding the Securities and Investments Board (SIB), which was supervising the investment industry. However, the FSA has progressively thought to become the main controller responsible for regulating insurance and investment industry, building societies, and banks. In addition to regulating financial exchanges such as Euronext.liffe and the Stock exchange besides clearing houses, along with other functions such as the responsibility of regulating the access of companies to Official List in cooperation with the UK Listing Authority.

The initial development occurred in 1998, when the Bank of England transferred its responsibility of regulation and supervision of banking to the FSA, which was succeeded with the passing of the Financial Services and Markets Act (FSMA) 2000 that provided the FSA with full power as the main regulator. The FSMA requires the FSA to attain the following objectives:

  1. Promote public awareness of financial system
  2. Maintain confidence in the UK financial market
  3. Secure consumer protection
  4. Reduce financial crime.

7) The FSA approach to supervision

The FSA approach to supervision is risk based; the primary phase is to assess the risks associated with four objectives above. The FSA attain this through gathering information from various sources including customers and supervision of firms. The secondary phase is risk weighing and estimating impact, by giving each risk the probability of occurring, thus giving it a score or value. Thus firms with high magnitude impact require greater supervision. This is to reduce systemic risk and consumer losses. However, firms that possess highly sophisticated and effective risk assessment systems require less supervision by the FSA.

Finally, after the risks are identified, assessed and weighted, the FSA select the appropriate measures to respond using various tools, which can be summed as follows:

  1. Those aimed to influence the behaviour of consumers, operators, and the industry
  2. Those aimed to influence the behaviour particular firms.

The first category encompasses consumer education, the discloser of information, and compensation method, while the second category includes the provision of authorisations to firms and discipline, in addition to reimbursement of losses.

8) Capital adequacy (Basel Capital Accord, 1988).

Liquidity is essential for any firm to maintain its daily operation, whereas solvency refers to the ability of a bank to meet its commitments in terms of liabilities at due time. However, there is a distinction between liquidity and solvency. There is a general understanding that if a bank is thought to remain solvent then it should be able to borrow fund from open market to meet its short term liquidity requirements.

Likewise, the presence of liquidity problems that cannot be resolved through the wholesale market suggests that other lenders believe that the risk of insolvency of that particular bank is great. Furthermore, if a bank struggle to find short term funds in the markets, it will face difficulties in paying its claims. Therefore the Bank of England and the FSA requires banks to efficiently managing their liquidity as a principal policy element of reducing the risk of insolvency.

The Basel committee on Banking Supervision has introduced Basel Capital Accord II; it included new amendments to the assessment of capital adequacy of banks. This new approach was ought to be implemented in year 2006, which contains three pillars:

  1. Minimum capital requirements
  2. Supervisory review of capital adequacy
  3. Public disclosure.

Basel II accord focuses on credit risk and market risk. In pillar 1, the treatment of market risk was not altered but changes were made on the treatment of credit risk notably operational risk. The bank for international settlement and the Basel committee on banking supervision have founded the financial stability institute (FSI) to assist central banks across the world to improve their financial systems. The new Basel II requirements set challenges on banks to develop and increase efficiency on their capital management.

In this section, there is a discussion of the effect of Basel II on Banks in Europe and North America, and how the new directives are going to improve the cohesion of trade between the International Banks. Furthermore, this study will examine the banks resource capability to meet Basel II requirements, and discuss the impact and the implementation of the proposed guidelines.

The Basel II framework is a tool that international financial institutions have created to be used by banks around the world as a common standard. The principle of Basel II is that banks are required to hold in reserve certain level of capital as a protection to maintain bank operation when making losses. It promotes transparency of banks activities and encourages efficient management of capital. It is estimated to total 8% of bank assets.

The Basel II framework has set standards for banks in managing their capital and requires the discloser of information to detect any risks. The guidelines promote efficiency, this is to reduce risks and create a stable financial system. The three Pillars of Basel II are the Minimum Capital Requirements, Supervisory Review Process, and Market Discipline.

The objective of Basel II is to increase banks ability to meet their obligations and maintain their services to customers particularly in periods of economic slowdown.

Banks need to have a good risk management and adequate capital. Thus, it is essential that banks are supervised by specialists to asses their risk management capability.

Basel II aim at improving banks activities by relating Bank risk with capital requirement.

9) The impact of Basel II on Banks in the US and the EU

In the US Basel II requirements are applied only on large international Banks, unlike in Europe where the regulation is expected to be applied by banks of different sizes.

The US banks have delayed the implementation of Basel II guidelines, this may put the European Banks in competitive disadvantage, the capital used for achieving compliance could be used to fund other investments, thus minimising the banks ability to generate more revenue (Bear, D et al .2001).

The Basel II guidelines are enforced in the US by the Sarbanes-Oxley Act, which sets new challenges to financial institution by emphasising on more transparency, and similar directive are introduced by the European Commission know as CAD III.

10) The Implementation of Basel II

The information deficiency that exists in the banking business does not create confidence in the market; the lack of clarity of information could cause financial instability. Basel II promotes transparency of Banks activity and weight the risks linked with their capital management (Linsley and Shrives, 2005). The Basel II scheme permit banks to use two methods for calculating adequate regulatory capital, the first utilise internal rating based approach (IRB) to estimate probabilities of default, the second is a standardised approach which rely on external rating, it assesses the risks weights based on credit rating.

