A Financial Intermediary

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A bank is a financial intermediary that offers loans and deposits, and payment services. Its core activity is to provide loans to borrowers and to collect deposits from savers. Banks stock money, people need money; therefore, people need banks. Banks provide a home for people's money, which is something accountants do not do; and banks also lend money, which accountants certainly do not do. There are three main kinds of banking: commercial banking, investment banking and central banking.

Commercial banking is the traditional role of the banker as it relates to the taking of deposits and granting of loans. Commercial banking is split into two types: retail banks and wholesale banks. Retail banking relates to financial services provided to consumers and is usually small-scale in nature. Retail banks are often known as High Street banks, because they large branch networks, many of them comprising well over a thousand branches, usually located in the main shopping streets. Wholesale banks are found in the major financial centres of the world, eg London, New York, Frankfurt, Hongkong and Tokyo. They serve the major companies and have large-scale dealings with other banks throughout the world. The key different between these is that retail banks borrow from and lend to members of public and companies whilst wholesale banks deal with other banks and with governments (national and overseas).

Investment banks are a US creation; and it could not be combined with commercial banks in one institution. The main role of investment banks is to help companies and governments raise funds in the capital market either through the issue of stock or debt (bonds). Typically, their activities cover the following areas: financial advisory; underwriting of securities issues; trading and investing in securities on behalf of the bank or for clients; asset management; other securities services.

A central bank can generally be defined as a financial institution responsible for overseeing the monetary system for a nation, or a group of nations, with the goal of fostering economic growth without inflation. The core functions of central banks in any countries are: to manage monetary policy with the aim of achieving price stability; to prevent liquidity crises, situations of money market disorders and financial crises; and to ensure the smooth functioning of the payment system. Banks, as other financial intermediaries, play a pivotal role in the economy, channelling funds from units in surplus to units in deficit.

Financial crisis:

The financial crisis of 2007-2009 has been called the most serious financial crisis since the Great Depression by leading economists, with its global effects characterized by the failure if key businesses, declines in consumer wealth estimated in the trillions of U.S dollars, substantial financial commitments incurred by governments, and a significant decline in economic activity. The immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005-2006. High default rates on subprime and ARM (adjustable rate mortgages), began to increase quickly thereafter. An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favourable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006-2007 in many parts of the U.S, refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. In the years leading up to the start of the crisis in 2007, significant amounts of foreign money flowed into the U.S from fast-growing economies in Asia and oil-producing countries. This inflow of funds combined with low U.S interest rates from 2002-2004 contributed to easy credit conditions, which fuelled both housing and credit bubbles. Then, the global financial crisis really started to show its effects in middle of 2007 and into 2008. Around the .world stock markets have fallen, large financial institutions have collapsed or been bought out, and governments in even the wealthiest nations have had to come up with rescue packages to bail out their financial systems.

Literature Review:

The world economy is experiencing perhaps the most serious financial crisis since the breakdown of the Bretton Woods system in the early 1970s, in terms of both its scope and its effects. Its impact is much more global than that of the financial crisis we have seen in the past two or three decades. Today, global financial integration is much more pervasive, and the Asian countries have a much higher share of world trade and production. For some, the global nature of the current crisis has been unprecedented as several advanced economies have simultaneously witnessed declines in house and equity prices as well as difficulties in the credit market.

The origin of financial crisis:

As we know the current global financial crisis originated with losses on US subprime mortgage related securities, losses that first emerged with the slowing of the US housing market in the second half of 2006. The first origin of financial crisis is that the growth of housing bubble precipitated the beginning of financial crisis. Between 1997 and 2006, the price of the typical American house increase by 124. (Economist, 2007) During the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2006. (Steverman and Bogoslaw, 2008) This housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the appreciation. By September 2008, average US housing prices had declined by over 20% from their mid-2006 peak. (Economist, 2008) The other origin of financial crisis is easy credit, and a belief that house prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable rate mortgages. These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term. Borrowers who could not make the higher payments once the initial grace period ended would try to refinance their mortgages. Refinancing became more difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default.

The process of financial crisis:

There is evidence that both government and competitive pressures to an increase in the amount of subprime lending during the years preceding the crisis. Major US investment banks and government sponsored enterprises like Fannie Mae and Freddie Mac played an important role in the expansion of higher-risk lending.

In 1996,HUD, the department of Housing and Urban Development, gave Fannie Mae and Freddie Mac an explicit target: '42 per cent of their mortgage financing had to go to borrowers with incomes below the median income in their area.'(Schwartz, 2009, pp46) Between 2000 and 2005 Fannie Mae and Freddie Mac met those goals every year, and funded hundreds of billions of dollars' worth of loans, many of them subprime and adjustable-rate loans made to borrowers who bought houses with less than 10 per cent deposits. Finnie Mae and Freddie Mac also purchased hundreds of billions of subprime securities for their own portfolios to make money and help satisfy HUD affordable-housing goals. (Schwartz, 2009) Due to the deregulation loans, some borrowers could get loans under easy credit conditions. Predatory lending refers to the practice of unscrupulous lenders, to enter into 'unsafe' or 'unsound' secured loans for inappropriate purpose. When the housing bubble burst, USA housing and financial assets decline in value, and the subprime crisis was coming out. After that the financial crisis had been basically formed.

