Global Financial Crisis on Different Financial Norms by Financial Institutions in British Economy

The Impact of Recent Global Financial Crisis on Different Financial Norms Undertaken by Financial Institutions within the British Economy

Chapter 1: Introduction

1.1 Introduction

The global financial crisis severely affected the world’s market in 2007-08. During this period, stock markets fell down across the world; along with this, a number of leading banking institutions became weakened (Lin 2008).  The credit crunch in 2008 made financial products complex, which badly affected customers’ and investors’ trust in the financial system (Batten, and Szilagyi 2011). Moreover, the global crisis made a profound impact on the output and the employment rate, and caused deflation (Savona, Kirton and Oldani 2011). Altogether, the crisis turned down the economic activities in the UK economy, which resulted into fall of investment in sectors like real estate and banking.

In context to the research topic, the introduction chapter covers different sections, such as background, aims and objectives, research question, and significance. Additionally, it reflects the impact of the financial crisis on different financial norms of banking institutions in the British economy.

  1. Background

Financial crisis and its impact on the financial norms, both are subjects of research study under the financial field. The recent global financial crisis has affected the working of financial institutions at the international level (Jackson 2010). This research study has prime focus upon investigating the impact of the recent financial crisis on the banking institutions’ financial norms. The global financial crisis is mainly caused by far-flung failures in the financial institutions’ policies, regulations of the government, and corporate mismanagement (Canstar Research 2009).

The financial crisis in the mid of 2007-08 was an unpreventable disaster that badly affected the credit markets around the world (Chan 2011). In 2008, banking institutions faced a serious problem in obtaining credit. A number of leading financial institutions and insurance companies failed due to the credit crunch. Overall, the recent financial crisis weakened the liquidity position in the inter-bank market (Valdez and Molyneux 2010).

The global financial crisis caused enormous losses due to the sub-prime lending in the US, but after this, a large number of financial institutions collapsed in Europe, mainly in the United Kingdom (UK). Due to the financial crisis, financial institutions operating within the British economy suffered from the loss of substantial value. In the same context, ten most prominent financial institutions and insurers in Europe faced the loss of their total market capitalisation; their losses have been 51% and 70% respectively. Due to this, the market confidence in Europe declined as investors lost their confidence in making investment in the financial institutions in the UK and the Eurozone (Sesric Reports 2011).

1.3 Research Question

Research question is a significant part of the dissertation that provides a base for doing a research study. The global financial crisis and its impact on the financial norms of the financial institutions within the British economy is the main background of the research. In this respect, the main research question is, “What has been the impact of the recent global financial crisis on different financial norms taken by the financial institutions within the British economy? Moreover, the research is also going to find answers to various sub-questions, like global financial crisis and its causes, financial norms/measures undertaken by British financial institutions before the financial crisis and after the financial crisis.

1.4 Aims and Objectives

The main aim of the research is to explore and evaluate the impact of recent global financial crisis on different financial norms undertaken by the financial institutions within the British economy. This aim helps in identifying changes in the current financial norms, like credit and monetary policy, capital reserve ratio, and internal auditing after the terrible impact of the global financial crisis on the market credit and liquidity position. The given aim addresses the measures undertaken by the financial institutions to limit losses and improve confidence of the investors in the British market.

The key research objectives in relevance to the given topic that are being addressed throughout the research study are depicted as under:

1.5 Significance of the Research

As reviewed earlier that the global financial crisis has had a drastic impact on the working of financial institutions, so it is significant to evaluate the ways in which the financial crisis has impacted the financial norms followed by financial institutions. After the United States, Europe being the most prone region has been affected by the global financial crisis immensely. With the conductance of this research, the British economy would be made better through examining whether the changes made in the financial norms of British financial institutions have been favourable to overcome the negative impact of the financial crisis.

The global economy has been affected to a great level as a result of the financial crisis. Financial institutions have made significant changes in their operational process as well as financial norms to deal with this. The British economy will have the knowledge of the facts that led to the economy’s growth at a great level by adopting the new financial norms through the conductance of this research (Suter and Herkenrath 2011). In the academic area, this research provides a robust information base and adds new information in the existing knowledge domain.

1.6 Outline of the Chapters

A complete dissertation comprises a number of chapters to give a comprehensive and complete knowledge about the research topic. The glance of the chapters covered in this research work has been reflected as follows:

Literature Review: This chapter covers a critical and thorough review of the relevant and authentic literary sources (books and journal articles) to explore the topics related information in detail.