It is argued that Basel II favours larger Banks; these banks have the resources and the capability to implement the required changes. The lack of the necessary resources will make smaller Banks less competitive, hence limiting their chances of realising more growth.

Basel II raises issues of fairness in competition, larger banks use the more advanced internal rating (AIRB), but smaller banks use the standardise approach which put them in a competitive disadvantage to larger banks. Larger banks are likely to get a lower risk weighting, this will gives them a higher external rating that require a lower capital charge (Lastra, 2004). Basel II applies only to Banks; this may put them at competitive disadvantage if other financial institutions start to operate in the field of banks business.

Basel II guidelines have considerable consequences on Banks; compliance with the regulations may require changes in the infrastructure. The managers have to address issues such as the cost of implementing systems such as the (IRB) approach and the upgrade of IT system to meet the rising standards, also the time and staff training (Cornford, 2004).

By having a system in place, Banks can estimate the probability of default for a particular scenario. However, probability may create burden on banks, disclosing unfavourable statistics may expose the higher risk, which would lower the rating, thus higher financial cost and higher capital requirement for the bank. For instance, Credit Suisse had estimated the cost to amount to $100m to fund the implementation of system. Celent a research firm from Boston found that spending is expected to exceed $1.16 billion in 2009 compare to $992 million in 2006.

The following example describes the method adopted by the Norwich and Peterborough Building Society in implementing requirements stated in the Basel II regulations.

The society had realised that the effective way to implement Basil II requirements, is to put a system in place to store and assess the data. The conclusion was that acquiring an external model or data may not be the appropriate solution to its needs and strategy. The society selected the AIRB because this system of rating is broadly used by financial institution that arrange residential mortgages, the AIRB rules require the use of models such as probability of default (PD) and loss given default (LGD) for residential mortgages. The society used current and historical data to build its statistical model which was utilised to generate estimates of PD and LGD for the residential mortgages; however the society is planning to introduce another model for commercial mortgages in 2008 (Pritchard, 2004).

Banks may not comply with Basil II rules because they are not obligatory; banks may retain capital for future investment such as market expansion or merger and acquisition. Furthermore, Banks may issue new shares or keep their earning or may also raise interest when extending or renegotiating bad debts.

Basel II has treated the issue of operational risk, which includes risk from people. Human error could also have consequences on the market. For instance, a typing error in the company accounts can send a wrong signal to the market; this is where operational risk links with market risk. The company therefore may suffer financial loss and need time to recover from the event. Operational risks also include fraud and illegal activities and processes such as corporation financial scandals as with the Barings Bank (Syer, 2003).

The Basel II framework aim to reduce failure in the banking system and minimise the risk associated with Banks Capital Management, the guideline promote transparency, the banks are required to supervise and assess their activities and report any potential risks, the level of risk determine the banks capital requirement. Banks need to recognise their capital requirements outlined in the three pillars, compliance relies on resources and infrastructure to implement the needed changes, and the willingness of banks to adopt the proposed guidelines.

Issues such as cost and lack of capability may delay the implementation of Basel II regulation. However, the benefit it adds to the global financial system will offset the Banks short term monetary loss. Moreover Banks compliance will potentially reduce their capital charge. Their support to the scheme will create for them the opportunity to build reputation in the financial market as institutions that have good risk management skills and systems.

The more efficient the bank become in processing its data the more it improve in making accurate decisions, which will enable it to attain competitive advantage.

Staff training and upgrading the IT system and regular supervision will reduce operational risk and increase efficiency in the bank processes. Accurate statistics, good and sound practices by banks will increase their rating; this is beneficial for banks as it will reduce their capital requirements and financial cost, thus achieving a greater competitive advantage.

There should be a standardisation in the system of internal rating; banks may use seasonal data to projects different outcomes, or to appear to be performing better then what the reality is. Different institutions uses different models of rating, Basel II do not specifically define the tools it only sets the guidelines, and banks are allowed to select the desired model to implement. Transparency should be embedded in the corporate culture; it is the responsibility of managers and staff to identify the risks to the organisation and create a system in place to mitigate any problems when they arise.

VII- Retail banking

Retail banks were distinct from wholesale banks; however such distinction has become less significant in recent years, because a number of retail banks undertake in addition wholesale trade. There is a great advantage that can be achieved through retail banking that is regarded as unique from wholesale banking. The appropriate method to approach this is to differentiate between wholesale and retail banking industry.

In retail banking industry a number of processes are followed to create a supply of retail banking output in a form of products and services. Institutions that specialise in these activities are known as Banks, which have traditionally been the main providers of these products and services. Nevertheless, due to legal (the 1986 Act) and technological developments other non banks financial institutions are penetrating the retail banking industry.

Banks therefore have faced greater competition in this industry, which consequently lost monopoly position, yet banks can diversify their products and provide other services using their competitive advantage and competencies to tap to new segments or to increase market share. Thus, the recent development in retail banking has transformed the industry, which became more typified by a diverse variety of suppliers.

1) The nature of retail banking in the UK

The fundamental business of banking concerns receiving in deposits, which are then gathered and then lent for credit as loans. Retail banking encompasses the large volume and low value of these business transactions. This is where deposits are collected from a group of small businesses and individuals, which in turn loans are lent to the same category. This differs from wholesale business where transitions are small in numbers but large in volume mainly provided to large institutions.

