Financial Services Industry

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Thefinancial systemis the system that allows the transfer of money between savers and borrowers, and comprises a set of complex and closely interconnected financial institutions, markets, banks, instruments, services, practices, and transactions (Steven M & Sheffrin, 2003). All Financial institutions in any country follow certain regulations which are placed by the central monetary authority (e.g. financial service authority) in order to provide improved service to the public and work in the best interest of the nations. Regulationis controlling human or societal behaviour by rules or restrictions (Bert & Jaap Koops 2006). The purpose for regulating the institutions is to reduce the risk of failure and to attain social goals. For example banks are regulated, as they by their very nature are prone failure, and the costs paid by the public for failure is extremely high compared to the financial costs to regulate the banking system. Regulations should be fair and limited so that they assist banks to develop new services in accordance with the customers demand, make sure competitions in financial services is strong, maintain the quantity and quality of the service provided to public and better utilisation of resources. Over the last five years, the financial system in the world has gone through its greatest crisis. The financial problems have appeared at the same time in many different countries which makes it unique from the crisis in past. The overall economic impact is felt all through the world, which is resulted from the interconnectedness of the global economy. This does not mean that the economic recession which many countries in the world now face will be anything like as bad as that of 1929-33(turner 2009). The crisis in 1930s was made worse by the policy in response. But it is clear that effective the policy response cannot prevent the large economic cost of the financial crisis. If we are to prevent or minimise the scale of future crisis there is an increased need of policy framework that can bring different factors and the corresponding powers to act positively when risks are recognized. Currently Britain’s existing framework is confused and the powers and capabilities split awkwardly between competing institutions, which results in nobody identifying the fundamental problems when these institutions are building up and none of the institutions can act in response to crisis as they do not have the authority to do so. In order to avoid future crisis changes in regulation and supervisory approach is needed in order to create a more robust financial system for the future. Our focus in the research is on banking institutions, and not on other areas of the financial services industry. In 2007, Britain experienced its first bank run of any significance since the reign of Queen Victoria (Reid. m, 2003). The run was on a bank called Northern Rock. Britain was free of such event not by misfortune, but because in early third quarter of nineteenth century the Bank of England developed techniques to avoid them. These techniques were used, in Britain and had worked, and appeared to be trusted. The run of northern rock was triggered by the decision to provide support for troubled institution. That run was brought to a standstill, when the Chancellor of the Exchequer (Alistair Darling2) declared that he would use taxpayer’s funds to guarantee deposits at Northern Rock. Unlike runs in banking history, it was a run only on that one institution as funds withdrawn from it went only to a small amount into cash, and were mostly redeposit in other banks or in building societies. The research has three major objectives: * Describes the role of financial regulations and reviews the literature on role played by the regulations in financial system. * To describe and evaluate the banking crisis in United Kingdom in last 5 years and the reasons of the crisis which affected the banking system. * To analysis and evaluate the role and benefits of living wills in context of changes in regulation. This leads to the research question: “Can living wills address the perceived failures in the regulation of financial services highlighted by the current credit crisis?”

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A literature review is a summary of a subject field that supports the identification of specific research questions (Rowley J & Slack F, 2004). Literature review explains the role of financial regulations, discuses the banking crisis in UK in last 5 years (2005-2010), and proposed new regulations which are to counter such failures in the future and at what cost these failures can be averted. The main focus of literatures review is the Banking Industry, proposed new regulations in order to minimise the effect of such crisis.

The functions of financial services industry

The existence of money is taken as for granted in all advanced societies today so much so that most people are unaware of the huge contribution that the concept of money, and the industry to manage it, have made to the development of our present way of life. Moneyis anything that is generally accepted aspaymentforgoods and servicesand repayment ofdebts (Mishkin & Frederic S, 2007). In earlier civilisations the process of bartering was sufficient for the exchanging goods and services. Barteringis a medium in whichgoodsorservicesare directly exchanged for other goods or services without a common unit of exchange (without the use ofmoney) (O’Sullivan, Arthur & Steven M. Sheffrin, 2003). In modern society, people still produce goods or provide services that they could, in theory, trade with others for exchanging for things they need. Due to complexity of life and the size of some transactions make it impossible for people today to match what they have to offer against what others can supply to them. What is needed is a commodity that individuals will accept in exchange for any product, which forms a common denominator against which the value of all products can be measured. Money carries out these two important functions. In order to be acceptable as a medium of exchange, money must have certain properties. In particular it must be * Sufficient in quantity * Generally acceptable to all the parties in all transactions * Divisible into small units * Portable Money also perform as a store of value, which means it can be saved because it can be used to divide transactions in time received today as payment for work done or for goods sold can be stored in the knowledge that it can be exchanged for goods or services later when required. In order to fulfil these functions, money has to retain its exchange value or purchasing power and the effect of inflations can, of course, affect this function. The financial services industry exists largely to facilitate and to deal with the management of money. It helps commerce and government by channelling money from those who have surplus, and wish to lend it to make profit, to those who wish to borrow it, and are willing to pay for the benefit they acquire of having it. The financial organisations want to make profit from providing such services and, by doing so, they provide the public with products and services that offer, convenience ( e.g. current accounts), means of achieving otherwise difficult objectives (e.g. mortgages) and protection from risk (e.g. insurance). Prior to the 1980s, there were clear and distinct boundaries between different kinds of financial institutions; some were retails banks, some wholesale banks, others were life assurance companies or general insurance companies, and some offered both types of insurance and were called composite insurers. Today many of the distinctions have become unclear, if they have not vanished altogether, increasing numbers of mergers and takeovers have taken place across the boundaries and now even the term banc assurance, which was coined to describe banks that owned insurance companies, is inadequate to describe the complex nature of modern financial management groups. For example one major UK bank offers following range of services * Retail banking services * Mortgage services through a subsidiary that is a building society * Credit cards services * Wealth management services * Financial asset management for institutional customers * Investment banking * Insurance services


Bank failures around the world have been common, large and expensive in recent years. It is common to think of banking failure as something that happens in emerging economies and countries with advanced banking system, but there have been some shocking failures of banks and banking system within the developed economies in recent decades. The scale and frequency of the bank failures and banking crises have raised doubts about the efficiency of bank regulation and raised questions as to whether the regulation itself has created an iatrogenic reaction. Regulations for banks and other financial institutions hinge on the coase (1988) argument that unregulated private actions create outcomes whereby social marginal costs greater then private marginal cost. The social marginal costs occur because bank failures has a far greater effect then throughout the economy than, say, failure of a manufacturing concern because of the wide spread use of banks. Nevertheless it should be borne in mind that regulation involves real resource costs. These costs arise from two sources (a) direct regulatory cost, (b) compliance costs bear by the firms regulated. In IMF global financial stability report (2009), it estimates that the eventual cost to British taxpayers of support for the banking sector will be 9.1% of GDP, or more than £130 billion, that is more than five times the equivalent of 1.8% of GDP in France and three times the estimated 3.1% of GDP in Germany. The main reason for regulating the banks is firstly consumers lack market power and are prone to exploitation from the monopolistic behavior of banks. Secondly depositors are uniformed and unable to monitor banks and, therefore, require protection. Finally, governments need regulations to estimate the safety and stability of the banking system.