Primary Data Collection (Research Methodology): The details about the primary data collection method chosen for the research work will be covered under this chapter. Additionally, this chapter includes research approach, research design, research philosophy, and ethical considerations.

Findings and Analysis of the Results: The results collected through conducting the survey are covered under this chapter along with the detailed analysis.

Discussion of Results: All the research results analysed in the above chapter are critically discussed here with support of the authentic evidences.

Conclusion and Recommendations: The main points of the research are concluded under this chapter. Besides that, this chapter covers recommendations with respect to the identified problems.

1.7 Summary

The recent global financial crisis that induced changes in the financial norms of the financial institutions is the main background of the research. This research is specifically being conducted in the banking sector within the British economy to explore the impact of 2007-08 financial crises on the prevailing financial norms. Overall, this chapter provides introductory knowledge and base of the research study.

Chapter 2: Literature Review

2.1 Introduction

The recent global financial crisis severely affected the economic system of the world. In 2006, sub-prime mortgage crisis originated after real-estate bubble in US that caused financial and credit problems. This unexpected crisis weakened the credit arrangement across the globe and wore away investor’s trust and capital. This ultimately led to the collapse of a large number of leading financial institutions. The credit crunch flowed through global financial markets in August 2007 and affected the prevailing financial norms of European financial institutions (Savona, Kirton and Oldani 2011, p. 70).

In context to research topic, the literature review chapter covers an in-depth theoretical knowledge through reviewing literary sources, like books and scholarly articles. This is an important part of dissertation that provides good background information about the topic. In this research, the literature review chapter is based on the recent global financial crisis and its impact on banking sector. The purpose of this chapter is to address the defined research aim and objectives, along with research question and therefore, all headings are framed accordingly in this chapter. Literature review mainly focuses on recent global financial crisis and its roots, impact of financial crisis on financial institutions, financial norms followed by British financial institutions and lastly, the crisis impact on prevailing financial norms. Additionally, the conceptual framework is also included in this chapter to give a clear picture and glances about the overall literature review.

2.2 Conceptual Framework

          The conceptual framework model is designed to take a quick look at the impact of recent global financial crisis on the financial norms. The financial norms can be considered as the legal rules and policies related to financial aspects of financial institutions. The examples of these policies are budgeting, Revenue and Expense Recognition, Asset and Liability Recording etc.  (Phillips 2004). The recent financial crisis has raised a great problem of credit across the world and induced demand to reconstitute financial norms, basically to smoothly govern the financial system (Colander, et al. 2009). Across the leading world economies, an uneven impact of the global financial crisis on financial institutions or banking sector has been noticed.

The financial sector has significantly faced liquidity and other problems after the financial crisis. In the United States and European countries, financial institutions faced the problem of liquidity and solvency at an extreme level. The problem of liquidity broadened in European financial system because of direct link with the US financial system. The UK bank, Northern Rock was one of the first victims of the economic crisis of 2007-08, which indicated the rippled effects of liquidity problem (Soriano 2011). The conceptual framework covers the intensive information about financial crisis. For this, the framework includes the background of the global financial crisis, the impact of financial crisis on financial institutions/ banking sector, prevailing financial norms undertaken by financial institutions prior and after the financial crisis of 2007-08 in the British economy. Altogether, the conceptual framework depicts changes in the financial norms or measures that were taken to safeguard and support the financial system.

2.3 Recent Global Financial Crisis and its Roots

          Peters (2010) has stated that the recent global financial crisis commenced in 2007-08, which led to the downsizing of world markets and financial system. In the United States, the global financial crisis started after the sub-prime mortgage crisis and later, it moved to European markets (Peters 2010, p. 6-7). The gross domestic product (GDP) of the world sharply declined and showed negative growth trend due to financial crisis. It critically evaluates that developed and developing countries were differently affected by the recent global financial crisis, as per the linkage of the country to the US and global economy. Overall, the financial crisis and real estate bubble in the United States or developed countries led to a complete credit crunch, which spread out across the globe (Peters 2010, p. 6-7).

          Goodhart (2008) states that the impact of global financial crisis on United Kingdom was that the economic activity slowed down in the first half of 2008, resulting in the fall of investment in residential and business sector. The rate of interest started rising increasingly in 2005 and 2006 in relation to normal rate in US. Due to this, the US house prices started stumbling in 2007. There was an upsurge in unemployment, and unemployed people increased by more than 290,000 over a year, reaching 1.90 million and the economy contracted to a large extent (Goodhart 2008). From this, it can be identified that the financial crisis has negatively affected the economic planning at an extreme level.