Furthermore, in the UK it is hard to differentiate between retail and wholesale banking because a number of banks operate in the retail industry also to certain extent are involved in wholesale markets. In the UK, to operate as a bank and commence collecting deposits a company must gain permission from the Financial Service Authority (FSA) (the Bank of England prior to June 1998), subsequent to receipt of authorisation, banks depositors fund is protected by the UK compensation scheme.

2) Recent development in retail banking in the UK

Banks traditionally had a network of branches spread across controlled area to reach their customers; this was the main mean of interaction of clients and their banks, which characterised the function of retail banking. Nevertheless, the development of technology with the introduction of the automated teller machine (ATM) networks, internet and telephone banking, along with widespread of interactive digital television have enabled an emergence of an innovative banking system that does not require high street branch to perform business. In the UK, the initiator of this type of banking was First Direct, which started as a telephone bank in 1989 as part of HSBC group, one of the major Banks.

By 2002 First Direct customers reached 1 million, and provided a wide range of banks services, from personal loans to cheque accounts. The majority of First Direct customers use internet to access their accounts, which led other competitors to adopt the same business idea and began offering remote banking service that permit clients to access their accounts via telephones, mobile phone, or internet.

In 2002, a report by the British Bankers Association stated that in 2001, one third of all bank accounts were accessed through the internet or the telephone. The internet becomes the dominant of these remote transactions, which constitute for 176 million transactions compared to 127 million telephone banking.

The classical business of banking was founded on the provision of payment services and acting as intermediation. The former comprise transaction services offered through cheques drawn from bank deposits that are accepted as means of money. The latter includes bank activities such as issuing money certain deposits and keeping hold of money uncertain deposits and non-tradable loan assets. Banks guard their existence by maintaining their monopolistic position, through superior expertise, which provides them with comparative advantage in a particular market place. However, recent technological advancement has lowered banks monopolistic position and barrier to entry for potential competitors.

Furthermore, an innovative process has emerged that is referred to as the process of deconstruction, which has allowed small firms to penetrate the banking market by providing some part of a banking service, and outsourcing the remaining parts, thus minimising entry costs. The process of deconstruction involves the breakdown of services or products into small constituent elements, thus allowing these elements to be supplied by individual separate institutions, such as the supply of mortgage loan. Modern financial innovation permits the elements of this service to be divided into:

  • Origination: the mortgage loan is presented to customers by means of brokerage.
  • Administration: the mortgage application is processed
  • Risk assessment: the credit weighting of the borrower is measured
  • Funding: finances are provided, assets are included in the balance sheet, and capital is set aside to the risk.

Some firms may posses a comparative advantage in one of the service component, such as risk assessment whereas another company may specialise and develop a comparative advantage in origination, besides a firm may originate the loan credit but it may not be efficient in providing finances for the loan because of capital limitations. This practice has become widely used amongst firms in this market.

Securitisation of mortgages loans and issuing securities in capital markets in particular was used by banks to take off loans of their balance sheet, thus the process of deconstruction has minimised barriers to entry into the banking market, as institutions are now able to penetrate the market without managing the entire process. They only select the element of the process in which they hold a comparative advantage. An institution that create the loan but choose not to undertake the remaining components of the process can outsource or subcontract them to other companies.

These companies may have established an efficient system and proficiency in risk assessment which they contract and acquire only this particular process from other institutions. Through subtracting, small companies are capable to engage and take part in economies of scale in which were unable to attain by simply utilising their own resources due to limited capacity and scale of their operation.

In the future, modern banking is likely to see the emergence of contract banking in which competing firms supply some parts of the process of retail banking and subcontract the remaining others. Moreover, this new system has created more pressure through increased competition for banks trading in their established markets, which as a result banks may loss their comparative advantage by means of efficiency, cost and information.

The UK banking industry has seen some changes in recent years, the emergence of non banking institutions providing retail banking services, these new entrants represent two groups:

Supermarket banks: This category includes for instance major supermarkets such as Tesco and Sainsbury which are part of the retailing business, also provide retail bank services among other services and products, taking advantage of the large branch base.

Initially these supermarkets provide services in conjunction with existing banks, though some will decide to manage the operation alone in the future, as Sainsbury which is currently authorised to collect deposits at its local branches.

Other non-bank institutions: these are firms supplying retail banking services through remote banking provision networks, without a physical high street location. For example, insurance firms such as Scottish Widows, Prudential, and Virgin, which are retail conglomerates that diversified their activities and penetrated the banking market.

3) The changes in banking activities

Banks activities have evolved over the years; this was due to regulations restrictions, and capital adequacy requirements, the Basel directive recommend that banks keep a proportion of their asset in reserves (8%).

The traditional approach in banking was Originate to hold (OTH), this model requires banks to hold their created credit (loans) until maturity date, thus banks had to manage the risks through efficient risk assessment systems based on credit checks on borrowers. This is to limit the likelihood of default. However, the level of risk at this model is quantifiable, potential borrowers are assessed for risk, and given an appropriate credit scoring, which determines the credit decision.

The innovative approach in banking has developed to Originate to Distribute (OTD), this model allows banks to create more credit, and provide more loans to borrowers, such as mortgage loans for home buyers. This method permit banks to continue issuing loans to customers, these loans are repackaged in a pool as securities, which get rated by rating agencies such as Moody's or Standard and Poor, and then sold to investors. Thus banks eliminate risks and reduce their balance sheet assets, which allow them to create more credit. Securitisation enabled banks to free their assets from Capital Adequacy Ratios (CARs) requirements. (See constructed illustration figure 1).

