Banking System in the United Kingdom: Reliance, Deregulation, Economic Downturn, Policies - Case Study Example

Banking System in the United Kingdom: Reliance, Deregulation, Economic Downturn, Policies, and Remedies to Avoid a Double-Dip Recession Donna PurcellOrder # 609414 University Banking System in the United Kingdom: Reliance, Deregulation, Economic Downturn, Policies, and Remedies to Avoid a Double-Dip Recession Introduction “One ring-fence to rule them all and in the darkness bind them” (Morrison & Foerster, 2011). These words were extracted from the final report of the United Kingdom’s Independent Commission on Banking published on September 12, 2011. The report focused on activities for a proposal to ring-fence the banking system within the United Kingdom. To summarize the term “ring-fencing” (Moe, 2011), the proposed UK banks will enclose their retail operations as legally separate entities that are well funded and can operate independently of the rest of the financial group. Investments will be conducted outside the fence and will be allowed to fail without the government stepping in. This report is predicted to be one of the biggest shake-ups in banking within the United Kingdom in a generation. This commission was formed by the United Kingdom in June 2010 by Sr. John Vickers and is comprised of two main proposals. One proposes a retail ring-fence for UK banking operations and measures to upgrade the loss absorption of UK banks. The second proposes improving issues affecting UK banking markets and focuses mainly on attention to financial stability. The following information will attempt to show how over reliance on the banking industry in the United Kingdom has affected the economy in an economic downturn or recession. It also will show what effects deregulation has had on the United Kingdom economy and the banks. It will also delve into the economic downturn, the history, its effects, and what is going on now. And finally how can the United Kingdom avoid a double dip recession. The following information will discuss these and other key factors in relation to the banking system. Over Reliance on the Banking Industry In a study by Tony Latter in 1997 on “Causes and Management of Banking Crisis” (Latter 1997), he states that the industrial development banks are normally founded to promote longer-term capital formation. He also says that it is necessary for the state or international entities to take part because business forces and normal banking activities are not able to provide the required funding. This thought can be justified if there is evidence present that shows market failure or any deliberate government policy that contributes to this sector. This gives the impression that dangers are present regarding how banks compete. Banks compete unfairly on terms of deposit, misdirected resources in any economy, and build losses that eventually have to be supported by the public through government budgets (Latter 1997). Latter points out that as a matter of principle, it is better to give support to regions of the economy in as clear means as possible and with as little damage as possible to the forces driving the market. He further adds that this could mean subsidies might come directly from the fiscal budget or interest rate subsidies rather than less visibly through the bank itself. All banks should be able to compete for business and control their own subsidies (Latter 1997). Causes of the banking crises are continually being debated. Several have been attributed to the structure of the banking system, while others have been attributed to macro/micro forces or regulatory factors. Others include harmful strategies of specific banks, operational failings, and fraud. When dealing with macro forces, triggers can includes the collapse of asset prices in real estate, a sharp upheaval in interest rates, or a sharp fall in the exchange rate. Another trigger could be a sudden slowdown in general inflation or the beginning of a recession. Banks have typically prospered in a high inflation environment. Another problem that is noted is sharp shifts in related pricing, or dropping of subsidies which puts extra pressure on some businesses or sections that banks deal with directly (Latter 1997). It’s the responsibility of bank management and bank supervisors to ensure that banks can handle the shocks that these problems can cause in a reasonable fashion. But what is considered “reasonable?” Unless it is a very unusual circumstance far outside the macroeconomic conditions, it should not be used as a scapegoat for failures. Unfortunately, these shocking circumstances do happen, as seen in the Mexican crisis of late 1994. Because of political factors a sharp monetary squeeze was induced by deterioration of the economic position. Specifically the devaluation of the peso in December 1994 brought a sudden end to inflows of money and threw them into a financial crisis (Gil-Diaz 1994). Microeconomic factors include bank supervision failures, inadequate infrastructure in accounting and laws, liberalisation or deregulation, and government interference. Moral hazard can occur when banks are too generous in deposit protection, which puts the depositors in a position to not discriminate between “good” and “bad” banks. Assumptions that banks cannot fail can prolong the survival and exacerbate a crisis. Inadequate legal or regulatory structure or bank culture can cause a lack of clear facts to depositors, shareholders and others to be multiplied and cause problems (Latter 1997). Deregulation in the Banking Industry Financial deregulation refers to a variety of changes in the laws that allow banks and other financial institutions the freedom in how they compete. Financial deregulation does not mean that all regulations are dissolved. Economists argue whether deregulation as a whole is good for the economy or bad. Referring to the United States, the best known form of deregulation