There is a story of financial crisis stated by Butler (2009: p51): 'Once upon a time, greedy bankers, mostly in the USA, made fortunes by selling mortgages to poor people who could not really afford them. They knew these loans were unsound, so they diced and sliced them and sold them in packages around the world to equally greedy bankers who did not know what they were buying. When the housing bubble burst, the borrowers defaulted, and bankers discover that what they had bought was worthless. They went burst, business loans dried up, and the economy shuddered to a halt. The moral, accounting to this description of events, is that capitalism has failed, and we need tougher rules to curb bankers' greed and make sure all this never happens again.' This story could express accurately the process of finance crisis.

The impacts of financial crisis in the world:

A collapse of the US subprime mortgage market and the reversal of the housing boom in other industrialized economies have had a ripple effect around the world. Furthermore, other weaknesses in the global financial system have surfaced. Some financial products and instruments have become so complex and twisted, that as things start to unravel, trust in the whole system started to fail.

First, it affected on financial institutions. Initially the companies affected were those directly involved in home construction and mortgage lending such as Northern Rock and Countrywide Financial, as they could no longer obtain financing through the credit markets. Over 100 mortgage lenders went bankrupt during 2007 and 2008. Concerns that investment bank Bear Steams would collapse in March 2008 resulted in its fire-sale to JP Morgan Chase. The crisis hit its peak in September and October 2008. Several major institutions either failed, were acquired under duress, or were subject to government takeover. These included Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac and AIG.

Second, it affected the money market. During September 2008, the crisis hits its most critical stage. There was the equivalent of a bank run on the money market mutual funds, which frequently invest in commercial paper issued by corporations to fund their operations and payrolls. Withdrawals from money markets were $144.5 billion during one week, versus $7.1 billion the week prior.

Third, wealth effects in the financial crisis. There is a direct relationship between declines in wealth, and declines in consumption and business investment, which along with government spending represent the economic engine. Between June 2007 and November 2008, Americans lost an estimated average of more than a quarter of their collective net worth. By early November 2008, a broad U.S. stock index the S&P 500, was down 45 percent from its 2007 high. Housing prices had dropped 20% from their 2006 peak, with futures markets signaling a 30-35% potential drop. Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in late 2008. Total retirement assets, Americans' second-largest household asset, dropped by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total a staggering $8.3 trillion. (Altman, 2009).

Finally, it is the effects on the global economy. The crisis rapidly developed and spread into a global economic shock, resulting in a number of European bank failures, declines in various stock indexes, and large reductions in the market value of equities and commodities. Moreover, the de-leveraging of financial institutions, as assets were sold to pay back obligations that could not be refinanced in frozen credit markets, further accelerated the liquidity crisis and caused a decrease in international trade. World political leaders, national ministers of finance and central bank directors coordinated their efforts to reduce fears, but the crisis continued. At the end of October 2008 a currency crisis developed, with investors transferring vast capital resources into stronger currencies such as the yen, the dollar and the Swiss franc, leading many emergent economies to seek aid from the International Monetary Fund. (Landler, 2008).

The impacts of financial crisis on US banking system:

GDP, the output of goods and services produced by labour and property located in the US, decreased at an annual rate of approximately 6 percent in the fourth quarter of 2008 and first quarter of 2009, versus activity in the year-ago period. The US unemployment rate increased to 9.5% by June 2009, the highest rate since 1983 and roughly twice the pre-crisis rate. The average hours per work week declined to 33, the lowest level since the government began collecting the data in 1964.

From time to time confidence in the USA's banks would weaken and banks' note-holders would demand their specie (i.e. gold or silver) back. Banks could meet these withdrawals either from their own vaults or by taking back some of the bullion left with the clearing-house association. The lower the level of their balance the clearing system, the greater would be the likelihood that individual non-central banks would be overdrawn. (Congdon, 2009) There is an example from him: 'suppose bank Y's initial deposit with the clearing system was 30 pounds. If its customers instructed it to make net cash payments to other banks of 35 pounds, bank Y would have been overdrawn by 5 pounds'. (2009: pp50).

So financial crisis and the public's associated large-scale note redemptions would cause increased tension between members of the clearing house.

The impacts of financial crisis on UK banking system:

Just how serious the financial crisis was becoming, not only in the US but also in the UK, hit home late on September 2007 when news emerged that Northern Rock, had been forced into a bailout from the Bank of England. Northern Rock Bank is the most affected by financial crisis in the UK, and also the most typical bank for my study.

