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Enterprise and Social Responsibility
The Financial crisis - A Case Study
The financial crisis is only easing very slowly and the finger of blame continues to be pointed at the banks for unethical conduct. The Governor of the Bank of England, Mark Carney, is calling for a change of culture from the Banks. As recently as 19th September 2013 Morgan Chase has been fined £527 million (combining UK and US fines) for failure in control and culture after London traders lost £4 billion. Other recent issues that have come to light include mis-selling of financial products (such as complex interest rate swaps to small businesses and the manipulation of LIBOR by several UK Retail banks (This short term interbank borrowing rate is critical in providing a base rate for many other interest rates charge by banks to their customers). However the origins of the current controversy go back several years.
In September 2011 the UK Govt. accepted the findings of the Independent Banking Commission led by Lord Vickers, which recommended wide ranging reforms to our banking system, most significantly the separation of retail and investment banking, and a requirement for banks to maintain higher capital ratios to support their lending. The intention is to prevent a recurrence of the 2008 banking crisis, the most serious crisis since the Great Depression. Subsequent to the crisis, it appears that Banking bonuses are back, even for the British High Street Banks supported by Government guarantees and funding. This is despite the fact that in 2009 the world entered a deep recession, still forecast to be the most severe in the last 70 years. Britain, whose economy relies on income from international banking based in London, is likely to be one of the worst affected of the developed countries, and the economy remains in a dangerous phase.
The difficulties affecting the economy appeared first not in the UK, but in the U.S. Banking sector, where a crisis was triggered by problems which arose in the subprime mortgage market. However British financial institutions such as Northern Rock and Bradford and Bingley were following similar business strategies such as offering 125% ‘loan to value’ mortgages and granting loans based on self-certified income declarations. The crisis in the banking sector stemmed from two main factors – the first was related to high levels of deposits and the need to make a return on capital. American banks were awash with Chinese money deposited with them after years of Chinese export surpluses, and looking around for new lending opportunities. The second factor was deregulation, allowing banks much more freedom as to how they run their business. In the years following deregulation of the banking sector in the 1980’s, banks became progressively less conservative in their lending policies, until the point was reached where loans were being granted for the purchase of homes to people with poor credit history and little prospect of being able to ever meet repayment schedules in the medium to longer term. Often this grim reality was masked by short term discount periods with ‘teaser’ rates set artificially low, which temporarily reduced the extent of actual monthly payments that would become due once the discount period ended. Banks became progressively much less risk averse in their pursuit of new business, in some cases lending out up to 40 times the amounts that had been deposited with them. This was in some cases combined with rash acquisition and diversification policies. The drive for new business was caused by a shift in banking culture following deregulation which increasingly linked staff bonuses to sales volumes and so incentivized them to maximize bank lending.
However the banks were in fact building up loan books which were riddled with bad debt, and subsequently in order to shore up their balance sheets were then ‘bundling’ loans in to packages which they subsequently sold on in the financial markets – known as C.D.O’s (Collateralized Debt Obligations). But hidden within these bundled package were ‘toxic assets’ consisting of loans unlikely to ever be fully repaid. This situation created a bubble which would inevitably burst, as the banks were broadly aware of each other policies, and therefore of the underlying weakness of their financial position. It all finally came to light when the banks lost confidence in each other and began to charge high rates of interest for short term interbank loans (the ‘LIBOR’ rate), or even to refuse to lend to other firms. This created a crisis, because aggressive lenders such were not able to borrow to finance their operations – the beginning of the ‘credit crunch’.
Before long other institutions with weak balance sheets were failing, notably in the U.S.A Lehman brothers, and in the UK Northern Rock (which relied heavily on the money markets to finance its business) were the first banks to run out of money. As rumours of the difficulties spread, both companies and individuals started to queue up (in some cases quite literally) to close their accounts. A bank has not failed in the UK within living memory, and if it were to happen it would create a public loss of confidence in the banking system, and lead to massive withdrawals of deposits. This could easily cause the whole banking system to fail, so not surprisingly the UK Govt. stepped in and nationalized Northern Rock.
But this did not halt the rot, and the Government subsequently was quickly forced to offer up to £70 billion financing to support UK banks and so prevent widespread banking failures. In the U.K the banking sector has rapidly witnessed a reduction in the number of building societies, and consolidation among the clearing banks combined with partial State ownership through increased Gov’t funding – for example the Govt. at present owns over 90% of RBS (Royal Bank of Scotland), and is the majority shareholder in Lloyds TSB. The credit crunch rapidly spread across the banking sector globally, and also to other sectors needing loans to finance their business activities. In other regulatory regimes where the Govt has less ability to support the banking sector, failure has followed (e.g. in Iceland and the Isle of Man) and it appears that depositors may have lost most of their savings. In the USA the housing market was also badly affected very quickly, and the Government had to step in with rescue packages to bolster up its key mortgage broking firms (known as ‘Freddie Mac ’and ‘Fanny Mae’).
