Good Example Of Report On Effects Of Credit Crunch On Performance Of British Banks

Executive Summary

This research report provides information about the causes of failure of British Banking system due to emergence of financial crisis or credit crunch which originated from the United States in 2007-08. Some of the discussion is also made about whether the British banking system should be left alone to fail followed by a general overview of existing regulatory requirements that apply to British banks. The last section gives some recommended policy measures to help the British banking system surpass the “double-dip” recessionary pressures. It is found in this report analysis that banks relied heavily on debt capital and ran highly leveraged business due to which interest cost increased and income declined sharply when interest rates sky-rocketed all over the world. It is also found that British banks control 85% percent of the global industry due to which it is too big to fail. The current regulatory environment for managers of British banks is very tight as their compensation and bonus rewards are highly linked to performance.

Introduction

In every economy, each sector contributes to the progress of a nation by improving the methods of production and increasing the number of outputs. Of all those sectors, the finance sector is the one with influence almost in every industry . Not only that, this sector supports the household sector in an economy as well. In view of this, the banking sector is of prime importance with regards to supporting every financial aspect of an economy.
Therefore, this paper is written to make a general discussion about the failure of British banking system. The paper also mentions the reasons as to why the British banking system should not be left alone to fail in future. Some of the attention is also given to effectiveness of existing regulatory systems whereas the paper, in the end, emphasises the cooperation between regulatory bodies and some of the recommended actions to keep the British banking system run smoothly.

The Reason for the Global Influence of Credit Crunch or Financial Crisis

Before discussing the major reasons behind the failure of British banking system, it is necessary to mention how the crisis started and how it paved its way into the British banking and finance sector in 2007. Also known with other names like credit crisis and credit squeeze, a credit crunch of financial crisis reflects a sudden decline in the availability of general credit (or loans) irrespective of any increase in the level of interest rates. This condition also represents an economic condition conditions required to obtain a bank loan are further tightened or made stricter followed by a rapid reduction in their availability to numerous economic agents like, individuals, households and businesses etc . In other words, a credit crunch relates to severe shortages of or credit money in affected economies. This situation, from recent studies, stems from bad news broadcasted by a French bank, BNP Paribas, which dictated that the cost of credit has increased sharply on August 09th, 2007.
The lending crisis or credit crunch originates from sub-prime loan crisis of the United States. This incident is also known with the name of global financial crisis of 2007-08 in the worldwide finance industry. One of the major reasons for this crisis was the aggressive lending by banks and heavy borrowing by U.S. citizens to buy homes and sell them at higher anticipated prices. On the other side, banking and financial institutions started extending high risk credit to those applicants with poor or no credit histories. However, due to a drastic increase in level of interest rates from one percent to five percent approximately, the housing market slowed down due to dramatic trade in the housing sector. Furthermore, as interest rates increased dramatically, borrowers started defaulting on their highly risky outstanding loans because they could not manager mortgage payments.
This way, number of default loans increased to record levels all across the United States. Due to this, not only banks saw a sudden reduction in their interest incomes, they were also unable to cope-up with asset and liability management. In other words, banks witnessed problems in their maturity mismatches with regards to the assets and liabilities on their balance sheets. The number of written-off loans also rose to record high marks whose negative influence spread to other corners of the globe and was felt in the global finance industry.

Question 1 - Effects on Global Credit Crunch or Crisis on British Banks

Under this section, reasons for which British banking system failed in the past due to credit crunch or crisis that originated from the United States. Whether the banks should be allowed to fail in future will also be discussed in light of contributions of the banking system in supporting British economy.

Reasons for the Failure of Major banks Due to Credit Crunch or Crisis

The British banking system started to face failures during the mid of September 2007 when the first victim, a British bank named Northern Rock failed. Since the credit availability was short in the market and interest rates in the global industry increased, Northern Rock failed because of relying heavily on borrowed debt in form of highly leveraged business. In reaction to this, investor and depositor panic spread like a grass-fire in the British financial market.
Another reason for the failure of British banking, which hurt this sector severely, was that majority of banks were running a highly leveraged business carrying high debt burdens on their balance sheets. This followed by heavy declines in profits resulted in emergence of depression or recession in the British economy. Financial institutions started failing, economic growth became slow, unemployment rate increased and social unrest was high.
During 2011, economy failed to recover from depressive state and grew only by 0.9 percent when the economic growth shrank, during the final quarter, by approximately 0.4 percent. This was followed by a recessionary start of 2012 when, in the very first quarter, the British economy posted a growth of only 0.3 percent. After the turmoil of 1975, it was the first double-dip economic recession when the British witnessed a depressed economic growth again and again before it could recover from previously witnessed recessionary pressure.