Basel accord

Basel committee for banking supervision a committee for BIS (Bank for International Settlement) was first established in 1974. This committee operates at international level and the main focus of the committee is to strengthen the capital of banks. The principle reasons for the establishment of the committee were to safeguard the financial stability of the banking system worldwide and to create a level playing field. The first major achievement of the committee was in the form of Basel I. Basel I aimed at: 1. Promote the co-ordination in the regulatory and capital adequacy standards of the member countries. 2. Guard against risk in credit worthiness 3. Finally, it suggests for the minimum capital requirements for the international banking. Since 1988 when the Basel committee introduced the first capital accord Basel I the risk management practices, the banking business and the whole financial market has changed. The New York Fed President argued that “it also has not kept pace with innovations in the way that banks measure, manage and mitigate risk.”(EBSCO, 2002) Although the accord covered fairly relevant issues but it wasn’t helpful enough to make a major impact in the industry. Therefore in 1999 the initial steps were taken which led to the amended of Basel I. There were several different reasons for the amendments. One of the misunderstandings about Basel I was that it was the only way to the financial stability of a country. The positive results of implementation of Basel I were seen in the G-10 countries, as these countries were previously operating their financial industry on mostly the same rules, but still there were many new product introduced and reforms took place which remained unexplained by the accord and resulted in the financial industry either fully collapsed or got taken over by other giant’s. For example Grupo Financiero Bancomer, a Mexican banking giant was reported as “US- based Citibank has agreed to acquire Mexican banking giant Grupo Financiero Bancomer-Accival (Banacci) for US$12.5 billion” (All, 2001). The initial results blinded the G-10 in the aspects of emerging markets as they got pressurized by the larger financial institutions to follow the same accord. Another failed aspect of Basel I which led to the new accord was that the old accord only focused around the credit risk. Basel I did not focused on operational risk which also supported the downfall of many financial institutions. As explained by Mohan Bhatia “Weather it is a fee-based business, emerging practices or income-based business. A bank is exposed to operational risk.”(Bhatia, 2002). Even though Basel I was not written to be applicable for the emerging markets, its functions created distortions in the banking sectors of the industrialized economies. “In countries subject to high currency inflation and sovereign default risks, the Basel I accord actually made loan books riskier by encouraging the movement of both bank and sovereign debt holdings from OECD sources to higher-yielding domestic sources” (Balin, 2008). Another problem with the 1988 accord was that it focused more on the type of loan rather than the credit status of the borrower. As the bank and large financial institutes saved just 8% for the unseen risks they had more capital left. That was used in form of loan and subprime lending which was later proved to be a real disaster for the financial institutions. Basel I created a gap between the regulatory capital and the economic capital as bank would choose to hold. The commonly know regulatory capital is different to the economic capital. The economic capital aims to enhance the value of the investor and is based on the internal risk assessment of the organization. Whereas on the other hand the regulatory capital secures the banking stability and the regulator decides it for the protection of the depositor. Considering the drastic effects of the Basel I accord the committee published the reforms in 2003 namely Basel II. “Basel II is a response to the need for the regulatory system governing the global banking industry.”(Garside, Bech, 2003) Basel II brought many reforms to the old accord and was based on three pillars. The first pillar was minimum capital requirement which explained explicit treatment for operational risk in the financial industry. However the market risk remained with the same explanation as from Basel I. The Basel II brought some new methods of measuring the credit risk by introducing the public and internal ratings which provided good risk mitigation techniques. Furthermore the second pillar explained the supervisory review of capital adequacy. The basic purpose of this pillar was to keep a check on the financial institution that they hold excess of minimum level of capital required. The regulator can intervene at the initial stage if this requirement was not fulfilled. Finally the third pillar was brought into place to bring a much better market discipline. The market is considered to be the role played by the shareholders, government or employees whether proper capital is maintained or not. With this improvement Basel II was considered to help both the lender and the borrower. Basel II spots the weakness in Basel I and proposed effective risk measurement, mitigation techniques and elaborates valuables for market discipline for good banking system and good financial stability as explained “we at the Federal Reserve had even more reasons for the most finely tuned Basel II framework: Not only are we the umbrella supervisor over all financial stability companies but, as the nation’s central bank, we are responsible for maintaining nation’s financial stability.” (Poole, 2005) The fines of Basel II are basically explained by the three pillars of it as the very dexterously explain how and where the accord will be effective. The first pillar of minimum capital requirement was extremely advantageous in providing enhanced risk measurement by helping the large financial institutions and big banks to measure the risk involved in their functions and operations more sophisticatedly. Risk management proposals were useful for the capital they require to hold in case of unexpected losses. The new accord proposed different approaches for the measurement of credit risk. The standardised approached being the more or less the same as the old accord was more risk sensitive for the creditworthiness of the customers and improved the requirement which was previously based on type of loan instead of the credit status of the customer. This approach explained the birth of credit rating of individuals but the problem with this approach was that the culture of rating is not popular in every European country and other countries with strong and effective economies. Whereas the internal ratings-based approach was based on the internal key risk drivers and therefore the potential for more risk sensitive capital was substantial in a way to mitigate the risk. But the internal ratings-based approach is not enough to calculate the capital required for the risks. “The approaches for calculating the risk-weighted assets are intended to provide improved bank assessments of risk and thus to make the resulting capital ratios more meaningful” (Pitschke & Bone-Winkel, 2006). Operational risk which the Basel I failed to examine is a crucial element and was elucidated by Basel II in three operational risk alleviation approaches. The first method called the Basic indicator approach advice the banks to hold capital equal to 15% of average gross income earned by banks in the past three years. The second method named the standardized approach separates every business to hold capital to shield itself against the operational risk. Finally the third method of advance method approach allows the banks to calculate their own capital requirement to protect themselves against the operational risk. A disadvantage of the first pillar was that it allowed the banks to set their own risk assessment techniques. This gave over sanguine reports to reduce the capital required. Furthermore it even maximized the return on equity. For a much better market discipline regulators must approve the requirement. As explained by (Lind, 2006) “banks must have methods and systems for risk management which are subject to adequate corporate governance processes throughout the banks.” The pillar II of The Basel Accord is based on Supervisory Review. It certifies that the banks should have enough capital to sustain all the unexpected risk in an organization and also provides with much more better techniques to monitor and mitigate those risks. It advises the banks to calculate their risks internally. It requires the regulators to assess the banks risk management processes and capital position to maintain a target level of solvency. “Pillar II recognises that national supervisors may have different ways of entering into such discussions and provides flexibility to accommodate those differences” (Caruana, 2003). It was helpful in a way to evaluate funding strategies and also gave an insight to the risk mitigation policies to the banks. In total the second pillar had two positive proposals. Firstly, it gave more power to the regulators to keep a check of the minimum capital requirement by banks as calculated in pillar 1. And secondly it alarms the repetition of the financial crises such as in countries like Korea and China by taking early actions and offering rapid remedial actions. “Some of the data submitted by individual institutions was not complete; in some cases banks did not have estimates of loss in stress periods–or used estimates that we thought were not sophisticate–which caused minimum regulatory capital to be underestimated” (Bies, 2006). At the same time while the corporate governance is in place the accord gave absolutely no information regarding the liquidity. Banks remained unaware of the true financial conditions of each other which forced them to stop lending and the State Bank of England was highlighted as the last resort to rescue. Pillar III based on the market discipline helped maintain discipline in the market place by greater disclosure of the banks risk profiles. The pillar III is connected to pillar I and pillar II as it complements the minimum capital requirement and the supervisory review process. “Market discipline can contribute to a safe and sound banking environment and supervisors require firms to operate in a safe and sound manner” (BIS, 2005). The disclosure is important for the benefit of the stakeholders. Therefore a disclosure of market risk, operational risk, interest rate risk and the disclosure of capital structure is required. The information should be disclosed timely. “It will fundamentally transform financial reporting for banks by demanding increased depth and breadth of disclosure” (Garside, Bech, 2003). One of the other disadvantages of Basel II is the complexity and potential cost of the framework. It is a defected draft of 450 pages and the cost of implementing it is too high for the banks. Banks were also afraid to lend because of the fear of Basel II as they would operate against the rules of Basel II on certain occasions. According to the Basel book the banks have to meet a certain level of capital reserves and in today’s scenario of credit crunch it is difficult. As Peter Spencer explains “the Basel system of banking regulations, which determine how much capital banks must raise to keep their books in order, are the root cause of the crunch and were serving to worsen the City’s plight” (Conway, 2007). The Basel committee produced the old and new accords which to an extent were successful for the strengthening of the capital of banks and also took into account the risk throughout the procedures. But the new accord did not changed with new reforms in the system which made it just a box to be ticked in a form and had no connection with the reality or implementation. Most of the organizations ticked the boxes and yet carried on with the risky decision which seemed profitable but yet proved out to be wrong such as Northern Rock. These decisions were not even against any of the accords as the Basel committee never updated to the new market.