Northern Rock is one of the top five mortgage lenders in the UK in terms of gross lending. As well as mortgages, the bank also deals with savings accounts, loans and insurance. In 2006 the bank had moved into subprime lending via a deal with Lehman Brothers. Although the mortgages were sold under Northern Rock's brand through intermediaries, the risk was being underwritten by Lehman Brothers.

On 14 September 2007, the Bank sought and received a liquidity support facility from the Bank of England, following problems in the credit markets. This led to many customers queuing outside branches to withdraw their savings.

Partly as a result of the run, on 22 February 2008 the bank was taken into state ownership. The nationalization was a result of two unsuccessful bids to take over the bank, neither being able to fully commit to repayment of taxpayers' money within three years.

Because of Northern Rock crisis, customers lost their confidence for any banks in the UK. They started withdraw money from their saving account, so that all banks in the UK were affected a lot.

Aim & Objectives and Key Questions:

Aim and Objectives:

Nowadays, the US Financial Crisis (2008) along with the subprime crisis (2007) seemed to have delivered a severe blow to world's banking sector. Banks are thought to be central to business activity. Therefore, when they experience financial distress, governments usually come to the rescue, offering emergency liquidity and various forms of bailout programs. Then the aim of this dissertation is to determine impacts of financial crisis on banking and corresponding measures on these impacts.

In order to achieve my aim, I need to achieve following objectives which are the steps towards my aim:

  • To determine the impacts of financial crisis on banking in China. Achieving this objective will be much help as I would also understand different impacts of financial crisis on banking in comparing with other area.
  • To analyse the measures to the impacts of financial crisis on banking. During the objective I will have the chance to recognize the process of central bank in each country. Therefore, I would realize the measures for banks under the financial crisis in two different views: financial views and political views.

Key Questions:

To achieve the aim and the objectives, the research was set out to answer the following key questions:

  • What are the impacts of financial crisis on banking system in China? And what are the different impacts among China and other areas?
  • What are the corresponding measures for these impacts in these countries?
    • This paper is focus on banking sector under the financial crisis, and how banks faced the crisis. The importance of this topic lays on the impacts of banking sector under the financial crisis and what the best measure for banks is. Basically, my research is based on the origin and process of financial crisis to find out the impacts for banks in each country. Therefore, I would investigate how to resolve these impacts.

      Research Methodology:

      As discussed in the sections above, the research objective is to determine the impacts of financial crisis on banking in China so that I could compare different impacts with other countries. The study identifies questionnaires and interviews as suitable research methods for the present paper. The general belief of research is often thought of as collecting data, constructing questionnaires/interviews and analysing data. But it also includes identifying the problem and how to proceed solving it (Ghauri et al., 1995).

      Questionnaire approach:

      A questionnaire is a research instrument consisting of a series of questions and other prompts for the purpose of gathering information from respondents. Questionnaires have advantages over some other types of surveys in that they are cheap; do not require as much effort from the questioner as verbal or telephone surveys, and often have standardized answers that make it simple to compile data. Questionnaires are also sharply limited by the fact that respondents must be able to read the questions and respond to them. Thus, for some demographic groups conducting a survey by questionnaire may not be practical. Usually, a questionnaire consists of a number of questions that the respondent has to answer in a set format. A distinction is made between open-ended and closed-ended questions. An open-ended question asks the respondent to formulate his own answer, whereas a closed-ended question has the respondent pick an answer from a given number of options. In this paper, I have used the open-ended questions into questionnaires. Because the impacts of financial crisis on banking which is an open discussion, it is more suitable to use open-ended questions to discuss.

      In this research, I have posted out 100 questionnaires for several banks in different positions of banking areas. But I only get 50 feedbacks from banks include: China Construction Bank with 11 copies; Bank of China with 23 copies; HSBC with 2 copies; China Merchants Bank with 2 copies; Shanghai Pudong Development Bank with 2 copies; Agricultural Bank of China with 3 copies; Bank of Communications with 2 copies; China Citic Bank with 3 copies; Bank of East Asia with 2 copies. The questionnaire is to undertake ideas from employees in each bank above. The employees have been selected in different job positions that include: account managers; customer managers; salesmen; managing directors; operation managers; accountants; channel managers; international clearing managers; administrations; marketers; product managers; staffs; retail managers; and others with no answers. There are four key questions amount those seven questions in this questionnaire:

      • How much are you affected by financial crisis?
      • Explain what affects you in financial crisis?
      • What is different consumer behaviour between before financial crisis and after financial crisis?
      • What do you think how to resolve the effects of financial crisis on banking?

      In the view of above questions, we can find out different effects of financial crisis on banking to employees in different positions and the correspond measures for the effects.