4) The US Financial Market and the credit crunch

Confidence in the market is essential for maintaining the financial stability, adverse news often causes volatility in financial markets dues to uncertainty, thus financial market performance is influenced by investor's perception of the future.

The present global financial instability was triggered by the US financial market.

Banks in the US have been expanding fast; the issuance of mortgage loans had increased in recent years, notably the subprime segment (figure 2).This segment comprises low income people that have low credit scoring, and no collateral assets. Moreover, the probability of default is high among these borrowers. Therefore, to eliminate these risks, US banks used securitisation, which then been sold to investors (originate and distribute).

The increase in default rate in the US was caused by the failure of repayment maintenance, mainly from mortgage borrowers of subprime segment. These low or non income, no jobs, no assets individuals (Ninjas) were offered loans above their repayment capacity. However, these borrowers were encouraged and attracted by low introductory offers from mortgage brokers that focused more on gaining commissions and generating profits from fees and cross selling, such as insurances (adverse selection).

Initially, the borrowers benefited from low interest rates, but the Adjusted Rate Mortgages (ARM) for instance caused financial difficulties for these home buyers due to loan rescheduling following a rise of the cost of borrowing, thus increasing the risk of default. However, these lenders were aware of these risks (asymmetric information) but securitisation shifted these risks out of their balance sheet, and consequently resulted in a decline of US subprime housing market (Moral Hazard).

VIII- The comparison between the two banks

1) Barclays bank: Barclays is a major global financial services provider that engages in various activities ranging from retail and commercial banking, investment banking, credit cards, and wealth management services. The corporation is present in Europe, Asia, Africa, and the USA. Furthermore, Barclays operates in over 50 countries and employs more than 143,000 people. With over 300 years of history and expertise in banking; Barclays provide its services to over 38 million customers and client across the world (Barclays, 2008).

Barclays values are reflected in its mission statement, the bank seeks to be innovative, customer orientated group that offers outstanding products and services, provides excellent careers for the employees and enhance its contribution to the community. John Varley the Group Chief Executive (2006) stated that Barclays aim to be a leading universal bank adding to its current position of one of the largest financial services firms in the world by market capitalisation.

a) The bank performance: The bank chairman, Sir Peter Middleton had declared that Barclays realised significant performance improvement during 2002. The UK, the corporation's main market, continued in rapid growth exceeding other European states, although it was irregular and based on public and individual consumption. The Market in the US has improved from the 2001 weak performance, nevertheless remained unstable and consumption focused, while the market performance in Japan and the rest of Europe stayed sluggish. The year 2002, was marked by great uncertainty about future prospect, volatility and decline in financial markets, along with the increasingly competitive business environment.

This was partially due to the collapse of the overestimated dotcom boom, and partly the result of the threat in world security and the effect of uncertainty caused by the changing regulatory requirements such as the implementation of new accounting rules, and the capital requirements of Basel II. Similarly the UK government had produced reports such as the Higgs Review regarding non executive directors' role and responsibility, and the Smith Review about the audit committee role, with the likelihood of more comparable directives from the FSA and Brussels, in addition to the competition commission inquiry on price control. Compliance with this requirements and rules creates additional demands for banks management, resources used for conformity activities could be utilised for more business development and value added products and services (Barclays, 2002).

The company endorses transparency and clear communication to various stakeholders about its financial performance and management, which is evident by the inclusion of information in the annual report regarding risk management, and corporate governance with detailed remuneration statement. Barclays had spread its business in different markets, this is to reduce market risk and expand its global market share. Barclays is a pioneering major high street bank that developed a type of service known as integrated banking, following its introduction in 2002, more than 2 million customers in the UK selected the Openplan scheme. Furthermore, the introduction of Openplan in Spain in 2002 (cross selling) led to an increase to 4.5 products per person exceeding the average of 3.2 for customers without Openplan. This can be tailored to satisfy individuals' needs, which can also be accessed by various channels. Moreover, Barclays constantly aim to enhance performance and maintain improvement of services quality through equipping staff with the necessary skills. In 2002, around 750,000 hours of training were offered within the corporation.

Furthermore, Barclays Capital has become a world leader in this field of focus, by offering advice to customers on areas such as financing solutions and risk management, in addition to the introduction of new IT system, which was used as a pilot scheme in Spain. The sophisticated technology provides staff with clients' accurate historical data that displays full view of customers' relationship with Barclays in various channels. The group financial performance has improved notably following the introduction of ambitious plans in Personal Financial Services, and Business Banking.

Barclays invested around 381 million for strategic investment, together with efficient tactical management for costs reduction. For instance Personal Financial Services operating profit had increased by 8% as a result (Barclays, 2002). Furthermore, in 2006 total shareholders return increased by 25%, While profit before tax increased by 35% to 7,136m (2005: 5,280m), Earning per share increased by 32% up to 71.9p (2005: 54.4p), and dividend per share was up by 17% to 31.0p (2005: 26.6p) (Barclays, 2006).