was in 1999 when Congress repealed some sections of the Glass-Steagall Act. Passed in 1933 during the depression, it allowed any one company to act as a commercial bank, investment bank, or insurance company. The repeal meant firms could function as one, two, or three of these types. This meant that it would limit major effects of economic cycles on independent firms. The assumption was that people are more apt to save in a downturn and invest when they are doing well. So deregulation would make business more consistent and competitive (Lister 2003-2011). Critics of deregulation argued that it has fueled the banking crisis beginning in 2007. Consensus is that by removing barriers causes a conflict of interest. Deregulation took place in the United Kingdom in another form. Building societies or financial institutions, which were owned by their customers, and specialized in, mortgage lending. When these societies began to compete with banks in the 80s, the government allowed them to demutualize. In other words, if the members agreed in a vote, it could become a limited company. Since that time, every building society that demutualized has been bought out by a bank or taken over by the government. All had experienced financial troubles (Lister 2003-2011). The decade of buyouts was called “the Big Bang” in London. It was about modernisation, instilling the thought of up-to-date technology and computers in “the city.” Deregulation dissolved barriers between narrow focused firms, stockbrokers, and adviser; now they would be under one roof. Some argue it directly lead to the credit crunch. “Big Bang” was the start of investment banking in the UK” (News Source 2011), stated Tony Dolphin, chief economist at the Institute for Public Policy Research. The plus from the American side brought a transaction-based business atmosphere. Long-term was reduced to short-term and making the biggest buck for today’s deal replaced the long-term interest of the client. Toward the end of the 70s and into the 80s Margaret Thatcher, British Conservative Prime Minister along with the City of London, presented measures to privatize, add state budget cuts, and stand against labour and deregulation of the financial markets. When she could get backing, she stood behind her initiatives along with President Ronald Reagan in the USA. Both claimed that hard tactics were necessary in order to curb inflation and deflate bureaucracy. Called Thatcherite deregulation as “the efficient way,” but has in the process undone many of the fought for benefits. Social security, public health care, and pension security are “sinking like the proverbial Titanic” (Engdahl 2009), as William Engdahl puts it in an article in the Third World Traveler in 2009. He contends that the epi-center of the trouble lies in the USA and UK as well as Ireland, Canada, Australia, New Zealand and Iceland. All of these countries followed the Thatcherite financial market reforms. It has brought about soaring unemployment, falling currencies against the Euro, bank bailouts, and insurmountable foreign liabilities, according to Engdahl (Engdahl 2009). John McFall, Labour chairman of the Treasury Select Committee, believes nationalisation of the banks is eminent (Engdahl 2009). Economic Downturn Andy Kilmister contends that there are three factors that represent beginnings for the present economic crisis in Britain. First of all, what is happening now is due to the break-up of rules that have governed the world economy since the mid 1980s. The 80s were a temporary “solution” brought on by what took place in the 70s. Secondly, he contends that the crisis of the 70s and matters to try to resolve them in the 80s were contradictory. The attempt to create profits in production became contradictory to circulation and exchange. Thirdly, the weakened British capital located in Britain has left Britain open to the crisis (Kilmister 2008). The crisis itself has caused a build up of debt in corporate and household debt. Also, there has been a return to international instability in the monetary system. This has lead the world to not wanting to fund the trade deficits of the US and UK. The other factor that Kilmister mentioned is the ecological crisis on the world economy. These have all contributed to the underlying tensions (Kilmister 2008). The Banking Act of 2008 was established in February 2008 for the specific aim of nationalizing the failing Northern Rock Bank. It was one of the first British Mortgage Institutions affected by the US subprime mortgage crisis. It had seriously mismanaged its assets against its liabilities and had no choice but to look to the Bank of England for liquidity (Oluoseke 2009). Kilmister further contends there are two basic reasons for relying on debt, one being, consumption depends on debt because of the difference in wages coming down and profits generated in production have to have demand to sell the produced goods and make a profit. Second, the growing inequality in income, which is the largest in the USA and UK. Another underlying factor is that investments have become dependent on debt because of the weakness in profits. Therefore, with no debt available, expansion is not fundable and a recession becomes inevitable (Kilmister 2008). Government in turn, increases their borrowing and encourages banks to cut interest rates, thus creating further problems. When government policy attempts to boost the economy it’s limited because spending depends on debt due to low wages and inequality. Thus, the slowdown is more apt to be reversed and severe. Debt growth over the last two years in the USA and UK, referring to 2008, has come from international flows of capital resulting from exchange rate stability, in comparison to the upheaval of the early 1980s. The move toward a differing pattern in the exchange rate will put great pressure on the global monetary system (Kilmister 2008). Economic Policies “As the credit crunch has