Financial Services Authority (FSA)

Regulations of the financial services industry in the UK is a 5 tier process: * First level: European legislation that impacts on the UK financial industry * Second level: the acts of the parliament that set out what can and cannot be done. * Third level: the regulatory bodies that monitor the regulations and issue rules about how the requirements of the legislation are to be met in practice. The main regulatory body is now the Financial Services Authority (FSA), which has taken over the regulatory responsibilities of the number of other bodies, including the bank of England. * Fourth level: the policies and practices of the financial institutions themselves and the internal departments that ensure they operate legally and competently. * Fifth level: the arbitration schemes to which consumers complaints can be referred. For most cases, this will now be the financial ombudsman service, which takeover the responsibilities of a number of earlier ombudsman bureaux and arbitration schemes Before the arrival of the financial services act 1986, the UK financial services industry was self regulating. Standards were maintained by a promise that those in the financial industry had a common set of values and were able, and willing, to exclude those who violated them. The 1986 act moved the UK to a system which became known as self regulation within a statutory framework. Once authorised, firms and individuals would be regulated by self regulating organisations (SROs), such as IMRO, SFA or PIA. The financial services act 1986 covered investment activities only. Retail banking, general insurance, Lloyds of London and mortgages were all covered by different acts and codes. When labour party came in power in 1997 it wanted to amend the regulation of financial services. The late 1990s saw more fundamental development of the financial services system with the fusion of most aspects of financial services regulation over a single statutory regulator, the financial services authority (FSA) process took place in two phases. First the bank of England’s responsibilities for banking supervision was shifted to the financial services authority (FSA) as part of the bank of England act 1998. The second phase of development consisted of a new act covering financial services which would revoke key provisions of the financial services act 1986 and little other legislation. All the earlier work on regulation would be swept away and the FSA would regulate investment business, insurance business, banking, building societies, friendly societies, mortgages and Lloyds. On 30 November 2001 the act, the financial services and market act 2000 (FSMA 2000) came to form a system of statutory regulation. The creation of the FSA as the UKs single statutory regulator for the industry brought together regulation of investment, insurance and banking. The FSA took over the responsibilities for prudential supervision of all firms, which involves monitoring the adequacy of their management, financial resources and internal systems and controls, and Conducting of business regulations of those firms doing investment business. This involves overseeing firms dealing with investors to ensure for example information provided is clear and not misleading. Adair Turner (2009) argued that FSA’s regulatory and supervisory approach, before the 2007-2008 crises, was based on a sometimes implicit but at times quite obvious philosophy which believed that * Markets in general are self-correcting and disciplined which acts as effective tools than regulation or supervisory oversight to ensure firms’ strategies are sound and risks contained * Main responsibility for managing risks was of senior management and boards of the firms, who were thought to be at better place to evaluate business risk than bank regulators, and who are better off in making appropriate decisions about the balance between risk and return, provided proper systems, procedures and skilled people are in place. * Customers protection cannot ensured by product regulation or direct markets intervention, but by making sure that wholesale markets are tolerant and transparent as possible, and that’s the way in which firm’s conducts business is appropriate. Turner argued that this philosophy in supervisory approach resulted in: A focus makes sure that systems and processes were defined well instead of challenging the business models and strategies. Risk Mitigation Programs set out after ARROW reviews therefore tended to focus more on organization structures, systems and reporting procedures, than on overall risks in business models. A focus within the FSA’s failure to notice of approved persons on checking that there were no issues of honesty raised by past conduct, instead of evaluating technical skills, with the assumption that management and boards were in a superior position to assess the appropriateness of particular individuals for particular roles. A balance between business regulation and prudential regulation which, with the benefit of observation, appears biased towards the former. This was not the case in all sectors of the financial industry: the FSA for instance introduced in 2002-04 major and very important changes in the prudential supervision of insurance companies which have significantly improved the ability of those companies to face the challenges created by the current crisis. But it was to a degree the case in banking, where a long period of reduced economic volatility, which was attributed by many informed observers to the positive benefits of the securitized credit model, helped foster inadequate focus on system-wide prudential risks.