      Interview approach:

      An interview is a conversation between two or more people (the interviewer and interviewee) where questions are asked by the interviewer to obtain information from the interviewee. In most cases, interviews are only one of a number of qualitative/quantitative techniques that we are likely to use in a research project. The main types of interview include structured interview, semi-structured interview and unstructured interview.

      Semi-structured interviews are controlled interactions. However, this model enables the researcher to ask supplementary questions, for clarification and elaboration, whilst the use of open questions grants the participant greater freedom to discuss their experience. Unstructured interviews are relatively uncontrolled interactions where, once the question has been put, the researcher listens and do not prompt. This offers the participant the opportunity to discuss the subject using their frames of reference.

      Unstructured interviews can be very useful in studies of people's information seeking and use. They are especially useful for studies attempting to find patterns, generate models, and inform information system design and implementation. For example, Alvarez and Urla (2002) used unstructured interviews to elicit information requirements during the implementation of an enterprise resource planning (ERP) system. Due to their conversational and non-intrusive characteristics, unstructured interviews can be used in settings where it is inappropriate or impossible to use other more structured methods to examine people's information activities. For example, Schultze (2000) used unstructured interviews, along with other ethnographic methods, in her eight-month field study in a large company investigating their production of informational objects. What are the rationales for using semi-structured interviews? It can help us to obtain relevant information. It can give the freedom to explore general views or opinions in more details. It can use external organization so as to retain independence. The strengths of semi-structured interviews are that the researcher can prompt and probe deeper into the given situation. For example, the interviewer inquires about using computers in English language teaching. Some respondents are more computer literate than others are. Hence, with this type of interview the interviewers are able to probe or asked more detailed questions of respondents' situations and not adhere only to the interview guide. In addition, the researcher can explain or rephrase the questions if respondents are unclear about the questions.

      A structured interview also known as a standardised interview is a quantitative research method commonly employed in survey research. The aim of this approach is to ensure that each interviewee is presented with exactly the same question in the same order. This ensures that answers can be reliably aggregated and that comparisons can be made with confidence between sample subgroups or between survey periods. A structured interview also standardises the order in which questions are asked of survey respondents, so the questions are always answered given to survey question can depend on the nature of preceding questions though context effects can never be avoided, it is often desirable to hold them constant across all respondents. Structured interviews can also be used as a qualitative research methodology. These types of interviews are best suited for engaging in respondent or focus group studies in which it would be beneficial to compare/contrast participant responses in order to answer a research question. For structure qualitative interviews, it is usually necessary for researchers to develop an interview schedule which lists the wording and sequencing of questions.

      In this research, I have chosen structured telephone interview as main interview approach. There are three interviewees have been interviewed through telephone in three different banks which are Bank of China, Bank of Communications and Agricultural Bank of China. The positions of these three interviewees are Department Head in Bank of China, Branch President in Agricultural Bank of China and Financial Manager in Bank of Communications. The questions in the interviews are made quite same as to questions made in questionnaires.

      Findings and Analysis:


      From the view of all the questionnaires and interviews, I have organised the following points as findings:

      • In China Construction Bank there are two staffs affected by financial crisis are a lot; seven staffs affected by financial crisis are medium; and each one staffs affected by financial crisis is a little and almost not. Nine of all eleven staffs answered that their incomes have been reduced during the financial crisis. Seven of all staffs realized that customers became more prudent after financial crisis compared before.
      • In Bank of China there are nine staffs affected by financial crisis are a lot; ten staffs affected by financial crisis are medium; and each two staffs affected by financial crisis are a little and almost not. Almost half of all twenty-three staffs answered that their workings are much more difficult to handle such as some services closed, working period much longer and more competitions etc. Seven of all staffs stated that their incomes have affected very much because of financial crisis. Ten of all staffs realized that customers became more prudent and rational during the financial crisis. Other staffs almost realized that customers had no any changes under the financial crisis compared before.
      • In other seven banks there are five staffs affected by financial crisis are a lot; five staffs affected by financial crisis are medium; one staff affected by financial crisis is a little; and five staffs affected by financial crisis are almost not. Each five staffs answered that their workings are much more difficult to handle and their incomes have been reduced. Almost half of all sixteen staffs realized that customers became more rational and likely to transfer their money from some risky investments to a saving account or banking instruments.