shown, no corporate governance model is perfect” (Henderson & Hoare 2009). Neither the system within the United States nor the United Kingdom has prevented the large-scale collapse we have seen on both sides of the Atlantic. Most have expected the United States to be up front in establishing change to these failures. It has been the United Kingdom who has acted in a regulatory capacity in a much faster manner. In February of 2009 the United Kingdom announced Sir David Walker, who was former chairman of Morgan Stanley International and executive director of finance and industry at the Bank of England, will head a review of the UK banks focusing on risk management. One month later the UK’s Financial Reporting Council (FRC) said that it is investigating the Combined Code. Meaning the corporate governance code that corporations operate under. The main objective is to find the balance between regulation (if needed) and being flexible in what exists. Flexibility in the Code has been a determining factor in making the UK competitive in the world financial markets. The Combined Code deals with high-level principle provisions in much greater detail. Following the principles will be expected, however, they will have the option of whether or not to comply with the code’s individual provisions. This is called the comply or explain provision. The main focus will be on both the quantity and quality of engagement with investors. This concept has attracted many overseas companies to the United Kingdom for its primary investments. Some critics have pointed out that many of the failed financial institutions were compliant with the Combined Code in their annual financial statements (Henderson & Hoare 2009). “Tax or government spending is a revenue through tax laws that allow deductions and exclusions or exemptions from the taxpayers taxable expenditure, income or investment (businessdictionary 2011). Monetary policy means “the actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates” (investopedia 2011). Fiscal policy is the governments “revenue and spending policy designed to counter economic cycles in order to achieve unemployment, to achieve low or no inflation, or achieve sustained or economic growth” (businessdictionary 2011). The law of demand is microeconomic. It basically states all factors that are equal as the price of a good or service increases, or consumer demand will decrease for the good or service, according to demand (investopedia 2011). A Keynesian economists believes that aggregate demand is effected by both public and private decisions. The public decisions are mostly related to monetary and fiscal spending and tax policies. Nearly all Keynesian and monetarists now believe that both fiscal and monetary policies affect aggregate demand. According to Keynesian theory “changes to aggregate demand, whether anticipated or unanticipated, have their greatest short-run effect on real output and employment, not on prices (Blinder 2011). Therefore, monetary policy can have real effects on output and employment if some prices are unchanging and if dollar wages, for example, do not adjust instantaneously. Therefore, the multiplier effects regional income by an increase in spending that increases national income and consumption and becomes greater than the initial amount spent. Example: “If a corporation builds a factory, it will employ construction workers and their suppliers as well as those who work in the factory. Indirectly the new factory will stimulate employment in laundries, restaurants and other service industries in the factory’s vicinity” (dictionary.reference.com 2011). Changes to policy relating to the banking system are likely to be made in the non-executive director’s role, compensation, communication with major shareholders and their involvement (Henderson & Hoare 2009). According to Charles Bean, Deputy Governor for Monetary Policy at the Bank of England in a speech to the Alumni of Cambridge University, London in March 2010, the banking system is still addressing the decisions made before the crisis. It’s a matter of balance sheet repair, and it has to run it’s coarse before the supply of credit is loosened. He also states that the “housing boom has resulted in some households, especially younger ones, carrying forward high levels of debt” (Bean 2010). He contends that this debt is serviceable because of low interest rates at the moment, but if it does not normalize it could cause pressure in the future on household spending. He says that the government also allowed the deficit to rise in response to the downturn, which helped the blow of fall in demand. However, the current deficit is running around 12 percent of GDP for the year and that is unstable. Raising taxes or cutting spending could result in lower domestic demand. However, if this is not done it can cause long term high interest rates (Henderson & Hoare 2010). Despite recent volatility in inflation, it seems to have somewhat become stable and reasonable. He also points out that even with all the uncertainties, that inflation should pull back to 2 percent by the end of the forecast horizon (Henderson & Hoare 2010). How to Avoid a Double-Dip Recession According to an article in the Guardian in November 2011, the (OECD), Organisation for Economic Co-operation and Development, has cut its forecast of the United Kingdom’s growth in 2012. There is also information to suggest that unemployment will rise to 9.1 percent by 2013. These signs have prompted the West’s economic professionals to warn that Britain may face the possibility of sliding into a double-dip recession this winter (Elliott 2011). The problems have compounded in the last decade by countries including the US, United Kingdom, Spain, Greece, Portugal, Ireland, Iceland, Dubai, and Australia who have spent more than their income and are running current deficits. While other countries such as China, Japan, Germany and some emerging Asian economies have been producers. They have spent less than their income and run account surpluses. With the threat looming near, what should be done? 1, In order to compensate for recession and deflation effects of tightening, near zero policy rates should be in effect in the more advanced economies. 