Barclays poses a strong capital position; this is demonstrated by its double A credit rating, among the greatest in the banking industry. The bank objective was to maintain this rating with a combination of appropriate capital mix and good ratios. For instance the bank risk asset ratio in 2002 was 12.8%; dividend payment had increased by 10% at the same period. In addition to 546 million was spent for share repurchase, which improves the prospected earning per share.

b) The Bank asset: The increase in profit before tax of Barclays UK Retail Banking operation was driven by 7% increase in income growth, notably excellent performances in savings and current accounts, in addition to expanding mortgage market share. Moreover, Barclays wealth profit before tax increased by 28%, which reached 213m. These incomes reflect the good performances resulting from favourable market conditions; however, these were offset by the significant increase in investment in infrastructure and people for strategic future growth. Furthermore, total customers assets rose by 19% to 93bn, while the cost income ratio gained three percentage points to 79%.but the head office relocation cost in 2005 was reflected in the head office functions and other operations, where the loss before tax decreased by 64m down to 259m (Cost inefficiency).

2) Northern Rock Bank: Northern rock is headquartered in Gosforth, Newcastle upon Tyne. Its mission statement describes it as follows: Northern Rock is a specialised lending and savings bank which aims to deliver superior value to customers and shareholders through excellent products, efficiency and growth (Northern Rock, 2006). This statement reflects the company's philosophy which is transmitted across various levels in the organisation. Northern Rock specialises in providing lending for housing mortgages, individual finance and secured lending for trade.

Whilst obtaining funds from personal savings, covered bonds, wholesale markets, and from the securitisation of mortgage assets. Efficiency is fundamental to Northern Rock's business strategy. Cost efficiency enhances effective distribution which enables the competitive pricing, whilst capital efficiency is achieved by using debt and equity capital to an optimum level such as the use of wholesale borrowing and securitisation. Through increasing lending and enhancing returns on products, Northern Rock continued to

Increase shareholders returns and earnings, together with offering superior products to customers. Northern rock has 72 branches across the country which offers core residential mortgage and retail savings products, In addition to Telemarketing, Postal Retail, Offshore Retail Funding, and Regional Commercial Lending Centres, which enables it to reach a wider range of consumers, thus increase market share. The Bank's employees increased through the years benefiting from its growth. For instance, in the period from 2003 to 2006, there was almost 40% increase in full time employees (3,448 to 4,811), and 18% increase in part time employees (Northern Rock, 2003, 2006).

a) The Bank Assets: The Bank consolidated assets had increased by more than six times from 1997 to 2006, it grew from 15.8 billion to 101 billion. This was comprised mainly of secured lending on residential properties, mortgage loans represented high proportion of its assets. However, these loans were considered high quality loans. Northern Rock had been growing its assets by around 20% +/- 5%. The continuous growth led to Northern Rock entering the FTSE 100 in September 2001 (graph 1).

b) The overall funding of Northern Rock: Northern Rock offered competitive services to both existing and potential customers. This distinctive approach allowed the bank to increase its market share and promote loyalty to existing customers by allowing them to benefit from various new products. Moreover, the basic theory in banking is that Banks lend long, and borrow short. The Asset- Liability Management (ALM) principle requires Banks to match their assets with liabilities to remain solvent. Originally most banks created credit in a form of loans to customers that matured in later dates, and accumulated customers deposits that enabled these banks to meet liquidity requirements, therefore banks held their assets such as customers loans until maturity while keeping clients deposits (liability) to match the demand for liquidity, i.e. match assets with liabilities (originate and hold).

However, the traditional ALM model constrained banks projected growth, therefore securitisation was used to free them from Capital Adequacy Ratio requirements. Through securitisation, loans were repackaged in a pool, received ratings, which then sold to investors. This practice became increasingly utilised by banks (originate and distribute). Deposits funds were insufficient for Northern Rock to issue more loans such as mortgage loans for customers to enable it to achieve the desired growth. Moreover, the bank's retail deposits fell by more than 40%, for instance deposits represented 63% of total liabilities in 1997, but in 2006 it decreased to 22% of overall liabilities, at the same time the wholesale borrowings became increasingly the main source of fund for maintaining the growth. The bank used interbank borrowing to match its liabilities and assets, and therefore that is how it met its liquidity requirement (Northern Rock, 2006; HC Report, 2008)

3) The two banks Risk Management
a) Derivatives: The sale and the use of derivatives are an integral part of the group's trading activities. These instruments are also used to manage the firm's exposure to fluctuations in exchange rates, interest and equity and commodity prices as part of its asset and liability management activities (Barclays, 2006). Barclays engages in exchange traded and over the counter derivatives, the former involves the selling and buying of financial instrument by the group, which are then traded in exchanges. These include interest rate swaps, options and futures. The latter, consist of foreign exchange derivatives such as currency swaps and currency options. The group also trade in interest rate, credit, equity and commodity derivatives. For instance, Barclays recognised assets derivatives held for risk management has increased from 136,823m in 2005 to 138,353m, while the changes in liabilities were

-137,971m in 2005 to -140,697m in 2006 (Barclays, 2006). Likewise, Northern rock also trade in derivatives to hedge against market and credit risk. The bank traded instruments includes currency and interest rate derivatives, swaps and options, in addition to equity and commodity derivatives. For example, northern rock's total recognised derivative assets/(liabilities) were 1,449.8m (846.1m) in 2005 and 871.3m (2,392.5m) in 2006 (Northern rock, 2006).

b) Securitisation: Barclays also engages in off balance sheet arrangements, the group uses special purpose entities (SPEs) for securitisation, these involves the acquisition of financial assets that are funded by the issuance of securities then sold to investors. For instance in 2004, Barclays purchased then securitised 10 static pools of residential mortgage loans. Furthermore, in 2006 Barclays mortgage loan securitisation activity amounted to 17 whole loans and 4 commercial loan pools, which totalled 7,887m. Funding through securitisation is an important part of northern rock funding strategy, for instance in 2006, Northern rock had completed four residential mortgage backed issues with a value of 17.8billion gross (10.5b net) through granite vehicles. Furthermore, in early 2007 the bank had completed further 6.1b mortgage backed securitisation issue, while securitised notes amounted to 40.2b in December 2006 representing 43% of total funding portfolio (Northern Rock, 2006).