      From the findings of the study it emerges that:

      • Most participants who are in different positions of different banks realized that they have been affected by financial crisis a lot or medium. And most customers they deal with became more rational and prudent.
      • Before the outbreak of the financial crisis is not that customers apply for special financial management, the client's risk acceptance is very strong, and the abundant capital in the market. Most clients are seeking short-term immediate benefits, but did not fully take into account their own business and assets of the plan a long-term investment, life-long investment. But after the outbreak of the financial crisis, most customers whether it is their own operations and domestic and foreign investment had both a certain degree of loss. Customers will first consider the operating and investment risk, followed by another to seek profit; their sights would be to put the long-term, truly entered the era of the pursuit of long-term interests.
      • Adverse impacts to the unit under the financial crisis: First, non-performing loans increased pressure. The financial crisis on the business impact of large bank customers, especially export-oriented enterprises. Declining in exports led to decline in client business performance, repayment pressure, and increased risk of deterioration in credit quality. Second, the lack of effective demand for loans. Financial crisis led to bad corporate management, so that effective demand for loans fell. Third, the financial crisis lead to an international settlement business, hosting business, and capital markets businesses in a substantial decline so that intermediary business revenue. Fourth, the time when the economy is down, and constantly cut interest rates, bank's net interest yield was downward trend.

      The effects of the financial Crises on the banking industry and an evaluation of the measures for resolving the crises.

      Using evidence from the Great Depression and several other banking crises, Hoggarth and Reidhill (2003) concluded that banking crises can have a long term dramatic effect on the economy if left unresolved but the scale and character of any intervention should have as its prime objective to keep fiscal costs minimal and to prevent any future moral hazard. Moral Hazard in this case refers to the risk that bankers who are aware of the governments unwavering commitment to crop up dying banks may take too much unnecessary risk since they have a 'guarantee' that their banks will never go burst. This section discusses the effects of the recent 2007-2009 global financial crises on the banking industry. It further evaluates some of the measures put in place by the UK and US governments to alleviate the crises. At every point Hoggarth and Reidhill's 2003 conclusion will be my point of reference as I evaluate the Fiscal Cost and Moral Hazard issues related with the resolution of the crises. Finally, I will also discuss other view points and make recommendations on how the crises could have been tackled more effectively.

      The United Kingdom and United States economies were the largest hit and probably the most affected by the crises. It is worth bearing in mind that even though this crisis began in the financial sector and real estate sectors of these economies, it rapidly spread to the manufacturing and retail sectors. Without much notice every sector of the economy had been affected by the downturn. A vicious cycle quickly develops where as companies lack credit, they slow manufacturing and layoff workers leading to high unemployment rates. As unemployment increases and consumer credit and purchasing power drops, the demand for goods and services plummets and the entire economy is further hit. At the end of the cycle, the main cause of the demise is soon forgotten and the problem actually becomes one of scepticism and mistrust widely termed consumer confidence and/or investor confidence.

      It is popular opinion that such a crisis should not be left unresolved by country authorities even though it is caused by individual businesses and public companies. After all, a rapid decline in business profits and an increasing rate unemployment means a plunge in the state's tax revenue, a hike in unemployment benefit payouts, an increase in government debt and the crumbling of the economy. Politicians are therefore faced with the dilemma of whether or not to interfere with the free market economy, taking actions that will have serious implications on management and investor behaviour and spending public money to save private investors. As dreadful as this may sound, there appears to be no other viable way to resolve a banking crisis.

      Banks in particular, are generally not stand alone institutions. One view point to resolving a banking crisis amidst a recession emphasises that any measures designed to ensure that banks survive in a sustainable way will be aimed at reviving and supporting bank stakeholders (Customers and investors). This view point advocates that the best way of resolving the crisis is by allowing more money in the pockets of households and companies, encouraging lending, reducing taxes, recapitalising and supporting banks and increasing consumer confidence in the financial system.

      The UK bank Bailout Plan Summarised:

      The government continuously emphasized that these measures were not designed to protect banks but to protect the public from the failing banks. Northern Rock, one of the major mortgage lenders in the UK was the first casualty of the crises. The UK governments initial response (17 September 2007) response to the Northern Rock crises was to Guarantee all retail savings and certain wholesale liabilities of this bank. Their demise was attributed to the fact that they pursued a very risky business model that was solely or overly reliant on wholesale funding. Once the wholesale market crashed, they were bound to suffer from lack of liquidity.

      By February 2008 the bank was taken into temporary public ownership. The government further strengthen the bank by converting some government debt into equity. The bank further pursued a rigorous restructuring program to make it more nibbler and ready for private ownership.

      The FSA on September 28, 2008, realised the Bradford and Bingley was insolvent as it could not meet its credit commitments. Its demise was inevitable as it was heavily reliant on Buy-to-Let and Self-Certified Mortgages which are very vulnerable to an increase in the rate of arrears which is a characteristic of economic downturns.

      The governments approach was to transfer its retail deposit business and branch network to Abbey National while nationalising its mortgage arm, personal loan arm, headquarters & staff, wholesale liabilities and treasury assets

      The deterioration of the London Interbank Wholesale markets that resulted from the collapse of Lehmann Brothers had pushed HBOS into a very uncomfortable position. The risk of operating as a going concern became very high for HBOS as its source of finance became uncertain over night. This situation led to the Lloyds TSB and HBOS merger.