Failure of Current Regulation

Based on the “Geneva Report”, the “G30 Report”, and the “NYU-Stern Report” failure of current regulation Systemic risk:Reports established a point of view that the financial regulatory frameworks around the world pay little consideration to systemic risk. Carmichael and Pomerleano (2002) define systemic risk as systemic instability that “arises where failure of one institution to honour its promises leads to a general panic, as individuals fear that similar promises made by other institutions also may be dishonoured. Acharya, Pedersen, Philippon and Richardson (2009) argue that Current financial regulations seek to limit each institution’s risk seen in isolation; they are not focused on systemic risk. As a result supervisions focus on individual institutions, instead of having it on the whole system, while individual risks are properly dealt with in normal times, the system itself remains, or is encouraged to be, weak and exposed to large macroeconomic shocks This focus was a common feature and a common failing, of bank regulation and supervisory systems in the world. As per the Geneva Report regulations wholly assumes that it can make the system as a whole safe by simply making sure that individual banks are safe which is misleading. Pro-cyclical risk taking: Reports also agreed that financial regulations encourage pro-cyclical risking taking which increases the possibility of financial crises and their severity when they occur. Any economic quantity that is positivelycorrelatedwith the overall state of theeconomyis said to be pro-cyclical (Gordy MB and Howells B. 2004). Financial intermediation as a whole is inherently pro-cyclical. Financial activity such as new bond issues and total bank lending tend to increase more during economic booms than during downturns. Higher levels of economic growth lead to higher values of potential collateral, thereby loosening credit constraints and making access to debt financing easier. Another contributing factor to the financial system’s pro-cyclicality is that financial market participants behave as if risk is counter-cyclical. For instance, bank loan standards tend to be most lax during economic booms (Lown et al 2000)) and banking supervisors have historically been most vigilant during downturns (Syron (1991)). Regulations lead towards stability and reduce statistical measures of risk and encourage excessive risk taking. In bad times, the pendulum swings back producing excessive risk aversion. Large Complex Financial Institutions (LCFIs): All reports agree that current regulations do not deal effectively with LCFIs, defining LCFIs as “financial intermediaries engaged in some combination of commercial banking, investment banking, asset management and insurance, whose failure poses a systemic risk or `externality’ to the financial system as a whole.” (Saunders, Smith and Walter, 2009). The growing role of LCFIs poses various challenges.The complexity of these institutions has made it hard for financial analysis and effective supervisor’s oversight. The linkages among business areas within LCFIs are close which leads to increase of risk contamination from one business area to another as well as across jurisdiction. All reports also insist on the danger induce by implicit Too-Big-To-Fail guarantees. “Too big to fail” is an expression that refers to the idea that ineconomic regulation, the largest and most interconnected businesses are so big that a government cannot let them to declare bankruptcy for the reason that said failure would have disastrous consequences on the overall economy. Mervyn King on June 17th, 2009, the governor of theBank of England, called for banks that are “too big to fail” to be cut down to size, as a solution to the problem of banks having taxpayer-funded guarantees for their speculative investment banking activities. “If some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big. It is not sensible to allow large banks to combine high street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure” (, 2009). Capital requirements: All of the reports struggle with an inconsistency of financial regulation; capital held to meet minimum requirements cannot be used as a safeguard against unexpected losses. As such, fixed capital requirements can only ensure that losses do not immediately make banks insolvent. Banks play a critical role in the allocation of society’s limited savings among the most productive investments, and they facilitate the efficient allocation of the risks of those investments. They might give regulators enough time to intervene, but they are ineffective against systemic risk. The real shield can only come from equity in excess of the requirements. Liquidity and maturity mismatch: Geneva Report points out, “a key avenue through which systemic risk flows today is via funding liquidity combined with adverse asset price movements due to low market liquidity.” It has been recognised that maturity mismatches between liabilities and assets in balance sheets can lead to liquidity crises. An increase in the liquidity preference of international lenders then exposed the vulnerabilities of domestic banks that resulted from the mismatching of their balance sheets. If depositors know that the bank is illiquid they may be induced to withdraw a deposit, which, in turn, forces the bank to sell assets at a discount in order to pay out depositors. Given that banks operate with a relatively low equity capital ratio, the fire-sale discount does not need to be very large to exhaust the bank’s capital and force it into legal insolvency (which happened in the case of northern rock). Acharya and Schnabl (2009) also explain why regulators should take liquidity into consideration when assessing capital adequacy ratios, and Hellwig (2008) insists on the maturity mismatch in vehicles that relied on short term market financing to fund long term assets (real estate assets in particular). “ Stricter regulation could have stopped this crisis from occurring in the first place, had we had these processes in place ten years ago they would have produced a very different financial system today” Lord Turner, the chairman of the Financial Services Authority(June 5, 2009)

CH 2

Banking crises

To understand how to prevent a repeat of the financial crisis, it is important to try to understand its causes. The causes of banking crises can be categorised under several headings. Macro-imbalances: the roots of the crisis can be traced to the global macro-imbalances that have grown rapidly. Oil exporting countries, Japan, China, and a few other East Asian developing nations accumulated large current account surpluses, and on the other side USA, UK (table), Ireland, Spain and some other countries had large current account deficits. Since these high savings exceed domestic investment, China and other countries must accumulate claims on the rest of the world. These investments where not typically invested in a wide array of equity, property or fixed income assets, but almost exclusively in apparently risk-free or close to risk-free government bonds or government guaranteed bonds. This in turn has caused a reduction in real risk-free rates of interest to historically low levels. This commonly has driven two main effects: rapid credit expansion and search for yield among investors. These effects provided conditions for the growth of financial innovation which resulted in crisis. Turner (2009) argued that Regulators were too focused on the institution by institution supervision of idiosyncratic risk: central banks too focused on monetary policy tightly defined, meeting inflation targets and bigger picture was ignored.