IX- The Analysis: the Gap analysis

Northern rock bank total gap under 3 months in 2002 amounted to -2,681m, however it increased up to 759.2m in over 5 years period, but the Bank accumulated total gap had marginally increased from -2,681m under 3 month period to -2,407.6m. This indicates that northern rock had some short to long term liquidity mismatch. Likewise Barclays Bank total gap under 3 months in 2002 was -1,206m, nevertheless this has improved to 5,023m and 513m, for the3-6 months and over 5 years period respectively.

Furthermore, Barclays bank accumulated total gap in the same year had increased from -1,206m under 3 months to 4,330m in over 5 years period. This shows that Barclays bank similarly have some short term liquidity mismatch under 3 months period in year 2002, but its liquid assets exceeds its liabilities in a period 3-6 months and over 5 years, which indicate that Barclays can match its assets and liabilities both in the short and long term unlike northern rock at the same year.

Thus, this gap in northern rock exhibit the firm's ambitious strategy in pursuing greater market share and accumulating more debt through high gearing as a result.

Furthermore, the overall gap under 3 months at northern rock bank amounted to -30,790.2m in 2005. The gap expanded further to -36,361.2m in 2006, while at the same period Barclay's bank gap was -88,535m increasing from -51,790 in previous year. This shows that both banks accumulated short term debt obligations that exceeded their assets, northern rock's gap had increased by around 18%, while Barclays short term gap had an increase of over 70%, which indicates that northern rocks liquidity gap increase was proportionally lesser than Barclays. Nevertheless, the two banks assets are substantially different in terms of structure and size, which demonstrate that banks debts management varies and their ability to withstand debts also differ according to their assets size.

In 2002, Northern rock's debt securities in issue represented over 36% of bank total liabilities under the 3 months period, this has continued to increase the following years and exceeded 70% by 2006. Correspondingly, Barclays debt securities in issues for 2002 represented only 3% of its total liabilities under 3 months period; however this has gradually increased over time to over 17%. This indicates the reliance of northern rock on short term debt securities as a sign of liquidity shortage, which leaves the bank exposed to market price fluctuation that could result in the decline of securities value, and consequently leads to losses.

Northern rock's Assets to liability ratio was 0.85 under 3 months period, however this ratio increased to 4.4 over 5 years period in 2002. But this ratio decreased to 0.50 under 3 months and to 0.60 over 5 years in 2006. This shows northern rock's great reliance on gearing in funding its expansion strategy, which exposes the bank to interest rate fluctuation.

Furthermore, Barclays ratio was 0.83 under 3 months and 1.66 over 5 years period in the same year. Northern rock's Liability to Assets ratio was 1.88 under 3 months in 2005, this indicate that liabilities were almost twice the amount of assets, this figure increased to 1.98 in 2006, while it was only 1.21 at Barclays bank for the same period, which reveals the difference of risk taking between the imprudent northern rock and the well diversified portfolio of Barclays in obtaining funds from other sources and activities.

In 2002, 94% of Northern Rock's accumulated assets were in a form of loans and advances to customers, this figure was 88% in 2005, but decreased by a fraction to 84% in 2006, while this represented 87% for Barclays bank (Table1). Moreover, Barclays bank had a higher gap in 2006, however it assets exceeded the liabilities in contrast with northern rock notably over 3-6 months period where liquid assets are essential for the maintaining the flow of business operation avoiding financial difficulties due to liquidity problems.

Northern rocks assets to liability ratio shows that the bank pursued an aggressive growth, maintained by closely matching assets with liabilities relying on the wholesale market for short term liquidity requirements (figure 3).This figure shows that northern rock expansion ratio exceeded all major banks in the UK, for instance it was almost three times the rate compared with Barclays, figure (4) demonstrates the differences in assets size between northern rock and major banks. This figure shows northern rock's high level of mortgage based securitisation (RMBS), and its fragility due to its limitation of other corresponding assets.

The aggressive expansion that was backed by high gearing and the use of securitisation has increased northern rock's exposure to adverse market changes. Furthermore, northern rock had increased its debts securities in 2005 to 2006. This exposes it to short term interest rate risk due to a possible rise in interest rate. The increase in issuing securities was an attempt from the bank to raise more capital because the spread in the wholesale market funding became increasingly high (expensive) for banks. Therefore securities decreased in value due the high supply along with high uncertainty in assets prices, which made the market more volatile.

X- The wholesale market

Banks fund their lending activities through the accumulation of deposits and securities issue, while matching short term liquidity requirements by borrowing from wholesale markets such London Interbank Overnight Rate (Libor) 3 months rate. Furthermore, the Libor rate movement was consistent with the Bank of England (BOE) base rate changes. However, the spread increased during the second half of 2007 (graph 2). This means that banks became less willing to lend to each other due to the US credit crunch that created uncertainty in global financial markets, which was caused by high default in subprime mortgage market.