      There is however much controversy on the motivations of Lloyds TSB to engage in such a merger. Many argue that its takeover of HBOS was a political rather than economic decision. The main criticism has been that proper or sufficient due diligence was not conducted before the takeover. The immediate consequence was the huge loss recorded by HBOS in 2008 of £10,825million whereas Lloyds TSB recorded a profit of £807million in the same period.

      Again the merger was criticized on the grounds that competition rules were neglected. The new banking group, Lloyds Banking Group, is too big and thus transforms the UK banking system into an oligopoly.

      Aside from the unique support provided to individual banks, the government on 8 October 2008 introduced certain measures to guarantee the stability of the UK's financial system and to protect savers, depositors, borrowers and businesses. The government's approach was based on the issues which it identified as the root causes of the crises; LIQUIDITY, CAPITAL and FUNDING.

      A Special Liquidity Scheme (SLS) was introduced which housed £200Billion provided by the Bank of England. These funds were set aside to provide short term liquidity to financial institutions by swapping their illiquid assets (especially mortgaged backed securities) for highly liquid treasury bills.

      The government also created the Bank Recapitalisation Fund which provided an alternative source of capital for banks with weakened balanced sheets. To ensure solvency, banks were required to maintain a higher tier 1 capital ratio in excess of 9% well above the international average. RBS for example, announced a 15Billion Capital raising program, offering ordinary shares underwritten by HM Treasury. Only 0.24% of the shares were taken up by the public leaving the HM Treasury to own over 58% of RBS. The HM Treasury further purchased 5Billion worth of Preference Shares which were subsequently converted to ordinary equity further strengthening the bank. The Lloyds Banking Group was able to obtain 17Billion worth of Capital from HM Treasury taking its holding interest in the group to 65%.

      The Credit Guarantee Scheme was designed and introduced in a bid to tackle the funding problem. This scheme which exposed the tax payer to the tune of £250Billion was designed to unclog the interbank lending market by guaranteeing to refinance maturing debt of participating financial institutions.

      In January 2009, after a persistence of the Crisis, the government introduced new measures and further extended existing measures in a bid to resolving the crises. Most notably the government introduced the Asset Protection Scheme wherein, in exchange for a fee, the government will provide participating institutions with protection against any future credit losses above a certain threshold on one or more portfolios of assets. RBS and Lloyds TSB were the first two banks to register for this scheme and they have been protected to the tune of £585Billion of assets. The two conditions imposed on participating banks were as regards lending and staff remuneration.

      The downside of this bailout plan is that these actions may result in future moral hazard. As Hoggarth and Reidhill (2003) noted, if any protection offered to banks in a crisis is greater than they expected, this could increase their risk taking in the future. There therefore appears to be a trade off between maintaining today's financial stability and jeopardizing future financial stability. The issue of preventing future Moral Hazard has been the main concern of politicians as they design new fiscal and monetary policies to support banks in the recession. The fiscal costs associated with support packages cannot be underestimated. This huge national debt may stifle future growth and development and deprive future generations from the luxuries of affordable health, education, transport and communication infrastructure the nation enjoys today.

      The government has bought into several high profile companies. Even though the government has every intension of privatising these institutions in the future one can never be too certain how long this will take. The government's interest of tightening financial regulations has taken only a subtle approach. This has mainly been through imposing terms and conditions before bailing out companies. The major area of interest has been through reducing bank bonus payouts & compensation schemes and re evaluating bank risk taking. The government has also used its position to encourage lending to companies and individuals. Other issues such as the role and functioning of credit rating agencies, mark-to-market valuations, securitisation, lending etc that were at the centre of the crises have received less attention to date. These issues have to be resolved on a global scale to ensure that institutions and countries can still remain competitive even with more stringent regulation.

      The US Bank Bailout Plan Summarised - Troubled Asset Relief Program:

      In the case of the United States, the approach was similar. The government started by instituting a $700Billion bailout package designed to buy up bad assets from banks and in so doing recapitalise and make them stronger. The bill was supported by both the republican and the democratic political parties. The program was termed the Troubled Asset Relief Program (TARP). The program allowed the treasury to purchase illiquid, difficult-to-value assets including Collaterized Debt Obligations (CDO) from financial institutions, thereby providing them with liquidity, strengthening their balance sheets and stabilising the economy as a whole.

      As Stiglitz (2009) testified the trouble with the program is that the government had assumed wrongly that the major issues that needed to be addressed was the lack of confidence and the absence of liquidity for banks. In his (Stiglitz, 2009) opinion, financial institution suffered from insolvency not illiquidity and thus merely pumping funds into such corporations might be a waste of tax payers funds. The government approach also left much room for future moral hazard. He advocated that investors and management should be punished just enough to prevent future moral hazard while supporting the banks to prevent long term economic instability.