Should British Banks Be Allowed to Fail in Future?

The British banks should never be left alone to fail in the future because they form an integral part of the financial infrastructure. The major source of credit crunch in the British economy was the U.S. financial crisis which damaged financial industry and forced the U.K. economy into recessionary pressures for decades . Many economists and policymakers agree that the recovery from this recession will be slow when British economy is facing recessions one after another. Therefore, instead of leaving the banking system to fail, it is necessary that reforms should be introduced .
The British authorities should always support the banking system because by accepting deposits, even at higher rates, they channelize funds to productive business channels which stimulate an increase in economic growth. British banking system supports the business activity by providing borrowing facility in the debt market . The British banking system is so powerful that few of its banks control almost eighty five percent of the total business lending worldwide. Even after the financial crisis of 2007-08, this sector contributed around 9.4% of the total economic output (£125.4 billion) to the British economy .

Question 2 - Current Legal Regulation of the Banking System

In light of the credit crunch influencing the British banking system since 2007, this section makes discussion on the effectiveness of existing legal regulations that apply to banks followed by analysis of the ethics of banking behaviour.

Effectiveness of Existing Legal Regulations

British banks have already come under strong pressures from regulators, shareholders and taxpayers. Due to this, the very first regulations which European authorities implemented in December 2010 concerns strict restrictions imposed on staff bonuses. Under this effective regulation, bank managers are entitled to receive only twenty to thirty percent of their bonuses in form of cash . In other words, the managerial performance has been linked to a certain portion of bonuses awarded.
The existing regulatory environment is effective enough to influence every British bank to defer forty to sixty percent of total bonus payment to around five years and award fifty percent bonus in form of share ownership rather than in cash. This regulation also requires that compensation details should also be published. Regulatory influences have also forced banks to Claw-back the compensation if the manager’s performance is not worthy of such reward or bonus .

Greater Cooperation between Sovereign Bodies for Effective Regulations In Future

As mentioned in earlier sections of this report that British banking system has faced double-dip recessionary pressures since 2007 followed by a discussion on existing legal regulations, it is necessary that the Bank of England should keep an eagle’s eye on the money and banking markets all across the Great Britain. To prevent credit crunch from further devastating the economic outlook, FSA should closely monitor and supervise individual banks and protect the consumers’ interests.
It is equally important that banks should run the businesses from their own financial cushions. This will help to continue their business operations independently as a going concern if anything goes wrong with other bank operations. In other words, British banks should cooperate with each other and carry less debt on their balance sheet while having more internal liquidity strength to meet liabilities. The government should also discourage the banking system from depending upon risky sources of borrowing which makes the credit crunch or loan crisis much more intense.
During the start of credit crunch or financial crisis, the Federal Reserve Bank made no attempt to deal with the housing bubble which originated from the United States. The above mentioned regulatory actions in this section are important because the European Central Bank wrongly believed that current-account imbalances are less important to the British monetary system and therefore, made no attempt to control the credit surge. Tighter regulatory controls and close monitoring is important because since 1997, the Bank of England lost its supervisory influence over the British banking system and its inability to maintain stability in the financial industry resulted in credit crunch.
In the world of today, controlling the credit crunch or crisis would be difficult for the British regulatory bodies through increase in interest rates. Therefore, the sovereign states should cooperate with each other to employ other regulatory tools like reduction in maximum loan-to-value ratios for finances (credit) or the regulation may be passed that every bank should rely on its internal liquidity strength by keeping more funds available to meet liabilities .
Similarly, banks should rely on less borrowed debt because increased debt reduces the shareholders stake into the business. Due to this, shareholder demand higher returns against their investments in light of their declined stake. When pressurised from shareholders to increase return on investment, due to decline in equity stake, the bank is more exposed to interest rate risk where its becomes more vulnerable to bankruptcy .

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