Some of these high risks loans were repackaged in pools that been distributed to investors worldwide. Therefore the securitisation of such assets allowed the spread of the risks across different markets because these securities are often repackaged in a way that most financial expert fail to assess the true risk of these securities due to the complexity of their combination. The rise in spread in Libor made it increasingly difficult for northern rock to meet its short term liquidity requirement, which consequently led to its failure. However, the UK central bank attempted to increase liquidity in the market through decreasing the base rate to promote more stability, for instance there was a decrease in interest rate by a quarter point to 5.25% in 7th of February 2008, which was followed by further decrease to 5% in 10th of April that remained unchanged by the recent committee meeting in 7th 0f august 2008 (BOE, 2008).

XI- The findings

An increasing number of banks are using securitisation to free their capital constraint arising from capital adequacy requirements. Innovation is essential for banks to remain competitive and pursue greater market share. However, the complexity and the lack of clarity of some the traded instruments and their components has affected confidence in the global financial market following the rise of default rate in the housing market in the US, which was mainly due to the sub-prime market that created uncertainty and instability in the world financial market. Therefore, uncertainty has caused the decline in value of securitised mortgage based traded instrument, which consequently has affected a number of banks trading books, thus making losses as a result.

Moreover, the exclusion of the off balance sheet instruments and the lack of transparency in banks trading books in addition to cross border trading among banks along with technological advancement, which made major capital markets around the world more efficient has enhanced financial markets operations and improved traders immediate responses to changes, besides the slow reaction by regulatory authority in restoring confidence in the market has caused a systemic risk. The extent of severity and longitude of this credit crunch remain unclear because events in the financial market continue to develop and the affected banks and financial institutions true loses remain uncertain. Thus, financial innovation is essential for financial institutions development but complexity and lack of clarity rendered it less feasible.

The miss selling of mortgage products in the US are among the major factors that added to the severity of the current credit crisis. The instability and lack of confidence in the global financial market is prolonged due to more events unfolding in financial markets notably banking crisis besides to rise in energy and commodity prices, and the cost of living. The high default rate in the US sub-prime mortgage market has affected the value of mortgage based securitised collateral assets.

Thus, the decline of demand for these securities has led to decline in their values dues to lack of confidence, these instruments has become non tradable, therefore banks made loses from holding these uncertain value assets. As a result a number of banks had to write-off large lose out of their books because they became unrecoverable such as Barclays with losses up to 800m ($1.64bn), RBS with almost 5.9bn of write-downs and 691m losses, Freddie Mac and Fannie Mae $2.3bn losses, and Bear Stearns $3.2bn losses which was aided by the US Federal reserve and JP Morgan rescue package to remain solvent (BBC, 2008).

The lack of confidence in the financial market has made banks less willing to trade with each other, and also there was a decline in value in securities value due to lack of demand (graph 3). Furthermore, consumers and businesses also were affected by the credit crunch; the unavailability of funds in the wholesale market created liquidity problems for some banks and in some cases caused insolvency crisis such northern rock bank. These events have affected confidence in the market, and consequently have led to the decline of supply of credit to customers and investors.

Moreover, scarcity of fund led to the increase in cost of borrowing which had an adverse effect on existing borrowers, as a result for in instance the demand for mortgage borrowing has declined firstly because of reduction of supply by banks and secondly by the lack of demand from potential borrowers due to lack of confidence, recent statistics revealed that house prices has declined by 8.1% this year with 1.7% drop in July (BBC, 2008). The decline in house prices leaves some new homeowners with negative equity, this can cause severe financial problems for those home sellers, as they have to fund the remaining difference for their lenders for instance property repossession level in the UK has risen by 48% in the first half of 2008 (BBC,2008)

Regulation of banking industry is essential for maintaining stability and the integrity of the financial system. However, strict regulation may stifle the dynamicity of the financial market and can hinder economic growth.

There is not a clear definition of roles and responsibilities between the regulatory bodies in the UK. This was evident by the slow reaction from central bank and the lack of authority by the FSA in handling for instance the northern rock incident and in restoring the confidence in the UK financial system, compared to the fast reaction from the Federal Reserve in rescuing Bear Stearns. Competition between Banks is beneficial for customers. However, rapid expansion and excessive provision of credit to clients and investors can lead to an increase in default rate, which can have adverse effect on the banks balance sheets and on the economy as whole.

The rise in default rate amongst banks, investors and individual borrowers was encouraged by what is referred to as the credit culture. The availability of credit from banks and the high demand from customers has created favourable conditions for potential financial crisis due to high accumulation of debts by banks, investors and individual borrowers, thus it was inevitable subsequent to the emergence of liquidity problems for banks, the credit problem would cascade to investors and customers, causing financial difficulties and resulting in capital losses and bankruptcies.

Shareholders were content with the increase in share prices and dividend payments (principle agent problem); therefore they did not scrutinised directors management strategies for instance in annual general meetings, besides individual borrowers' particularly home buyers that obtained up to 125% mortgage deals as with northern rock notably the buy to let investors, which had a general understanding that property prices will only continue to rise.