          Barrell and Davis (2008) have noted that there are different events related to financial crisis. In 2007, the prices of houses in US fell down, and increased loan defaults led to potential losses on sub-prime mortgages, which is one of the major causes of the financial crisis. In the US banking system, the capital reserve assets is declined because of increased number of loan defaults in 2007, which resulted into the collapse of large financial institutions (Barrell and Davis 2008; Yeoh 2009). It is also identified that in US and UK, the stock market value in relation to GDP was less than its peak in the year 2007. Moreover, the problem of getting more and more credit became even harder to the banks due to which, liquidity problem badly affected the sound financial position of the financial institutions (Ambler 2011). The failure of market liquidity rapidly affected banks for securitised loans because of mark to market pricing. Due to this, fall in the prices directly resulted into the banks’ solvency (Barrell and Davis 2008).

          Angelides (2011) reflects the recent financial crisis and its major causes. The housing policy of the US government created around 27 million risky and sub-prime mortgage loans. This led to housing bubble in 2007, along with credit and illiquidity problem because of half or more than half mortgages in the US started getting defaulted. The confidence of wide number of investors turned down, due to increased rate of loan defaults in mid 2007. It is also noted that ‘Mark to market accounting and written off assets value by financial banks has worsened the capital and solvency situations, which increased the apprehensions among current and prospective investors and creditors (Angelides 2011, p. 455-457).

Financial crisis is also caused due to various reasons, such as low rate of interest, high credit defaults, deficient banking regulations, different business models of financial institutions and risk management failures (Angelides 2011, p. 455-457). In the similar context, Jickling (2010) has also stated major causes of the financial crisis, such as housing bubble, imprudent mortgage lending, securitization, lack of accountability and transparency, global imbalances, mark to market accounting, deregulations, risky investments, complexities, credit default swaps and many others (Jickling 2010; Martin 2009).

2.4 Impact of Financial Crisis on Financial Institutions 

          The recent global financial crisis has profoundly affected the financial institutions across the world. Malik and his associates (2009) have stated that the recent global financial crisis was an unexpected event for a large number of people. Over last 18 months, this crisis shook the world markets by severely affecting top markets, such as that of US and Europe. Due to this crisis, various leading financial institutions completely collapsed, while several others received government bailout, and merged with other financial institutions. From this, it has been seen that financial markets of the world were poorly affected because of shortage of credit facility (Malik, et al 2009).

In US, the financial crisis was originally initiated in 2008, which later turned around as a global issue. In addition to this, financial crisis also crashed stock markets of Asia and Europe. It is identified that around 350 billion dollars losses were faced alone by the markets of London, Paris and Frankfurt (Malik, et al 2009). Moreover, it is identified that approximately $945 billion losses were suffered because of mark to market losses on mortgage backed securities and collateralised debt obligations in 2008. Altogether, the financial institutions were significantly impacted by the global financial crisis.

Lannoo (2008) has put forth that the financial crisis of 2007-08 largely affected the European financial system. The recent global financial crisis impacted the monetary and financial market, as it collapsed structured products and induced mistrust in the British financial system. From the perspective of EU, it can also be identified that confidence of the investors turned down due to the recent crisis and thus, large number of current investors withdrew their funds from the market of asset backed securities. This resulted into fall of liquid funds in the European markets, and led to illiquidity and credit problem (Lannoo 2008, p. 4; Kilmister 2008).

As per Lannoo (2008), the recent global financial crisis has two phases, first phase (August 2007 to August 2008), and second phase (September 2008). In the first phase, financial institutions suffered from huge losses from assets backed securities, while in the US bailout for Fannie Mae and AIG insurance group and Lehman Brothers’ bankruptcy caused in the second phase of crisis. Financial institutions endured from the losses of around $1 trillion in terms of write downs and sub-prime losses. European banks comprised of share of one quarter out of this total value (Lannoo 2008, p. 4). From this, was seen that European banks were highly affected by the financial crisis after the US economy.

Berger et al. (1999) have reflected that banking industry across the world is largely impacted by the financial crisis. Due to the global financial crisis, the trend of mergers and acquisitions among financial institutions rapidly increased in the markets of United States. The same trend was seen in Europe occurring at a rapid pace in the future. During the time of crisis, the financial position of the banks and its subsidiaries turned down because of market instability, and low confidence among investors (Berger, Demsetz and Strahan 1999).