2, In countries like the US, UK and Japan, where the bond market has not taken hold, they should maintain their stimulus and consolidate as much as possible. 3, Countries that are over-saving like China, Asia, Germany and Japan should have policies that reduce their savings and account surpluses. This would entail cutting back on precautionary savings to let their currency appreciate. Germany should maintain it stimulus into 2011. Japan should try to reduce its current account surplus and stimulate income and use. 4, The countries with surpluses should let their currencies appreciate and the ECB should maintain a simpler policy for weakening of the euro to restore competition and growth in Europe. 5, In countries which private-sector deleveraging is growing due to a fall in private use and investment, stimulus should be held and extended. 6, In countries that show increases in liquidity and capital ratios for financial institutions, those ratios should be gradual to prevent further worsening of the crunch, 7, In countries with private and public high debt levels, both in household debt, housing boom gone bust, and government debt, as in Greece, restructure of liabilities is needed to reduce debt deflation withdrawal of spending. And finally, the International Monetary Fund, the European Union, and other institutions should have a policy of lend-of-last-resort in countries that require private and public deleveraging to stop severe deflationary issues (Roubini 2010). Roubini further adds that “deleveraging by households, government, and financial institutions should be gradual – and supported by currency weakening – if we are to avoid a double-dip recession and a worsening of deflation” (Roubini 2010). He feels that if these measures are not implemented, it could lead to a very damaging double-dip recession in the more advanced economies like the United Kingdom. Conclusion We have looked at how the United Kingdom has relied heavily on its banking system in the past. In some ways it had given its citizens a sense of false security to think that a bank or financial institution cannot fail. Deregulation has brought about major changes in demutualizing the banks and allowing further competition, but has it been for the better? The “Big Bang” and Margaret Thatchers’ policies were a time of excitement for Britain and many policy changes. The economic downturn brought a break up of old rules, dealing with the 70s and 80s and the weak British capital. There have been many policy changes, including the new so called ring-fence concept mentioned in the introduction. Many prominent economists have their own theory of how to avoid a double-dip recession. Modernisation involves structural change and relationship changes between social structures and social agents (Scott & Walsham 1999). The United Kingdom has come to recognize that these changes are necessary. “The past two and a half years have certainly been tumultuous for both the economy and for policy markers. After such an event, we should certainly examine how the overall policy making framework should be re-made in order to reduce the chance of a repetition” (Bean 2010). References Bean, Charles. “The UK economy after the crisis – monetary policy when it is not so NICE.” 16 March 2010. Viewed 02 December 2011. http://big.org/review/. Blinder, Alan S. “Keynesian Economics.” 2011. Viewed 07 December 2011. http://econlib.org/library/. Business Dictionary.com. “Tax/expenditure.” Viewed 05 December 2011. http://businessdictionary.com/. Elliott, Larry. “UK on the brink of double-dip recession, warns OECD.” 28 November 2011. Viewed 02 December 2011. http://guardian.co.uk/. Engdahl, F. William. “Death Agony of Thatcher Deregulated Finance Model.” 22 January 2009. Viewed 02 December 2011. http://thirdworldtraveler.com/. Gil-Diaz, Francisco. “The origin of Mexico’s 1944 Financial Crisis.” Viewed 02 December 2011. http://cato.org/pubs/journal/. Henderson, Sarah; Hoare, Edward. “UK governance laws set to change with two Agencies reviewing the Combined Code on Corporate Governance.” 01 July 2009. Viewed 02 December 2011. http://corporatesecretary.com/. Investopedia.com. “Monetary Policy.” “Law of Demand.” Viewed 05 December 2011. http://investopedia.com/terms/monetarypolicy/. Kilmister, Andy. “The economic Crisis and its Effects.” December 2008. Viewed 02 December 2011. http://internationalviewpoint.org/. Latter, Tony. “Causes and Management of Banking Crisis.” 07 1997. Viewed 02 December 2011. http://bankofengland.co.uk/education/. Lister, John. “What is Financial Deregulation.” 2003-2011. Viewed 02 December 2011. http://wisegeek.com/. Moe, Thorvald Grung. “UK report proposes ring-fencing of retail banking.” 13 September 2011. Viewed 02 December 2011. http://multiplier-effect.org./ Morrison. Foerster. “Lords of the Ring-Fence: UK Banking Commission Publishes Its Final Report.” 16 September 2011. Viewed 02 December 2011. http://mofo.com/. Multiplier Effect. “Dictionary.” 2011. Viewed 07 December 2011. http://dictionary.reference.com/. News Source. “The financial deregulation monster that Margaret Thatcher unleashed.” 09 October 2011. Viewed 02 December 2011. http://warincontext.org/. Oluoseke, Akinbola. “The UK Banking Act 2009 Was a Knee-Jerk Reaction to a Looming Crisis.” 2011. Viewed 02 December 2011. http://oppapers.com/. Roubini, Nouriel. “How to Avoid a Double-Dip Global Recession.” 15 June 2010. Viewed 02 December 2011. http://project-syndicate.org/. Scott, Susan V.; Walsham, Geoff. “Shifting Boundaries and New Technologies: a Case Study in the UK Banking Sector.” 1999. Viewed 02 December 2011. http://eprints.lse.ac.uk/. Read More