Furthermore, Banks manage risk differently; also their ability to resist risks varies according to their assets size and structure. For instance larger global banks are able to withstand losses from particular sectors or markets, thus losses made can be compensated from other bank activities or markets. However, larger losses can also threaten larger corporations. But smaller banks have limited assets therefore their ability to cover losses is limited; thus they have higher probability of default. Moreover, rapid expansion can have an adverse effect on banks or any other profit maximising firm, high gearing can be beneficial in short term but can cause severe financial distress following increases in cost of borrowing. Organic growth can generate modest revenue or growth but produces a firm financial structure for a corporation. A number of banks are using other alternatives methods to raise capital, such as rights issues for shareholders to raise additional funds to cover losses made and improve their balance sheets such as RBS rights issues with a value of 12bn (FT,2008).

XII- Conclusion

There are various factors that can affect Banks performance. However, there is a variation in degree of risk among banks, these depends on their business model, types of activities and assets size. The current credit crisis had different impact on various financial institutions.

Control and Regulation are essential for maintaining the stability and integrity in the financial system, but rigid regulation may hinder further development and economic growth.

The northern rock incident is not unique. However, such event may become frequent unless vigorous measures are taken by the regulatory bodies and organisations governing the financial systems and institutions. Northern rock failure had gave rise to issue concerning current bank behaviours, a number of other banks have been affected but with variable degree. Uncertainty in the financial market remains prevalent, and banks are taking a number of measures to improve their liquidity.

Inappropriate methods were used by banks in their pursuit for greater market share, methods used for risk assessment by banks are inadequate for the measurement of risks and potential losses, which can not estimate the true value of losses but only produce an indication such the use of Var technique. Moreover, the true impact of losses can exceed their monetary significance; it can cause social and economic problems in domestic and global markets. Therefore bank rescue is important for maintaining financial and economic stability; this is because of the important role that banks play in facilitation of wealth generation through intermediation.

Bank failures such as northern rock are not unique, but factors that led to its insolvency are complex and difficult to assess. Innovation such as securitisation has facilitated development but their extreme complexity rendered them unfeasible particularly in the current credit crisis. Rapid expansion and the great reliance on high gearing can cause financial distress following a rise in the cost of borrowing for any profit maximising firm.

Basic risk management procedures are neglected and substituted by more complex methods for risk assessment, but these new methods only produced estimates, which were then used by bank directors as a bench mark or as boundaries to risk taking.

The pursuit of profit maximisation and short termism in the financial industry can cause more volatility in the market, the lack of social responsibility by financial institutions often causes unnecessary difficulties for the public, although banks in the UK are involved with the community and donate to ambitious regeneration programs across the country. Sound governance of banks is important. Banks performance measurement and output should be assessed by customers' satisfaction and long term targets and not by shareholders returns.

Banks must value their depositors, and depositors insurance is solely for maintaining confidence in the system and not for compensation of banks bad governance.

The lender of last resort facility by the central bank is for offering help to prudent banks with short liquidity, and for restoring confidence in the market, but this can cause moral hazard and can be seen as an incentive to banks to be more imprudent due to the existence of a bailing system. However, central bank response to the northern rock crisis was appropriate and reasonable. Furthermore, the FSA's lack of authority has delayed its response to early signs of northern rocks financial distress. Moreover, credit culture is a social phenomenon that is affecting modern society, which requires more studies to establish its core causes and possible remedies.

XIII- Recommendations

The northern rock failure was caused by various factors, external and internal factors, but the external factors have affected a number of banks across the world, however only few has showed serious financial problems which indicate that bank failure of this kind is a combination of unforeseen circumstances developing in a global market and the banks corporate governance. Reasonable expansion often does not cause financial difficulties for banks; it is the consequences of reliance on high gearing that are fatale, which can arise from the increase in interest rate. Moreover, Banks should use the traditional business model, it is by matching deposits levels with the projected growth (originate to hold).

This method may hinder rapid growth but it help maintain banks structure firm and enables them to survive financial shocks when they occur. Likewise, the current financial difficulties in the UK highlighted the need for clearer definition of roles and responsibilities for bodies managing and regulating the financial system (tripartite), these includes the Central bank, the Treasury, and the FSA, as well as the necessity of more transparency in the securitised assets, the inclusion of off-balance sheet assets onto banks balance sheets, and a call for more flexibility in adjusting the capital adequacy ratio for banks according to their asset size, commitments, and the state of business cycle, both these latter points are under current discussion by the Basel committee.

The issue of corporate governance in banks and other financial institution must be addressed; also firms should improve their social responsibility towards various stakeholders and assess the short and long term effect of their business strategies and decisions. Consumers also are partly to blame for the escalating level of indebtedness in the UK. Individuals and firms alike must not obtain debt and borrow funds that are beyond their repayment capacity, sound investments must not be based on unfounded speculative forecasting.

Savings should be encouraged as a form of safe investment to restore banks liquidity problem, and individual investors should be offered information and advice on various other methods of investment, thus encouraging diversification for investors and reducing demand for property investments. The outcome of this credit crunch will give rise to mergers and acquisitions particularly in the banking industry. Larger institutions will acquire or merge with other financially distressed firms, this is to reduce risks and benefit from economic of scale, and increase competitiveness.

Moreover, the current credit crunch requires joint effort by the government and financial institutions to stimulate the market for a progressive recovery, a recent report from the treasury presented by Sir James Crosby has revealed various options that the government is introducing the revive the housing market (BBC,2008).

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