The emergence of banking conglomerate: facilitated by deregulation and globalization, huge financial conglomerate emerged which combine the traditional banking activities of borrowing and lending with asset management and advisory services. ‘These institutions were riddled with conflicts of culture and of interests. They proved largely unmanageable and were largely unmanaged’, (John key, 2009). Financial Innovation: Financial innovations occur because market participants are constantly searching for new ways to make greater profits. The process of “financial innovation” includes changes in financial instrument, institutions, practices and markets (Mishkin & Frederic, 1992). In broad sense, financial innovation affects the nature and composition of monetary aggregates through new financial instruments or changes in old instruments as well as the term and conditions of debt/credit arrangements. The financial innovation satisfies the demand for yield uplift. In last few years it was predicated on the belief that by slicing, structuring and hedging, it was possible to create value, by offering investors combinations of risk, return, and liquidity which were more attractive than those available from the direct purchase of the underlying credit exposures. It resulted not only in massive growth in the importance of securitized credit, but also in a profound change in the nature of the securitized credit model. Financial innovation led to 1) creations of products on which no accurate value could be placed; and, 2) ensured that the consequences of careless lending in specific markets would be rapidly globalised. Failure of corporate governance: The current financial crisis has exposed serious flaws and shortcomings in the system of non-executive oversight of bank executives and senior management in the banking sector. In particular, the evidence shows that many non-executive directors in many cases were well-known and highly-regarded individuals with no shortage of experience in the business and banking worlds failed to act as an effective check on, and challenge to, executive managers. Non-executive directors in the banking sector have operated in a calm manner rather than viewing their role as being that of providing effective identifying, or unwilling to object to, the unsustainable business strategies being pursued by those whom they apparently had a duty to oversee. House of Commons Treasury Committee report (2008-2009) led to the conclusion that this failure to act as an effective check on senior managers has a number of causes. First, there is the lack of time many non-executives devote to their role. We were surprised to learn that some non-executive directors appear able to combine their non-executive role with that of chief executive of a FTSE 100 company, or to hold four or five director or trusteeships. Secondly, too many nonexecutive directors within the banks lack relevant banking or financial experience; we wonder how, in such instances, they can effectively challenge, scrutinize and monitor business strategy and the executive management in a sector as complex as banking. Finally, we are concerned that the banks are drawing upon too narrow a talent pool when appointing non-executive directors to the detriment of diversity of views. The extraordinary growth of, and influence exerted by, the unregulated shadow banking system: As a global financial centre, Britain’s economy is particularly dependent on a successful financial sector (table). Savings from surplus countries prompted an increasingly desperate search for yield, with investors taking on more risks in exchange for higher returns. This demand was met by the development of new financial instruments, especially asset backed securities created by banks from loans against residential and commercial property, commercial and consumer credit (table). British banks were particularly active in these markets and some became dangerously dependent on these new instruments for revenue and profit growth. The result was a dangerous increase in leverage that the regulatory system failed to identify as a potential risk or take action to prevent. That massively reduced transparency and made regulations practically impossible to work. Remuneration practices: High levels of remuneration in banks, and in particular high bonuses paid both to top executives and to traders involved in trading activities which subsequently generated large losses, have been the subject of intense public focus as the financial crisis has developed. The banking crisis has forced the issue of remuneration practices in the banks to the top of the public policy agenda. This reflects two distinct areas of concern. Firstly the level of remuneration has been too high and that bonuses and substantial severance packages have continued to be awarded to senior executives at banks which have been part-nationalised and or received significant taxpayer support. Secondly the bonus culture, particularly amongst those involved in trading activities in investment banks, contributed to excessive risk-taking and based on short term and thereby played a contributory role in the banking crisis. As Nobel Prize winner Joseph Stiglitz explains, “the bonus culture in the City was designed to encourage risk taking but it encouraged excessive risk-taking. In effect, it paid them to gamble. When things turned out well, they walked away with huge bonuses. When things turned out badly as now they do not share in the losses”. During the past neither the FSA nor bank regulators in other countries paid significant attention to remuneration structures. Little attention was paid within the firms to the implications of incentive structures for risk taking, as against the implications for firm competitiveness in the labour market bonus culture in banks encouraged excessive risk taking in a system which is already fragile. Incentive pay might work for those performing basic and routine tasks but in situations where the decisions based on long term, pay that truly reflects performance is not achievable and the attempt to make it so is very counter-productive for firm profitability. In retrospect this lack of focus, by both firms and regulators, was a mistake. A reasonable judgement is that while inappropriate remuneration structures played a role, they were considerably less important than other factors (e.g. inadequate approaches to capital, accounting, and liquidity). It is nevertheless likely that past remuneration policies, acting in combination with capital requirements and accounting rules, have created incentives for some executives and traders to take excessive risks and have resulted in large payments in reward for activities which seemed profit making at the time but subsequently proved harmful to the institution, and in some cases to the entire system. Regulation: These macroeconomic and financial innovations were combined with a massive failure of regulation. The regulatory framework failed to ensure that banks had enough capital to insure against the risks of loans going bad, allowed banks to hide risks off their balance sheets, essentially ignored the issue of liquidity, and made worse the credit cycle by making lending cheaper during the boom and more expensive when the market turned. Regulators were far too ready to accept the claims being made for financial innovation. It is also to be remembered that, until the crisis hit, it was not considered good form to raise any concerns over the potentially destabilizing impact of the bonus culture. The most important flaw in the British regulatory system was that nobody was responsible for putting together all the different warning signals and acting on them. The FSA failed to spot or prevent a dangerous build up of risk throughout the banking system. Without the economy-wide understanding of a central bank, sufficient market expertise or the authority that comes with being the lender of last resort, the FSA was unable to challenge senior management over their unsustainable business models or risky remuneration structures. The end result was a banking sector that was undercapitalised, dependent on unsustainable funding strategies, low on liquid assets, poorly governed by weak boards and driven by dangerously short term incentives. The government nationalised Northern Rock in February 2008 and then Bradford and Bingley’s deposit and savings accounts were taken over by Bank Santander, a Spanish bank, to be run alongside Abbey National and Alliance and Leicester; which it had previously taken over, in late September 2008. These activities were in response to the wholesale funding problems they were facing as a result North Atlantic liquidity squeeze that began in August 2007 (Mullineux, 2008). The banking crisis went global see annex 1 following the collapse of Lehman Brothers, a major US investment bank, in mid September 2008 and the UK Government responded with bank recapitalisations in an October 2008. As a result, the UK Government accumulated shareholdings in two major banks of approximately 70 per cent in RBS and 43 per cent of the merging Lloyds TSB/HBOS (Lloyds Banking Group) (Mullineux, 2009). The government’s stake in the banks is managed by a company called UK Financial Investments (UKFI) and it works to unwind the government’s stake and make a profit for British taxpayers. The Northern Rock collapse has been a tremendous blow to the stability of the financial system and to the credibility of financial regulation and supervision