      It is worth noting that the bailout plans both in the UK and US have been designed to allow Tax payers to benefit immensely once the economy recovers.

      Political views to the Resolution Strategies:

      The strategies and measures used in reviving banks were designed and instituted by decision makers with a political agenda. Through out the crises, different political parties advocated the use of contrasting measures to resolve the situation. One thing that both countries (UK and US) had in common was the fierce opposition and criticism of the measures that were proposed to resolve the crises. This however appears to be a political rather than an economic debate. The UK Opposition Parties for example have heavily criticized the heavy fiscal spending, the Lloyds TSB and HBOS merger, the tax cuts and the nationalisation of banks. These critics have however provided no viable solution to resolving the crises. Most strategies employed in resolving the current crises are academically sound but have never been tested to such an extent. The results although might not be felt today will certainly have a long term impact on the economy. One can therefore expect that some strategies will seem wasteful at first sight but must not be criticized on the grounds that their impact was not immediately felt. The main concern has been the astronomical rise in the national debt since the onset of the crises. Supporters have argued that without the fiscal stimulus the situation could have been a lot worse. Without the benefit of hindsight, it is difficult to evaluate if the fiscal spending is worthwhile.

      Recommendations and evaluation of other view points:

      As a direct consequence of the subprime mortgage crisis, companies were unable to meet their immediate debt commitment (an indication of insolvency). Prominent economists such as Stiglitz (2009) and Sachs (2009) who were called to testify before the US congress proposed that the best way of resolving the insolvency issues, credit market liquidity problems and restore confidence in the financial system was to restructure corporate debt by converting debt into equity- Debt-for-Equity Swaps or Bondholder Haircuts. This conversion reduces the institutions' commitments while increasing its equity. Again, the problem of future moral hazard and the fiscal cost of a massive cash injection are mitigated. Ultimately, investors rather than tax payers will be punished for their bad investment decisions.

      Many will agree that the cheapest way of resolving a banking crisis is to prevent it in the first place. The government decided to stand behind many banks because they were considered 'too big to fail'. This sends a message to management that the best way of ensuring future sustainability is by attaining a size that matters to the government. Financial crisis and the failure of banks is not uncommon in these countries. Caprio and Klingebiel (2003) recorded 168 cases of systemic and non-systemic banking crises in both developed and emerging economies since 1970. The government must therefore be proactive rather than reactive in its prevention and resolution of crises of such a nature. Stiglitz (2009) emphasises that markets only work well when there are well designed incentives, a high level of transparency and effective competition. All three of these are absent in the American financial markets and many other leading markets. He realises that incentives are important but when they are poorly structure, they will encourage distorted behaviour. Today's incentive structure encourages short-sightedness and unruly risk taking.

      Stiglitz (2009) testified that the lack of transparency in financial markets played a key role in kick-starting the crisis. Information asymmetry was largely common as financial institutions hide assets and commitments in the form of off-balance sheet elements. The boom in the complicated world of over the counter derivatives did not help to solve the problem. To create and/or restore consumer confidence and to ensure long term sustainable stability in financial markets transparency and simplicity in reporting must thus be advocated.

      The third dimension was the absence of effective competition as stated by Stiglitz (2009). Banks and other financial institutions have become so big and have attained the status of 'too big to fail'. Management is aware that a failure of their banks will mean the collapse of the entire economy and this motivates them to engage in the practice of excessive risk taking. The worse that can happen is that the Government backed by the tax payer will run to their aid in case of any misfortunes. If a future crisis is to be prevented these mega institutions must be broken down into smaller, nimble and more manageable institutions. This will allow for effective competition which will advocate for good management and prudence.

      Reidhill and Hoggarth (2003) advocate that private sector solutions such as asking existing shareholders to increase their capital contribution are more preferable to public sector solutions. The advantage here is that this method attempts to keep the bank solvent while punishing those who have the most to benefit from it. A take over by a stronger bank will also punish incumbent management and shareholders.

      Reidhill and Hoggarth (2003) also propose that in a case where the government has no choice but to crop up such institutions, strict losses should be imposed on management and shareholders. This could be in the form of restrictions to severance payments for failed managers, banning failed managers from taking further work in public companies, imposing losses on uninsured creditors etc. These methods have the potential of reducing the immediate fiscal costs of resolving the crisis while discouraging long term unproductive behaviour.

      As proposed by Reidhill and Hoggarth (2003), the design of deposit protection schemes may be used in preventing moral hazard. Limited protection schemes[1] will ensure that smaller depositors[2] are fully protected while larger depositors such as other banks are still exposed. These bigger depositors have a higher monitoring ability on banks. This supports the findings of Hoggarth, Jackson and Nier (2003) and Caprio and Levine (2001) that schemes with unlimited protection or a generous deposit insurance are more highly associated with banking crises.

