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The recent global credit crisis leading to a recession has attracted huge attention and prompted researches towards finding the root causes of what has been described by many writers as the greatest financial crisis since the great depression (Allen, 2008; Carmassi, Gros, Micossi, 2009; Lo, 2007; Grigor'ev and Salikhov, 2008; Melvin and Taylor, 2009; Ely, 2009; Crotty, 2009; Berrone, 2008; Avgouleas, 2009; Yandle, 2010). Although subprime mortgage is mentioned as the main cause (Grigor'ev, and Salikhov, 2008; Schmudde, 2009; Crotty, 2009; Suetin, 2009; Brown and Lundblad, 2009, Flitter, 2009), Acharya et al. (2009) argue that the systematic breakdown was as a result of ‘the collapse … of two highly levered Bear Stearns-managed hedge funds that invested in the subprime assets backed securities (ABSs).' The literature however identifies other factors which are directly or indirectly implicated and will be discussed.
Background of study
Suetin, (2009) blamed the recent financial crisis on securitization which was invented in the 1970s. Securitization process as well as the rating agencies failed to identify dangerous risk-taking (Carmassi, Gros and Micossi, 2009). It is therefore described as the vector carrier of the subprime parasite (Eitman et al., 2009). Instruments like Structured Investment vehicles (SIVs), Collateralized Debt Obligation (CDOs) and Credit Default Swaps (CDSs) are components of securitization. ‘Global macroeconomic' disproportion resulting to large cross-border capital flows (Brown and Lundbald, 2009), poor judgments on the part of agencies responsible for bond-rating (Weisberg, 2010; Gaffney, 2009), lack of transparency about the risk borne by banks, over reliance on numerical models and compensation plans which made some executives take unnecessary risk, low interest rate (Carmassi, Gros and Micossi, 2009; Kudrin, 2009), ‘savings glut' (Rajan, 2008), credit companies issuing ‘easy credit', over spending on the part of consumers (Wallice, Avis and Smith 2008), behavioural factors (Avgouleas, 2009) are other factors implicated. Weisberg (2010) attributes it to failure by the regulatory authorities; also see (Lacker, 2009). Bruce (2008) argues that the credit crisis could be traced to the use of fraudulent accounting practices which hide the ‘underlying debts'.
Although financial institutions are at the core of what has lead to the global financial crisis (Acharya, et al. 2009), noted that financial institutions play an exclusive role in the economy, that they serve as mediators between parties that are seeking to invest and the ones that need to borrow. That without such mediation, business activities would be difficult to conduct. Prominent innovations were made in the banking sector through securitization (Suetin, 2009).
The subprime mortgage: what really happened?
The rise in price of houses, coupled with the financial novelty of easy financing resulted in low-income houses being brought into the housing market (Rajan, 2008). This was logically interpreted to mean that with a vibrant housing market, all that was needed was to get an interested buyer to have the house without adequate consideration of the credit worthiness of the buyer and the risk of default, and with the low interest rate attributed to the mortgage payments, little will be paid at the early months of repayments and by the time the payment becomes significant, the house would have appreciated and equity generated to make future payments (Quentin, 2009; Lacker,2009). Subprime mortgages as they were called were intended that mortgages would follow a short period of refinancing to avoid hike in the mortgage rates (Acharya et al. 2009). It was also expected that the prices of housing will continually increase, leaving the option of repossessing and selling the property very viable (Acharya et al., 2009). These activities continued until when the Federal Reserve started increasing interest rates (Lacker, 2009). The result was that fewer buyers could have the funds to buy. Therefore the lenders had to increase the amount of loans to attract buyers. However, the houses stayed longer in the market without buyers, which culminated in falling prices. As the rates increased, many buyers defaulted in payments and the houses repossessed from them could not find ready markets for buyers, the credit quality of buyers became now a matter of interest.
The Llyods banking group
Founded as a private bank in Birmingham by Taylors and Llyods in June 1765, it prospered using just a single office as place of operation. Legislative changes made it attain a joint-stock status in 1865 and resulted in massive expansion. However, Llyods Banking group as it is known today, and as one of UK based leading financial services group was formed in January 2009, after the acquisition of HBOS.
The main business activities of the group are retail commercial and corporate banking, general insurance, and life pension and investment provision. Its international banking service has had strong footing in forty countries of the world. The Llyods group is at present the largest of UK retail banks with a well diversified customer base and is quoted both in the London and New York stock exchanges and classified within the class of FTSE 100 (www.llyodsbankinggroup.com).
Effects of the Global Financial Crisis on Llyods Banking Group:
Like most other financial institutions, the global financial crisis and thus the effect of the global recession (described as a period of negative growth for two consecutive quarters) has had its toll of the Llyods banking group (http://recession.org/definition).
The effect has been significant on the Llyods TSB corporate markets business thus a reduction in profit for the year 31st December 2008, to £845 million (Appendix 1). The bank was seriously lacking in liquidity and has to be rescued from eminent collapse by the government.
