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Current Situation Of The Major Uk Banking Institutions



In this dissertation report, I discuss the current situation of the major UK banking institutions in face of the credit crunch and the recessionary economic conditions. It represents an analysis of the main trends in the performance of five major UK banks: the Royal Bank of Scotland, Northern Rock, Barclays, Lloyds Banking Group and HSBC. This research project aims to establish the relation between the resilience of the management of the banking institution and the organizational performance. The report presents a critical argument over the factors that led to the subprime crisis and eventually dragged the economy of the most of the developed countries into a recession. I attempts to identify who is to blame for the current state of the UK economy and provides a complex picture of the events that took place shortly before the economic crisis began to unfold in the US and UK banking sectors. The study analyses the performance data for each bank and provides an insight into the management practices and managerial decision making in each of the named banks. It then attempts to establish a match between the two and provide a critical evaluation of managerial approaches and decision making strategies at play. It then provides managerial recommendations as to the preferable risk evaluation and risk management practices so as to avoid or at least reduce the possibility of future crises of the same nature.

Background of the Study:

The Subprime Mortgage Crisis was a global credit crunch and the failure of financial system. Moreover, it has affected consumer habits, their economic values and relationship with financial sectors.

Many people failed to repay their debts. And they started to feel that they were being pursued by the creditors. Like the crisis was not of their own making and most popular financial institutions were collapsing around them. But the product of forces was beyond their control. So, the crisis was not only the liquidity crisis but also was the psychology of the real estate bubble.

We had financial crisis in 1980s that suffered by Mexico after the oil price boom. And in the 1980s stock and housing markets bubble in Japan and the mortgage lending booms in both Sweden and Mexico leaded their economy to major financial crisis in 1990s. (Shiller, 2008) In UK, Overend & Gurney, the discounted bank which provide money to commercial and high street banks, was declared as bankruptcy in 1886. Then the bank of England introduced �Lender of Last Resort�. (BBC, 2007)

In the past few years the USA as well as United Kingdom have suffered from the consequences of the global financial crisis that have started in 2007 as the US sub-prime mortgage crisis. The situation is still unstable and challenging for both countries, especially for their financial systems. This economic crisis has been considered as the return of depression for the US economy (Krugman, 2009). Current crisis is also named to be the worst in the last 75 years with dramatic negative effects on businesses, economies and financial systems (Altman, 2009).

Current global financial crisis has started with sub-prime mortgage crisis in the USA. Defaults on mortgage loans affected the US financial system dramatically as these securities served as underlying assets for structured financial vehicles such as collateralised debt obligations (CDOs) that were traded by investment banks. Banking system was the sector that suffered first as banks were over-lending huge amounts of money and conducting poor risk management.

Objective of the dissertation research:

The terms �the real money� and �the promises about money� works like someone promise to pay more money later for a little real money. So, there is a balance between the real money and the promises which is called credit.

For example, people promises to the bank to repay money with extra interest every month to owe a little money for a specific period. So, the bank gives the money and keeps the promise which is called Mortgage. According to the promise, bank is the actual home owner until the full mortgage payment done. That is called collateral. So, the bank is acting as a Depository Banking because bank need to manage a lot of deposit to give loan to the people.

Again, the bank brings all of the billions promises together and pack them as securities, and sell securities for money. So,

The main objective of the dissertation research is to analyse subprime mortgage crisis that includes

The reasons are behind the mortgages market �why did the crisis happen?, �how is it unfolding now?� and �What is the future activities?� related to subprime mortgage crisis.


The subprime crisis in August 2007 was a liquidity crisis but it did not seem to fit the facts. How could Britain�s largest mortgage bank Northern Rock reject customers� mortgages? Why the entire major banks stopped liquidity support in the interbank relationship? The story was surely deeper than a standard-issue credit problem.

Rationale of the Proposed Research:

The current proposed research has therefore been aimed at bridging the two schools of thoughts surrounding the subprime mortgage business crisis and the support to solve the crisis. It should be noted that there has been a lack of management literature directly concerned with the role of mortgages in recession and economic downturn.

Proposed Research Questions:

My target for this research is to analyze mortgage business crisis as a source of competitive advantage for companies to pursue in times of economic downturns. In order to achieve this broad aim of the proposed research a number of research questions have been furnished, that include:

The research project aims to answer the following questions:

1. Did the �freezing up of the money supply� (credit crunch) lead to weakening of the organisational performance among major UK banks?

2. Did the �non - resilient planning and decision making mechanisms� lead to weakening organisational performance among major UK banks?

Research Structure

This paper begins with an extensive critical literature review that attempts to establish what were the main factors that lead the global economy to its current state. In trying to do so it analyses the recently published literature and articles on the subject so as to provide the sum of knowledge on the subject to the present day. The literature review demonstrates the complexity of the reasons behind the subprime mortgage crisis and the downturn of the economy of the developed countries. Chapter Three provides the justification for the methodology used to carry out this research project. Through a critical consideration of the possible options it identifies the most suitable research design and describes the data collection methods and the sources used to collect the data for the purpose of this research. Chapter Four presents the research findings based on the data sourced from various sources described in the Methodology. It provides visual representations of the trends discussed through a wide use of graphs for the sake of clarity of the findings. The analysis of the research findings is the main focus of Chapter Five that also includes the conclusions, the managerial implications and the limitations of the research project.