Northern rock

Northern Rock was established as a building society. All the similar societies were jointly owned by their depositors and their borrowers. Their deposits came mainly from retail customers, and their major lending was to those who wanted to buy their residences. In the 1990s, these organisations were allowed to Demutualise, and switch to banks. Reasons to switch in to banks were strong. Management achieved greater freedom on both sides of the balance sheet, and the owners obtained shares in their institutions. These shares paid dividends and may well be traded on the stock exchange, both features being attractive to most society members. Most of the large societies converted. Northern Rock was among them to convert on 1 October 1997. Northern Rock remained independent as many of the societies were taken over by or merged with previously existing banks. Northern rock grew rapidly in its post-demutualisation period. At the end of 1997, its assets stood at £15.8 billion. By the end of 2006, its assets had reached £101.0 billion (Milne and Wood, 2008). According to Adam Applegarth, its then chief executive, Northern Rock had been growing its assets ‘by 20 per cent plus or minus 5 per cent for the last 17 years’. In spite of rapid growth, it never left its traditional focus on residential mortgage assets, which by end 2006 were £86.8 billion, that is, about 86 per cent of total assets (Milne and Wood, 2008). At the end of the 2007, in United kingdom northern rocks mortgage loans were only 8 % (by value) of the stock of mortgage debt, and hence only about 5 % of total bank lending, and its deposits were only about 2 % of sterling bank deposits. The asset side of Northern Rocks balance sheet stayed as the traditional building society model, in which it concentrated on lending on mortgage to individuals who wished buy their own home, there were prominent changes in the structure of its liabilities. Recent years have experienced an unprecedented wave of complex financial innovation with the creation of new financial instruments and vehicles most especially with respect to the shifting of credit risk (Llewellyn, 2009). It take on a model of funding, which were to use securitisation, the issue of covered bonds, and direct borrowing in the wholesale markets, to finance its lending, which resulted dependence on wholesale market. Overall Deposits in the bank did grow, but not quite as rapidly as did wholesale funds. Retail funds thus fell as a proportion of the total liabilities and equity of Northern Rock, from 62.7 per cent at end 1997 to 22.4 per cent at end 2006 (Milne and Wood, 2008). According to the European Central Bank (ECB), there is no bank with such an extreme degree of reliance on wholesale funding. The unusual nature of the Northern Rock balance sheet is illustrated in Table, which looks at total assets, lending and deposits of the 10 largest UK banks and building societies, as of end 2006. Northern Rock was practising unusual business model, with a building society’s traditional concentration on illiquid long-term mortgage assets while at the same time relying on very non-traditional sources of securitised and wholesale funding (Milne and Wood, 2008).


Assets and liabilities of the largest UK banks and building societies

£ billion end 2006 Assets Loans Deposits Loans/assets Deposits/loans (£ billion) (£ billion) (£ billion) (%) (%) RBOS 848 469 385 55 82 Barclays 997 282 254 28 90 HSBC (UK) 441 200 227 45 113 HBOS 445 217 107 48 49 Lloyds-TSB 346 190 141 55 74 Abbey 192 130 67 54 64 Nationwide 137 116 90 84 77 Northern Rock 101 87 27 86 31 Alliance and Leicester 69 48 30 70 61 Bradford and Bingley 45 36 22 80 61 Source: Bureau van Dijk Bankscope database and authors’ calculations The table highlights the significance of different non-retail sources of funding. The issue of asset backed securities provided 40 per cent of Northern Rock’s end-2006 funding. Wholesale borrowing provided a further 24 per cent, and covered bonds 6 per cent. The Northern Rock balance sheet show overall increase and there clear increase in liabilities over the previous year, which leads to an even greater extent reliance on non-retail funding. Retail deposits provided only around 12 per cent of this expansion, whereas capital and reserves were actually reduced in the course of 2006 (Milne and Wood, 2008). Two third of the overall expansion 2006 of the Northern Rock balance sheet was funded from mortgage-backed securities and of covered bonds.


Composition of Northern Rock’s end-2006 liabilities

£ billion Total liabilities Capital and reserves Retail Wholesale Securitisation Covered bonds Level end 2006 101 7.7 22.6 24.2 40.2 6.2 Increase on 2005 18.3 -0.5 2.5 2.9 10.6 2.7 Source: Northern Rock Annual Report and Accounts 2006 and authors’ calculations Much of the securitised funding, as well as Northern Rock’s other wholesale funding, was short term. According to Adam Applegarth former Northern Rock CEO in his evidence to the Treasury and Civil Service Select Committee, about half of their wholesale borrowing was at a maturity of less than 1 year, which meant that a large amount of mortgage-backed securities needed to be refinanced every year, requiring the issue of more mortgage-backed securities. Which meant that funding needs to be replaced and obtained from short term wholesale and securitisation markets, markets which were effectively closed from the summer of 2007 as Northern Rock did not make use of asset-backed commercial paper conduits as a source of short-term funding for the issue of mortgage-backed securities; until the autumn of 2007 all its mortgage backed securities were sold rather than held off-balance sheet, that forced Northern Rock to turn to the Bank of England for liquidity support in September 2007, In order to avoid default on its short-term wholesale borrowing. This announcement sparked a run on the bank until the government moved to offer a guarantee to all deposits and that this would not be restricted to the normal limit of the Financial Services Compensation Scheme. Although rumours developed about other banks, the problem was focussed only on Northern Rock. As the problem was contained, in this respect a true systemic bank run was avoided although what might have happened had the government not announced its full guarantee of deposits at all banks in similar circumstances is open to question.