The crisis also significantly impacted the bank shares which fell considerably on the acquisition of HBOS by Llyods TSB, a decrease of about 50% in the share price of Llyods TSB was recorded on the news of HBOS losing about £10 billion in 2008 and shattered the initial anticipation of £1.5billion annual cost saving expected from the takeover (Nadeem, 2009).
The effect of the financial crisis on the basis of the different divisions of the group showed the wholesale and international banking recording losses. However the UK retail Banking and the Insurance and Investment divisions recorded some increases in profit, compared to the previous year ended 2007. The changes recorded were 4% and 22% respectively (Appendix 2).
The overall profit before tax (statutory) dropped from £4000 million to £807 million, a change of 80%. The earnings per share were not spared as it dropped from 58.3p in 2007 to 14.3p in 2008, a percentage change of 75% (Appendix 2).
Impairment losses; the group was adversely affected by an overall losses on impairment of about 68%, which amounted to £3,012 million. Impairment on loans and advances taken as a percentage of the average lending was 1.13%, the impact of the market disorder not included. This is compared to 0.82% recorded in 2007. Impairment on assets increased by 64% to the tune of £8700 million and stands at 3.5% of the total lending, this is an increments from 2.5% recorded as at December 2007 (Appendix 3).
Strategic adjustments employed by the Llyods group to protect its financial performance against problems caused by the recent credit crisis:
The Lloyds group developed both short-run and long-term strategies to cushion itself from the effect of the financial crisis as well as put measures in place against the future occurrence of such events. The strategies may also be discussed from the perspective of structural and financial position.
Structural remedies: The Llyods group has a business risk committee as well as a group assets and liability committee which encompass the Chief executive and all members of the group executive committee. This enables them to have an agreement on the nature and level of risk the group will allow without letting the risk adverseness or otherwise of a manager of a business unit affect the overall performance of the group (i.e. they must act within the confines of agreed level of risk while trying to maximize performance). This is enhanced by giving the Chief risk officer (a newly created position) direct access to the Chief executive officer, the Chairman and the ‘risk oversight committee'. The officer must also be a full member of the group executive committee (appendix 5)
Other structural measures aimed at the long-term include putting into more effective use of non-financial measures by introducing the balanced scorecard as a measure of the long-term incentive plan directed at HBOS incorporation and reduction of staff strength.
In the interim at the heat of the financial crisis with the high instability and volatility rate in the market, the UK government decided to ‘inject liquidity into the financial system' so as to restore confidence to investors and thus the market. The Llyods group took advantage of this to reposition itself and had the government take a stake of 43.4% of its shareholding (Llyods group annual report, 2008) (Appendix 6). Funds were also raised by selling new shares worth £21 billion, of which the government was to support with a provision of £5.7billion (Werdigier, 2009)
There was also a review of the remuneration of serving directors by the remuneration committee which agreed that no bonuses were to be awarded to executive directors for the year 2008, directors' base salaries were to be frozen at 2008 level. A reduction of incentive level of 175% of salary is implemented. The plan and adjustments also included:
- Strengthening the role of risk-adjusted economic profit through its introduction as a measure in the long-term incentive plan and its immediate use in yearly incentive.
- The incentive plan was also adjusted so that payment could be deferred over a period of three years and could be withdrawn if act on which the incentive is based is unsustainable.
- It was also asserted that executive directors will no more take part in the ‘final salary pension' starting from the year 2012, by April precisely.
Since the overall result of the group despite the crisis showed statutory profit before tax of £807 million and economic profit of £731 million for the year 2008, one may say the strategies adopted were effective. It could also be argued that the strategies adopted would yield better results in the long-run as there are directed. However, interim result from the view of combined business showed a reported loss of £6,300million before tax for the year 2009 an improvement compared to 2008. Impairment losses increased by £9,108million to £24.0billion an effect of set-back from HBOS portfolio. In the fourth quarter of 2009, bad debts increased to £5.4 billion as against £5.2billion in the third quarter (http://ftalphaville.ft.com). The HBOs deal may not be perceived as the best for now as results show it to be a major set-back of the Llyods group . The scale of this decision was felt even more when the 2009 result showed a provision of £30billion was made over the past two years and estimated £12billion on HBOS loans for this year (http://ftalphaville.ft.com).
Applicable financial theories
The portfolio theory happens to be implicated in the recent financial crisis since the belief in it lead to investing in low grade investment credit quality. ‘The theory held that whereas a single large subprime borrower constituted significant risk, a portfolio of subprime borrowers which was securitized …represented significantly less risk of credit default and could therefore be awarded investment grade status (Eistman et al., 2009: p.113)
The arbitrage pricing theory (APT) which was adopted by Clare, (1995) in a similar situation during the recession of the early 1990s fits the evaluation of the recent financial crisis. Clare, (1995) is of the opinion that this model would be good since the comparative risk related with each circumstance is reflected in the prices of common stock. The theory of market efficiency rightly applied in the case of Llyods as the price of its stocks fell drastically when the announcement of its takeover of HBOS was made.
In conclusion, one may say the financial crisis and thus recession is a result of numerous factors most prominent of which is subprime mortgage. It is the cumulative effect of unchecked lapses in vital areas.