Veron (2008) has reflected that the financial crisis 2007-08 ruined the interbank lending market, which was mainly because of increased losses and defaults. It can be inferred that the crisis has induced mistrust into the overall financial system of British economy, because of poor financial framework and lack of effective regulations. Earlier, the financial authorities had the autonomy to provide credit and loan easily to the public, and after the financial crisis, the intervention of government in banking crisis was multifaceted to hold liquidity (Veron (2008). According to Global Financial Stability Report (2008), the financial institutions confronted with liquidity problem or problem in having required credit to hold sound liquidity. The main reason behind financial institutions downturn was increased quantity of bad debt in the structure, more than expected. Due to this, there was confusion among the ruling class of Britain, about responding to the rising number of loan defaults, which caused collapse and fall down of financial institutions (Global Financial Stability Report. 2008).

2.5 Impact of Global Financial Crisis on the Financial Norms in UK 

Veron (2012) has reflected the changes in the prevailing rules and regulations after the recent financial crisis. The recent global financial crisis caused several shifts in the norms to bring effective reform in financial markets. After the crisis, interaction between various factors including political, technical, public and private shifted. The influence of private sector over the financial policy is a drawback of the crisis. It is identified that after the recent crisis, the policy process captured by private sector is best illustrated by the amendments made in International Accounting Standards 39. In October 2008, the Internal Accounting Standard Board (IASB) was forced by the European Commission to induce required modifications in IAS 39 standard on financial products. This was done so that financial institutions escape from the losses induced by the financial crisis. The debate has two contrasting views; firstly, mark-to-market accounting has the advantage of reflecting the relevant value of the balance sheets of financial institutions and as a result, facilitating the regulators and investors of accounting information to better access the risk profile of the financial institutions (Veron 2012). In contrast Kesselman, Krieger and Joseph (2012) have elaborated that that mark-to-market accounting is considered to result in excessive and artificial unpredictability. Therefore, as a result, the value of balance sheets of the financial institutions under this accounting system can be determined through short term fluctuations on the market, and do not reflect the long-term values of assets and liabilities (Kesselman, Krieger and Joseph 2012). 

The shift in public policy decision-making towards politicisation is another induced shift by crisis. Just like US, financial issues have been upgraded to the general public in Europe. This practice is difficult for European Commission because technical rationing for hedge funds, credit rating agencies, audit firm regulation, financial transactions, and tax and remuneration policies have already been reflected by the Commission. Most of the financial institutions in UK failed due to credit crunch, which declined the autonomy of Financial Service Authorities in UK. After the crisis, central bankers (financial supervisors and regulators) looked financial matters in respect to the public interest (Veron 2012).

In accordance with BBC 2010, ‘New Bank Capital Ratio to be set at 7%’, it is critically identified that an adequate level of capital reserve is highly crucial for banks for long term sustainability and financial soundness. The major factor in the recent global financial crisis was the low ratio of capital in relation with assets. In evidence to this, certain banks in UK, such as Royal Bank of Scotland and Northern Rock were found with insufficient capital reserve in proportion to the total value of assets as backup to recover their financial stability. Because of the crisis, the percentage of the capital ratio in relation with assets decreased in comparison to current ratios. This resulted in illiquidity problem for the largest financial institutions in UK, and therefore, these financial institutional lacked liquid cash (BBC 2010). The implication of banks running out of cash can be seen in the case of insolvency of Lehman Brothers, which was one of the leading national investment banks in the UK. At the time of recession, despite having significant amount of fixed assets, the lack of liquid cash led the bank towards bankruptcy (Statistical Report Lehman Brothers 2012).

The financial norm of the capital reserve ratio of the financial institutions was highly affected after the crisis. Now, strict regulations and restrictions were started being imposed on the banks to hold the capital adequacy by central bank regulators and governors (New Bank Capital Ratio ‘to be set at 7%’ 2010). The minimum ‘tier one capital ratio’ is 7%, which is lower than that of 10%, which is the currently held ratio by the UK banks (New Bank Capital Ratio ‘to be set at 7%’ 2010). In context with this, it is critically identified that the requirement of new capital ratio or tier one capital ratio induced problem for several major financial institutions of UK, as was lower to the current ratio held by the financial institutions.

Statistical Report Lehman Brothers (2012) shows the condition of financial markets largely deteriorated after the collapse of several financial institutions, like Lehman Brothers. Lehman’s bankruptcy led to more than $46 billion of its market value being wiped out (Statistical Report Lehman Brothers 2012). According to HM Treasury (2009), the chances the world economic damages increased intensively after the collapse of banking institutions. Increased illiquidity of financial markets impacted banks through increasing uncertainty to fulfil payment obligations on time. In response to the financial crisis, challenges and to ensure financial stability, the ‘Financial Service Authority’ in the UK with Bank of England and Treasury intensively discussed on the matters of financial stability and put them in a Memorandum of Understanding (HM Treasury 2009).