Research Methodology

“The job method is only to hold apart the researcher and their objects, so that we can tell the difference between them. Methods do not tell us what the thing is; they do not even describe it. All they tell us is the circumstances under which the researcher met the object; and they normally seek to provide a guarantee that researcher and object are distinct from each other” (Clough and Nutbrown, 2007).


The research on ‘‘Can living wills address the perceived failures in the regulation of financial services highlighted by the current credit crisis?” is a library based research adopting theoretical research which is conducted to analyse the Banking regulations and banking crisis in UK in last 5 years. In order to find the solutions to the question raised, research will be looking at secondary data and reports that reflect qualitative and quantitative perspectives.

Research Approach

Research can be categorised into two distinctive types: qualitative and quantitative. Denscombe (2003) states about qualitative research as: Qualitative research and quantitative research are widely used and understood within the realms of social research as signposts to the kind of assumptions being used by the researchers and the nature of the research being undertaken. Denise G. Jarratt (1996) made clear difference between quantitative and qualitative research which can be seen in table

Table Difference between Quantitative and Qualitative research


Quantitative paradigm Qualitative paradigm Purpose Prediction and control Understanding Reliability Stable-reliability is made up of facts that don not change Dynamic-reality changes with changes in people’s perceptions Viewpoint Outsider-reality is what quantifiable data indicate it to be Insider-reality is what people perceive it to be Values Values free-values can be controlled Value bound-values will impact on understanding the phenomena Focus Particularistic- defined by variable studied Holistic Orientation Verification Discovery Data Objective Subjective Instrumentation Non-human Human Result Reliable Valid- the focus is on design and procedures to gain real, rich and deep data. Source stainback and stainback (1998) Taken from Denise G. Jarratt (1996). The ultimate aim of research is to offer a viewpoint on the financial and banking regulations and taking in the account, the living wills to provide well-written research reports that reflect the ability to illustrate and describe the corresponding facts.

Research Method

To analyse Regulations and living wills, collections of existing data would be used to determine what is known already and what new data are required, or to form research design. As opposed to data collected directly from respondents or “research subjects” for the express purposes of a project, (often called “empirical” or “primary research”), secondary sources already exist (Joselyn, R. W. 1977). Analysis will include descriptive material, newspaper, magazine and journal content, government statistics usually, extracts from interviews, conversations, documents and field notes. There are also a wide range of software to support the management and analysis of qualitative data (Weitzman, 1999). A key performance area in secondary research is the full citation of original sources, usually in the form of a complete listing or annotated listing, (Green, P.E. Tull, D.S. and Albaum G, 1993).

Data Analysis

“Can living wills address the perceived failures in the regulation of financial services highlighted by the current credit crisis” research would raise different questions which willarise from re-examining material which up till now has not been thought worth researchers’attention. Financial regulations, Living wills and Banking crises in last 5 years would be looked at distantly. The review will set the research in context by critically discussing and referencing work that has already been undertaken, drawing out key points and presenting them in a logically argued way, and highlighting those areas where you will provide fresh insights. The critical review of the literature is necessary to help you to develop a thorough understanding of, and insight into, previous research that relates to your research questions and objectives, (Saunders and Thornhill, 2007).Different viewpoints on Financial regulations as one of the major causes of Banking crises will be looked at, and the effect of living wills in order to prevent any crises to occur.

Data collection method

Secondary data are crucial for any research. Secondary data is collected from the various source of literature and is more convenient and cost saving for research (Saunders, M., Lewis, O. and Thornhill, A, 2003). Secondary data refer to information gathered by someone other than the researcher conducting the current study. Such data can be internal or external to the organization and accessed through the internet or perusal of recorded or published information. There are several sources of secondary data, including books and periodicals government publications of economic indicators, census data, statistical abstracts, data bases, the media, annual reports of companies, case studies and other archival records. Secondary sources of data provide a lot of information for research and problem solving. Such data are as we have seen mostly qualitative in nature. Also included in secondary sources are schedules maintained for or by key personnel in organizations, the desk calendar of executives and speeches delivered by them. Much of such internal data though could be proprietary and not accessible to all. Financial databases readily available for research are also secondary data sources.

Ch4 Summary and Conclusion:

Bank regulation cannot prevent crises, but the regulations which are being introduced and the framework that is currently being shaped will influence the development of the banking system in future. We need to recognise that no system of regulation will ever be perfect. But in any system there will occasionally be firms that fail and there will always be market participants seeking to use financial innovations to escape regulatory constraints. This understanding was sadly lacking over the last decade, but it has important implications. In particular, it means we need a regulatory approach that minimises the costs of regulatory failures if and when they occur. That means we cannot continue to accept a system where financial institutions have a free option to pursue high-risk strategies with the assurance that the taxpayer will step in to protect them and the rest of the financial system in the event of failure. Therefore, where the failure of a financial institution would threaten financial stability, the public purse, or consumers, a responsible Government must take steps to protect the taxpayer and the financial system. We need to make sure both that important institutions are less likely to fail and that any failures can be managed without systemic complications. None of these reforms or protections should be designed to prevent institutions from choosing to pursue high-risk, high-reward activities as long as they do not pose a threat to other parts of the system or impose a cost on the taxpayer. Prudential regulation should be proportional to the risk an institution presents to financial stability, the taxpayer and the consumer. When an institution can realistically be allowed to fail without wider social implications its regulation should reflect this. The same applies to financial innovation like any industry the financial sector must be allowed to innovate as long as those innovations do not put financial stability at risk. Recent measures by governments such as, to purchase impaired assets, recapitalize troubled banks, and inject liquidity into the system, have supported banking and banking system, despite concerns due to publicly funded bank bailouts, which were seen as build up for the next crisis in future. The recovery plan remains highly uncertain, as many banks still have long way to go before the consequences from subprime lending and securitization is completely erased from their balance sheets. Doubtless banks will become leaner, more strongly capitalized, less highly leveraged and more heavily regulated than they have been in the past. Banks risk management practices will be overhauled, and executive compensation will be more closely aligned to risk-adjusted performance, measured over periods of sufficient duration to allow the underlying risks to be properly identified. If the banking system that emerges eventually is more stable, and more reliable and efficient in performing the core banking function of intermediation between lenders and borrowers, then the lessons of the 2007-2010 global financial crises may yet prove to be helpful.