Definition of Terms:

Traditional Banking:

It arranges liabilities from the depositors and lends the liabilities to the consumer loans and other loans. So in this system if any risk arises like this one; the liquidity risk than the depositors wanted to take the money out but the money is locked in the long term loans like mortgages and others. So then central bank can help as a lender of last resort. Again, if the loans go bed then the banks can face the solvency problem where insurance corporation; like the Federal Deposit Insurance Corporation (FDIC) can help in this aspect. It is noted that the traditional banking system is covered with a lot of regulations and regulatory support.

Shadow Banking:

Fischer Black, in his book �Fundamentals of Liquidity� in 1970, defined the corporate bond as three parties shared the bond where one supply the money, the other took the interest rate risk and the last party took the risk of defaults.

In the modern banking system, the interest rate risk and the risk of defaults is turned as interest rate swaps and credit default swaps respectively. By this way, the credit becomes cheaper and more available for the ultimate borrowers. In the same way, the credit system is separated from the payment system.

The traditional banks originate loans, get the interest rate risk off the balance sheet and avoid the risk of loan defaulting by the consumer. For this they originate loans, packaged and securitised them and finally sell them in the shadow banking systems. The shadow banking arranges funds from asset back securities, mutual funds and other money markets.

Collateralized Debt Obligations (CDOs):

The Asset Backed Securities (ABX) Index:

This is a traded index of 20 CDO tranches.

Credit Insurer of Last Resort:

It is the Bagehot Rule indicates to lend or insure the mortgages freely but at a high rate or high premium. Perry Mehrling, professor and economist at Barnard College proposed �the credit insurer of last resort� as people want to borrow more systematic risk if they get it at a lower rate and systematically it brings them from cheating earthquakes.

Main characteristics of the UK and US financial system

The head element of the US financial system is the Federal Reserve System that has authority to conduct monetary policy, regulate banking sector and is responsible for the stability of the financial system (FRB, 2009). It also provides advice to the Government. The main elements of the Federal Reserve System are Board of Governors, Federal Open Market Committee, Federal Reserve Banks and advisory councils (FRS, 2009). Financial system is represented by lending and investment institutions, organised markets (e.g. stock market), financial services and products being traded. For the last few years, the US financial system was making huge profits without considering what consequences there would be. Risk was underestimated and more and more complicated financial vehicles appeared in the market and were sold to institutional investors. Underlying assets, however, were partly rotten and risky. Financial institutions seemed to play with fire and spread risk from one party to another until the whole system started suffering.

As many other countries, the United Kingdom has various connections to the US economy and financial system, UK banks invested in the US MBS and ABS � mortgage and asset-backed securities. Two economies are also interconnected through trade, borrowings, loans and banking sector. Here, the crisis had spread through financial operations, loans and bad debts to the UK banks, causing some to go bankrupt (e.g. Northern Rock, which was later nationalised). Even such giants as HSBC, RBS and Lloyds had to seek government support.

UK financial sector is governed by the Bank of England that has a mission to secure and �to contribute to maintaining financial stability in the UK as an essential ingredient for a healthy and successful economy� (Bank of England, 2009). However, this stability was at the risk of failure at the beginnings of 2008.

The financial system of the United Kingdom includes financial institutions (commercial banks, investment banks, insurance companies, hedge funds etc.), investment products and services being offered and infrastructure that facilitates trading. Banking sector has always faced different types of risks (credit risk, market risk, currency exchange risk etc.) and risk management is therefore essential. The crisis of 2008 demonstrated that financial system was very sensitive to economic shocks and vulnerable.

London is considered to be financial centre of Europe and financial services are one of the most important sources of income of the UK economy. IMF (2003) used to indicate that British financial system was very stable and secure against external shocks. It could have been so. However, the point is not what it was but what it has become. Financial crisis has revealed weakness even in the seemingly strong British financial system.

Both US and UK financial systems are now damaged and are trying to rehabilitate through restructuring and adoption of new reforms and policies. Financial institutions suffered unprecedented losses that will continue to have an impact on the economy in the near future.

Changes in the UK and US financial system after the global crisis

It should be noted that changes in financial system occur not only under the influence of economic disasters such as the credit crisis but also as part of the whole evolutionary process in the economy that needs to adapt to constantly changing competitive environment. Current financial crisis has intensified the tendency of changes. Today a lot of efforts are taken by the US and UK governments in order to rehabilitate financial system (GAO, 2009).

Regulation of financial system is increasing. This can be observed in issuance of new financial reporting and accounting rules that attempt to protect investors from future failures in the system. Particularly, the question of qualified special purpose enterprises (QSPE) was raised as these were the main bodies that performed securitisation of risky financial instruments and remained off balance sheets of head companies (Herz, 2008; Haldane, 2009).

