The Financial Crisis of Late 2000s in UK: Factors and Policy Implications - Essay Example

Your Prof The Financial Crisis of late 2000s in UK: Factors and Policy Implications Many economists consider the financial crisis of late 2000s as one of the worst financial crisis since the Great Depression of the 1930s. What would otherwise have been restricted to a cyclical short-term trough in the US housing market, soon led to collapse of some major financial institutions with an imminent risk of collapse of the entire global financial system as it was. This could well have happened but for the timely intervention of world governments in supporting some large and small financial institutions through big ticket bailouts. While the trigger for the crisis was the bursting of the housing bubble in the US, several corporate governance issues at banks were equally responsible for the spread and deepening of this crisis. Two of the most important corporate governance issues at play were – the merger of retail and institutional banking under one banking entity and the fat bonus culture at financial services companies. Whereas retail banking refers to banking in which banks interact/transact with individuals, institutional banking refers to transactions with corporate. The retail banking is rather risk averse and mostly a stable business in itself whereas institutional banking generally involves a lot more risk taking and the business is quite volatile. By having retail and institutional banking under one parent company, the risks taken for doing business in one area become a possible liability for the other. Therefore, losses incurred at institutional banking would have to be borne by the retail banking branch as they fall under the same group. Secondly, some institutions can indulge in putting more risk in its institutional banking business in order to increase their retail business, which is what explains how many banks were able to sell sub-prime mortgages before the crisis started. Sub-prime mortgages are high risk investments for banks and by packaging them into mortgage-backed bonds and selling/buying them through their institutional banking arms, banking groups take on significant risk on their balance sheets. Now, in the event of losses in the institutional banking business, financial services groups had to delve into their equities and reserves to cover these losses and to pay their dues. Thus, from retail banking clients’ point of view, the financial groups were using up their savings put in the bank to pay for losses incurred on the institutional banking business. This led to loss of confidence in the retail banks and caused bank-runs at some banks. As the retail banks keep only a small percentage of customer deposits as cash (rest is invested in bonds or loans), some small banks were unable to pay the money and had to go bankrupt. This exacerbated the whole financial crisis to a point that retail banks stopped lending money causing acute liquidity crisis in the market. The financial crisis was thus feeding on itself and getting worse. Had the institutional banking business been under separate entities from retail banking business, this exacerbation of the crisis would not have occurred. The institutional banks that indulged heavily in sub-prime mortgage backed bonds would have incurred losses (or even gone bankrupt) but the rest of the financial system would not have been contaminated. It’s as if the infected would have been quarantined. However, this was not the case, the set-up of retail and institutional banking under one parent company led to the worsening of the crisis. The second key reason for worsening of the crisis was the culture at financial services companies to give fat bonuses to executives (at the end of the financial year). In most cases, the bonuses encouraged the executives to focus on short-term success. Performance pay or bonus often represented a large part of the total executive compensation and in most cases performance was measured through sales figures and/or share prices. The lack of focus on risk in determining the bonus payouts led to executives taking on more and more long-term risk in order to boost the short-term performance. This was also noted by the Committee on Economic Development in the US in 2007, which stated that “…this preoccupation with short-term results at the cost of long-term success was in large part due to the nature of the compensation packages being offered to management” (Keller, 2008). The link between this is further evident from the Bear Stern’s story where in 2006 the CEO took home $40 million in compensation and in the 2007 annual report they stated that the soundness of the company was reflected by the compensation paid to company’s executives. Not surprisingly, less than a year later, Bear Sterns suffered heavy losses and was sold to JP Morgan for $2 a share. Clearly, these two factors were fundamental in contributing to the financial crisis. As a result, the UK government has proposed and taken some steps to prevent this situation in future. Regarding the separation of retail and institutional banking activities within the financial services entities, the government has acknowledged that complete isolation of retail banking may not be feasible. It has, therefore, in its interim report from Vickers Committee of April 2011 proposed that retail banking be “ring-fenced” from rest of the banking activities. This means that there should be a limit to the exposure of retail banking activities to risks coming from other activities. Also, it would mean that banks with both retail and investment banking units would have to finance the two businesses separately and the retail banking would be required to maintain a set capital ratio for retail bank business first; only additional capital, if any, after maintaining this capital ratio can be moved to other areas of banking. On September 12, 2011 the independent commission on banking headed by Vickers released its final report stating that ring fenced banks would be required to maintain a capital cushion of up to 20% (of which 10% equity) and capital from retail banking could be moved to other businesses only if this 10% equity capital requirement is met. Although this does not completely isolate retail banking from other activities of many large banking groups, it does ensure a higher safety net in case of any future shock in the financial services industry. Concerning the executive compensation, the UK government set up a Turner review committee which in 2009 proposed several guidelines for executive compensation to be implemented in the UK banking industry (especially for banks bailed out by the UK government) with key focus on including risk management into the compensation scheme. Among others, the key features of the revised remuneration scheme were to base bonuses on profits rather than revenues, to put in place within banks an independent remuneration committee to decide the bonus schemes, to not base bonus on current year performance alone, to have higher basic salaries so that the bonus component is not too big. These measures were however, not implemented and the government is currently further studying the executive pay and bonus mechanisms and proposals for policy regulation are expected in December 2011 (Garside, 2011). As of present, the government has issued proposals on a new narrative for reporting which proposes changes in reporting of executive bonus in the annual reports with more focus on transparency, and the relation between pay and performance. Overall, it can be said that the operations of retail and institutional banking under one company and inefficient executive bonus schemes were indeed two important factors in worsening and spreading of the financial crisis of the late 2000s. The UK government has initiated steps in direction to ensuring that these factors could be taken out of the financial services industry in as efficient and effective way as possible. While the proposals have been made, it remains to be seen how far the government is successful in implementing these steps as some proposals might hurt both the banks profitability and their executives’ incomes. References Chance, Clifford. The UK Independent Commission on Banking’s Interim Report. UK, 2011. Garside, Juliette. “FTSE 100 executive pay rising faster than inflation.” The Guardian (12 September, 2011). Keller, Christopher. “Executive Compensations Role in the Financial Crisis.” The National Law Journal (November 18, 2008). Marshall, John. “Executive Remuneration in UK Banking .” 2009. House of Commons Standard Note: SN/BT/04970. 22 September 2011 . Read More