Annex 1

Chronology of key events in the financial crisis

The problems began in late 2006 in the United States when the rise in the number of mortgage foreclosures began to expose the scale of poor lending decisions to home owners. In 2007 foreclosures increased and a shortage of liquidity developed as the marked for mortgage-backed securities in the US banking sector collapsed. 16.08.07: US bank Countrywide Financial experiences liquidity problems, leading to a run on the bank; the Federal Reserve intervenes by accepting mortgage-backed securities to aid liquidity; Countrywide sold to Bank of America in January 2008. 14.09.07: Northern Rock receives liquidity support from the Bank of England as it is unable to raise funds; run on the bank commences. 17.09.08: UK Government guarantees all deposits in Northern Rock and halts run; 22.02.08: Northern Rock nationalised after no buyer comes forward. 11.03.08: US Treasury introduces a new facility to allow banks to use mortgage-backed securities to be used to obtain Treasury notes worth a total of $200 billion. 14.03.08: Bear Stearns, fourth largest bank in the USA, given loans by JP Morgan Chase and later acquired by them. 21.04.08: Bank of England announces it will accept a range of mortgage-backed securities in exchange for liquidity for banks. 07.09.08: US Federal Housing Finance Agency takes control of two US mortgage backers, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) to prevent their possible collapse. 14.09.08: It was announced that Lehman Brothers would file for bankruptcy after US Treasury Secretary Henry Paulson declines to bail it out. 7 15.09.08: Global stock market turbulence, repeated two days later, sees dramatic fall in equity values. 16.09.08: Merrill Lynch sold to Bank of America; equity markets fell with Dow having its worst day since September 2001; Bank of England injected £5 billion into the banking system; US insurer AIG asks the Fed for $45 billion of liquidity. 18.09.08: Lloyds TSB announce takeover of HBOS. 19.09.08: US Treasury Secretary announces a plan to stabilise the banking system by buying up the most difficult assets of banks using public money. The Troubled Asset Relief Program envisages the purchase of up to $700 billion of assets. This “bail out” is widely discussed and soon criticised because of the lack of detail provided as to how it would operate in practice. 24.09.08: President confirms details of the bailout plan. 25.09.08: Congressional leaders meet with the President, Senator Obama and Senator McCain to discuss the bailout package but the meeting breaks up without agreement. Washington Mutual, the largest savings and loan corporation in the US is taken over by the Federal authorities and most of its assets transferred to JP Morgan Chase. 28.09.08: Congressional leaders announce tentative agreement on bail out plan. 29.09.08: US House of Representatives unexpectedly rejects the bailout plan. Dow Jones falls by eight per cent, its largest drop in a single day since “Black Monday” in October 1987. Collapse in the value of bank shares on the Irish stock market. Bradford & Bingley nationalised and its retail savings arm transferred to Bank Santander. Icelandic Government announces intention to nationalise Glitnir; this triggers worldwide reports of liquidity problems in the Icelandic banking system. Governments of Belgium, the Netherlands and Luxembourg purchase 49 per cent of banking and insurance company Fortis and oblige it to sell its stake in Dutch bank ABN. 30.09.08: The Irish Government announces that all deposits in Ireland’s main banks and building society are guaranteed for two years.US stock market drops 777 points in a single day – its largest ever single-day drop. 06.10.08: EU ‘big four’ meeting in Paris – leaders of France, Germany, Italy and the UK. German Government rescues major property lender Hypo Real Estate. 07.10.08: ECOFIN meeting agrees action plan to deal with financial crisis Russian Government announces 950 billion rouble loan facility for Russian banks. European Commission announces that it will shortly publish guidance on bank recapitalisation and state aids/competition issues. 08.10.08: Co-ordinated half-point cut in interest rates by several central banks, including those of the US, UK, Sweden, Switzerland, Canada and the ECB. UK Government announces £50 billion will be available as part of a package of finance to recapitalise the UK banking system. Eight banks and one building society agree to take part in the scheme. The Bank of England announces that a 8 further £200 billion would be available to banks under its Special Liquidity Scheme. 10.10.08: Equity markets plunge as fears of global recession grow; the G7 meeting of finance ministers and central bank governors in Washington issues declaration promising “decisive action” to deal with the financial crisis. 11.10.08: G7 meeting Washington DC agrees to take all necessary measures to support the banking system and in particular to ensure that banks are fully capitalised and the secondary mortgage market can function properly. 12.10.08: Eurozone Heads of Government meet with the UK Prime Minister and promise to act “in a decisive and comprehensive way” to tackle the banking crisis. 12.10.08: Hungary requests assistance from IMF and EU. 15.10.08: G8 statement European Council begins October meeting in Brussels. 16.10.08: European Council agrees to establish a co-ordinating group in Brussels (thefinancial crisis cell) to exchange information and act as an informal warning mechanism to EU institutions and governments. The Council endorsed the decisions of ECOFIN and the eurozone summit the previous weekend. 17.10.08: French bank Caisse d’Epargne announced losses of £500 million as a result of trading errors in derivatives the previous week. 22.10.08: Belarus and Pakistan request help from IMF. 24.10.08: IMF loan package agreed for Iceland. 26.10.08: IMF loan package agreed for Ukraine. 27.10.08: G7 finance ministers and central bank governors statement on the yen. 28.10.08: IMF, EU and World Bank package worth £15.6 billion announced. 28.10.08: Dutch Government injects €3 billion into insurance giant Ageon. 15.11.08: G20 Summit in Washington DC agrees that countries should pursue fiscal stimuli where they can in order to slow the downturn; agree that reform of international financial institutions is necessary; and that there should be agreement on the Doha trade round by the end of 2008. Source: The EU and the Global Financial Crisis By the Senior Experts Group


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