As might be expected, shareholders in some of the banking institutions are pretty displeased with the current situation. In the case of Northern Rock the value of shares have been effectively reduced to worthless, and share prices of all the major banks have suffered badly, particularly those where ownership has been diluted due to the Government taking a minority stake (some of the banks which had remained more prudent and risk aware during the race increased their loan books, and in the subsequent crisis the least affected was HSBC, which alone of the UK banks has not needed to raise extra funds in order to weather the storm).
Towards the end of 2008 the result of this crisis was that loan funds for companies looking to the banks for working capital finance dried up, and confidence began to drain from the world economy. The resulting sharp contraction in world trade continued into 2009 and 2010 with no immediate prospect of recovery this last year. What went wrong? On the face of it, this could all perhaps be blamed on aggressive selling of loans and mortgages initiated by American banks, but in truth the UK was in no better a position. Here, house prices have risen relative to incomes more than anywhere else in the world except Ireland, and much of this ‘boom’ had been driven by aggressive lending policies of the banks themselves. Now house owners are faced with negative equity and an inability to sell. In previous times, it was not easy to apply for a mortgage but this all changed in recent years. Bank managers became driven by sales targets linked to very high bonuses and began to ignore the assessment of risk in favour of meeting sales targets in order to increase the bonuses they would receive related to sales targets. The apologies of senior bankers to a UK Parliamentary Committee for unwise policies has not been generally well received or believed to be genuine – particularly since Sir Fred Goodwin, former CEO of RBS has since refused to give up any part of his pension package initially calculated at £704,000 per year which is now supported through tax payer funds.
There are regulators in the banking sector, whose responsibility was to monitor banking activities. The Financial Services Authority (FSA) set up under Gordon Brown’s Chancellorship had adopted a light touch regime, which with hindsight was totally inappropriate and ineffective. The Bank of England, also in a position to influence the commercial bank policies, has for a decade been preoccupied with controlling inflation as its main task. It was a Conservative Govt. that had brought in deregulation to allow the banks to lend significantly more than they were holding in deposits in the 1980’s, but a Labour Govt had been in power since 1997 and had done nothing to step in to control the situation as the banking sector began to run amok. As of today, it looks likely that the impacts of the lending and borrowing spree of the last decade will be a sustained and deep recession affecting the global trade for at least the next two to three years. Moreover, to rescue the banking sector the UK Government has taken on liabilities which could potentially rise to over a trillion pounds, and will certainly result in higher taxation and cuts in public expenditure which will start next year and continue for years to come. Both large and small businesses are complaining of loans being recalled, and the banks’ unwillingness to provide new finance, despite consumer credit still being widely available. An initial announcement at the London G20 summit this year of intentions to develop a global banking regulatory framework has to date not resulted in any concrete proposals. Meanwhile the UK Govt. has announced that it intends to provide further powers to the F.S.A to enable it to rip up contracts of bank executives and traders in future years where excessive bonuses not linked to share price are still in place. However it is likely that for this year at least the Govt. bail out and underwriting of bank business may have provided the banks with the cash to enable a something of a return to the bonus culture which originally led to the banking sector crisis.
Since the onset of the banking crisis, the ripple effects continue. National Governments borrowed heavily to shore up the global banking system, and this has subsequently led to a protracted sovereign debt crisis, with counties finding it increasingly difficult to borrow at reasonable rates, which increases their risk of eventual default. This in turn could lead to further difficulties for Investment Banks, particularly in mainland Europe. The risk of Government defaults across Southern Europe in particular also threatens the viability of the Euro as a currency.
Every month brings fresh revelations as to the extent of questionable business practices by banks. It is now emerging that many rural Italian towns are in serious financial difficulty through financing of loans through C.D.O’s which have subsequently left them with further liabilities – in effect if Greece defaults on its bank loans Italian towns become liable for the debt ! Only Milan has to date refused to accept the liability and threatens to prosecute the banks for mis-selling of C.D.O’s. The banks making these deals were based in London and benefitted from its light tough regulatory policies.
However not all stakeholders agree with the UK Gov’t proposed reforms. The Confederation of British Industry has added its voice to the banks in claiming that structural reform will reduce lending volumes and also render London less competitive as an international banking centre. If fully implemented the reforms will make Britain (alongside Switzerland) the most tightly regulated international banking centre in the world. The reforms however are planned to be enacted over an 8 year period, and doubts have been expressed as to whether they will ever be fully implemented.