One similarity of the changes regarding banking system that took place in the USA and UK is nationalisation of a number of large banks in order to rescue them from failure. The US example is Citigroup that is partly owned by the Government and the UK examples are The Royal Bank of Scotland which is almost totally owned by the UK government and Lloyds Banking Group (Webster, 2008).

Changes in the financial system of such countries as the USA and UK are mainly connected with changes in such elements as financial institutions, credit markets, banking sector, including shadow banking system. The problem of shadow banking system was previously raised after Enron case and similar failure of corporate governance in the US. However, in spite of the significant changes that were done back then, e.g. Sarbanes-Oxley Act, problems of shadow banking system remained. The problem of off balance sheet items was also discussed. Besides that, changes in disclosure of financial assets have been enforced (Herz, 2008).

US government had several changes and responses for the global financial crisis. Before September 2008 the Federal Reserve decreased interest rates and adopted various programs to enhance liquidity in the financial system, nationalised the Bear Stearns bank and attempted to mitigate the problem of increasing foreclosures (Marshall, 2009, p. 3). However, after September 2008, the situation needed another approach � US Treasury became the main body along with Federal Reserve, to maintain and control the Emergency Economic Stabilization Act that was adopted by the Congress in 2008. The government experimented with maintaining the rules of free economy and let Lehman Brothers fails instead of rescuing it. This failure had a huge negative impact on stability of both the US and UK financial systems. This stability was shattered and public lost confidence in capitalist forces. So, the process of nationalisation of some financial institutions was inevitable to restore or improve the confidence (Marshall, 2009).

Financial Regulatory Reform was adopted to remedy the consequences of the crisis and improve financial system. It was pointed that new approaches must be found in order to work more effective and be more secure to face changes. Briefly, the reforms cover the following major areas. They propose improvements of regulating financial and lending institutions as well as supervising them more closely. Secondly, the reform has made supervision of capital market stricter. Thirdly, the reform implies taking measures for protecting economic agents from financial fraud. Finally, the reform aims to increase regulation on international level by cooperation of the US with other countries (Financial Regulatory Reform, 2009). It can be said that the mentioned reforms all sound important and vital in today�s situation. However, their implementation may take significant time and resources. So, these can be viewed right now only as preconditions of future significant changes in financial system of the US and other developed countries.

An important change in the financial system that should be mentioned is the increase of the value of ensured deposits in the US and UK. The governments are aware that during the crisis when banks and other financial institutions face problems and even bankruptcy, depositors and savers will be reluctant to keep their money in banks if it is not secured. In the US, insurance of deposits is guaranteed by FDIC. Within the proposal of US Treasury, even more changes touched Federal Deposit Insurance Corporation (FDIC) and National Credit Union Administration (NCUA) � as FDIC now will regulate and control some state banks and NCUA will support its authorities, taking into consideration credit unions (Block, 2008).

Changes in the United Kingdom started during the crisis mainly with nationalisation. Changes in banking sector influenced the UK financial system dramatically. The Government had to rescue several large banks from failure. Northern Rock Bank had serious support from the Bank of England and later was nationalised in 2008, followed by Bradford & Bingley, The Royal Bank of Scotland and HBOS-Lloyds TSB. After that, the Bank of England adopted �Special Liquidity measures in the money markets�, different changes in the money market operations, introduced extended conditions for the asset swap discount and asset protection scheme (Edmonds, Webb and Long, 2009). Asset protection scheme was adopted in January 2009 and includes �protection against credit losses� for the financial institutions (HM Treasury, 2009).

Further significant changes in financial system of the UK and US are also likely to occur. This can be deduced from observing the plans and intentions of the Government.

The Bank of England proposed changes to be taken in the international banking connected to liquidity and capital requirements (Shah, 2009). In his speech, Executive Director of the Bank of England, Haldane (2009) pointed that one of the main mistakes that caused crisis is the lack of information. Therefore, changes will be taken in order to open and improve communication channels and information delivery. He also proposed the necessity of new controlling body that will monitor the financial system and fix problems that appear immediately.

Major changes should be done also in the management of financial institutions and particularly banks. Banks must improve their risk management practices and carefully maintain the balance between liquidity and return. It can be projected that both the US and UK government will attempt to separate functions of investment banks. Over the recent years, practices of investment and commercial banks became interrelated. Mortgages provided by private clients were repackaged into structured financial instruments such as CDOs and sold to institutional clients (Gorton, 2009). So, failure of private clients to meet their debt obligations spread to the corporate world very fast. Separation of activities can be recommended to reduce chances of future crises similar to this.

Among macroeconomic measures that were taken in the UK are changes in interest rates. They were lowered to the point of 0.5%, which is the lowest figure for the last ten years and it is believed that such reduction will have positive effects in the near future. Also the policy of quantitative easing was introduced as an instrument that will help to increase activity level of the economy (Edmonds, Webb and Long, 2009).