Moreover, the given financial stability framework in Banking Act 2009 has been updated by the UK government to withstand this crisis, such as set required changes in the role and objectives of Bank of England. The changes are made in the liquidity operations of the banks, such as additional reserve funds, and term auctions. This fact is empirically illustrated in the report published by OECD (2009). As per the report, in 2008, the ‘Special Liquidity Scheme’ was initiated to recoup with illiquidity problem. Under this scheme, £200 billion would be provided to banks as per the announcement made in October 2008. Another scheme introduced for banks, ‘Discount Window Facility’ provides banks an option to exchange their high illiquid assets for gifts. Additionally ‘Bank Recapitalisation Scheme’ was introduced by the government to hit liquidity to the solvency of financial institutions (OECD 2009).

To secure investors’/ customers’ confidence with financial institutions, the government announced ‘Credit Guarantee Scheme’ that provides guarantee for debt issuance. In this scheme, debt issues amounting to £100 billion were guaranteed by the government. In 2008, the company namely UK Financial Investment Ltd was set by the government to manage government investments. The company’s role was not limited to increasing sustainability value for the investors but also maintaining financial stability, along with looking after customers’ interests (HM Treasury 2009).

Moora (2010) has stated about the nature of financial system in the UK market from a different perspective. The financial position of the banking institutions has been highly influenced by the recent crisis. After the recent global financial crisis, the prevailing norms have profoundly changed within British Economy. Due to the crisis, institutional structure of financial regulations completely reorganised. Financial Stability Agency was formed under this reorganisation to effectively regularise financial activities. Moreover, the changes have been introduced in the convergence and deregulation process to keep sparkling effect of the recent crisis (Moora 2010).

 In February 2009, the UK Banking Act was declared in response to the financial crisis of 2007-08. Under this Banking Act of 2009, the ‘Special Resolutions Regime’ was acted out to help financial institutions within British economy in dealing with crisis problem (Moora 2010). Both micro and macro prudential policies were effectively tuned to reduce systematic and inherent pro-cyclicality risks in the financial market. From this, it can be inferred that the government has made regulations for capital reserve ratio to effectively regulate the financial system.

The HM Treasury report (2011) focuses on the soundness and safety of financial institutions. It is reviewed that high volatility and uncertainty has been experienced by the global financial market after the 2008 financial crisis. The global economy has largely been hit by several financial shocks and collapse of financial institutions. To hold investors’ confidence and sustainable economic growth, budget 2011 is included with ongoing economic uncertainty to deal with the issues of financial crisis. It included sovereign debt and made required adjustments in the banking sector to bring fiscal consolidation (The HM Treasury report 2011). It is identified that consolidation plan of the government focuses on reducing loss of market confidence for sustaining the UK fiscal position. As a result, there were changes in the prevailing financial norms due to financial crisis. Moreover, the government also followed a consistent approach to deal with structural deficit in UK to maintain financial stability and soundness (The HM Treasury report 2011). Nanto (2009) has expressed that new financial market changes were made within the British economy. After the financial crisis, various actual changes were made to recover from the issue of financial instability. Some of these major changes were made in the categories of international relations, security, financial and economic bailout and fundamental philosophies. In context with the financial institutions, induced changes in financial and economic sector by global financial crisis lessened financial primacy or dependence on the United States financial markets across the globe (Nanto 2009, p. 3). Veron (2008) supported this and reflected that there was a continuous support for the financial system from European Central Bank and other banks. The national interest was protected by keeping public expectations, determining trade policy, multilateral development of banks and sufficient financial aid for International Monetary Fund (IMF) were certain reforms by the financial authorities to recover financial markets from the crisis (Veron 2008).

Mizen (2008) has reflected the major policy responses to withhold financial crisis. The financial crisis has induced the problem of illiquidity that negatively affected the growth and stability of financial institutions. In response to this problem, Malik (2009) has also supported this statement by saying that the central banks encounter illiquidity issue by providing sufficient funds to the distressed financial institutions. In context with market liquidity, the liquidity provision increased to 42% by the Bank of England as of August, 2007 to April, 2008 and similarly, the European Central Bank shift towards forward auctions to provide adequate liquid funds. For this, it injects €94.8 billion to deal effectively with illiquidity and credit related problems. This injection led to save the bank from being insolvent in tough situations (Mizen 2008; Malik, et al 2009).