      Once a crisis has started the speed of resolution becomes an important factor. A delayance in the restructuring process may give decision makers enough time to carefully analyse the situation and put through an appropriate and full proof resolution package. A poorly devised strategy may only lead to a higher fiscal cost with little or no results. If the intervention is too little its impact might rather be negative thereby increasing the depth of the crises. If it is too much, the current fiscal cost and the future moral hazard might be too great for the nation to bear. Research by the OECD (2002) and Dziobek & Pazarbasioglu (1997) however concluded that prompt intervention (intervention within one year of the onset of the crisis) reduces the fiscal cost of intervention and increases the efficiency of the intervention process. This therefore means that the government should not be too quick to respond but should not allow the situation to deteriorate before it intervenes.

      For so long supporters of the concept of market efficient have argued that financial markets are self regulatory. It is widely accepted that politicians lack the expertise to pass suitable laws that will adequately regulate the market yet allow for innovation, growth, stability and global competitiveness. The assumption of self regulation was centred on the role of rating agencies and on the concept of mark-to-market valuations (De Grauwe, 2008). Rating agencies however suffered from a conflict of interest as they advised financial institutions on which products to create then later rated the riskiness of these products. Mark-to-market valuation rules were responsible for the recording of exorbitant profit margins during the boom and the massive write downs that were experienced during the gloom. The market has therefore failed to regulate itself and thus the government should take full responsibility for market regulation.

      Another somewhat pro-traditional or conservative proposal has been made by De Grauwe (2008). He argues that today's risk assessment and mitigation procedures are solely based on the assumption that stock markets are efficient. He finds that the Basel Approach to stabilising the banking system or the practice of setting capital ratios for universal banks is inherently flawed as these ratios are based on the assumption of market efficiency. The assumption of 'efficient markets' helps management to mathematically compute the level of risks their banks take at any one time. De Grauwe (2008) shows that the risks that matter for universal banks are tailed risks associated with bubbles and crashes and not systematic and unsystematic risks proposed by the theory of market efficiency. These risks (Tailed Risks) cannot be computed and mitigated by the use of appropriate capital ratios. The only way forward i.e. the mitigation of future bubbles and crashes, is a return to the Glass-Steagall Act approach (De Grauwe, 2008). This approach advocates for narrow banking where bank activities are restricted and universal banks are non existent. Investment banks must be totally separate from commercial banks i.e. banks that collect depositors' funds cannot invest in equities, derivatives or complex structured products. Investment banks must therefore raise funds from investors and not savers. This proposition means the end of the practice of securitisation which played a contributory role to the global financial crises of 2007-2009. Securitisation in itself leads to the build up of huge credit mount linking banks, institutions and individuals. Although it may seem like a transfer of risk in the first instance, these liabilities quickly reappear on the originators balance sheet once there is a default in the chain. The risk of the whole process is always absorbed by the central bank which acts as a 'lender of last resort'. This approach has been heavily criticized by firms such as RBS and Barclays. The Bank Of England Governor, Melvin King, acknowledged the advantages of the Glass-Steagall approach but did not think the practice was sustainable. Others argued that non-hybrid retail banks such as Northern Rock and Bradford & Bingley and Investments Banks such as Bear Stearns, Merrill Lynch, Morgan Stanley and Goldman Sachs had suffered more than Universal Banks such as HSBC and Standard Chartered Bank. Even though there is a huge potential for conflict of interest in these Universal Banks, the synergies obtained from housing the different arms under one roof are very significant. None the less, the approach seems to be useful if it is applied in a global scale otherwise UK banks will become uncompetitive in the global banking market.


      Treasury Committee, House of Commons (2009), Banking Crisis: Dealing with the future of UK Banks, Seventh Report of Session 2008-2009.

      Grauwe D P (2008), The banking Crisis; Causes, Consequences and Remedies, Centre for European Plolicy Studies CEPS, No 178.

      Reidhill J. and Hoggart G. (2003) Resolution of Banking Crisis; A review, Financial Stability Review.

      Caprio, G., and Klingebiel, D., (2003). Episodes of systemic and borderline financial crises. World Bank Database.

      Dziobek, C., and Pazarbasioglu, C., (1997). Lessons From Systemic Bank Restructuring: A Survey Of 24 Countries. IMF Working Paper 97/161.

      Hoggarth, G., Jackson, P., and Nier, E., (2003). Banking Crises and The Design Of The Safety Net. Paper Presented At The Ninth Dubrovnik Economic Conference, Dubrovnik, 26-28 June 2003.

      OECD, (2002). Experience With The Resolution Of Weak Financial Institutions In The OECD Area. June. Chapter IV. Financial Market Trends, No. 82.

      Stiglitz J.E. (2009). Testimony Before The Congressional Oversight Panel Regulatory Reform Hearing, US Congress.

      1. schemes that protect depositors up to a certain maximum amount.
      2. Household and Small and Medium Size enterprises.
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