Types of Risk Encountered by the UK Banks during Financial Crisis - Assignment Example

Finance and accounting Number: Question a) During 2008, capital markets were had encountered tremendous turbulence which was experienced due to the sharp fall in equity prices. It also encountered substantial fall in the credit spreads which led to the decline of the economic growth and froze the money market. The financial crisis of 2008 has harmed a lot of financial institution whose business models were dependent on the easily accessible financial markets. The institutions relied on the short term wholesale financing of the illiquid assets and in many cases they were dependent on the cross-border financial sources. These practices had helped them to cope up with the market stresses and absence of deposits by the customers. The borrowers had however taken advantage of this situation as the market could afford short term financing for their assets. Types of risk (liquidity, market and payment risk) encountered by UK banks during financial crisis (What is risk – definition) Risk is an unavoidable part of every market (financial and non-financial). It has huge impact on the global performance of the economy (Aggarwal, 2002). Thus, it is very crucial to eliminate different types of risks in practical and logical manner. Few decades ago banks in UK were not facing huge challenges due to the fact that there were a number of investors associated to their organisations. However, with the passage of time, the investors were not happy with the amount of return the banks offered them (Alfaro, et al., 2006). (The risks that are encountered by UK banks) Investigations pertaining to the financial meltdown in 2008 revealed that there are several risks which had been the main cause for the downfall of the UK banks. The investigations revealed general view of the affair that lead to the crisis. The factors that were agreed upon were the conglomerate of macroeconomic factors like, interest rates, high market liquidity and booming rates of securities market and household. The market crisis gave emphasis on the facts that the banks and financial institutions were unable to predict the risk in UK (Kearns, Kulesza and Nevmyvaka, 2010). This resulted in weak communication between banks and its stakeholders. There are two kinds of risk that are particularly encountered by the banks in UK. Market risk Market risk is connected with the fluctuations that are observed in the trading prices of the securities and shares. The fluctuation is due to rise or fall in the trading prices that are listed in the stock market. Market risk can be classified into absolute, relative, vitality and non-directional risk. The absolute risk does not have any prior indication it occurs all of a sudden. Relative risk is related to the evaluation of risk at different levels of functions. The non-directional risk arises due to the inconsistency of trade followed by a trader. The most important market risk is the volatility risk. It pertains to the change in price levels of securities those results from change in the risk factor (Chen, Firth and Rui, 2002). It is noticed that the UK banks encountered this type of risk since they were losing the number of investor due to fluctuations in the share price movement. The banks took the help of UK government who funded them with capital. With the help of the capital, the banks recovered their financial crunch. Liquidity risk The liquidity risk originates from the purchase and sale of securities that are affected by the business cycle or the technological changes (Jones, 2002). The liquidity risk can be further classified into asset liquidity and funding liquidity risk. The asset liquidity arises from the inability to purchase or sell assets. The funding liquidity risk arises when there is no access to sufficient funds for making the payment all at one time. The UK banks lost most of the asset during the crisis period and thus the help from the UK government through injection of capital in the economy made it possible for the banks to ensure that they have recovered their financial position. Why the banks were rescued? (Reason why they are rescued) The meltdown of the UK banking sector was due to various reasons which are elaborated in this section. The UK banks were exposed to credit risks which were raised through the lending mechanism to the non-bank customers in UK and overseas (Arestis, Demetriades and Luintel, 2001). The first reason is that it has been noticed a number of countries had encountered pressure due to the failure of the banking system. It had affected the economy to a great extent. UK banks had encountered the pressure which had led to tremendous downfall of the economy. The counterparty credit risk encountered by the banks in UK had been the main problem for the economy. The risk exposure of the major European banking system rose due to the counterparty credit risk which included Germany and France. The second reason is that the downfall of the UK banks had been an indicator to the downfall of the economy of UK. Thus, the UK government had to rescue eight UK banks from this crisis. The government injected £ 37 billion in the banking sector to support the financial condition. It acted as the main rock for stability for the eight banks. The financial aid was for Royal Bank of Scotland, HBOS and Lloyds TSB. It made an attempt to prevent the banking sector from the huge melt down. The shares of these banks had fallen due to the weak performances of the London stock market. The reason behind the fall in the stock market can be depicted as the fall in the number of investors of the banks. The investors who invest in bank shares more often were informed that the central bank was offering unlimited dollars of loan which helped the banks to recover from their liquidity position. The government announced that there would be cut down of pay and bonuses in order to recover the financial position of the banks. The new rules and regulation that were formulated by the government axed the dividend of the shareholders as a result they were not interested in investing in their shares anymore. The government took control of the 60% of the stake of Royal Bank of Scotland and also took about £20 billion from the taxpayers of UK. Thus, the money of the taxpayers were utilised to recover the financial position of the banks. The banks admitted the facts that the performance of the shares have declined over the years due to the market condition. Lloyds TSB renegotiated with the government about its takeover of HBOS. The former received an amount of £17 billion after the merger was successful. This gave the government an enlarged stake of 43.5% and brought the 36.5% shareholders of Lloyds under its umbrella. The government also offered Barclays an amount of £ 6.5billion cash (Linsley, 2011). Question b) (How risks are contained) The condition of the UK banks affected the economy to a great extent. This inserted pressure on the monetary condition of the whole country (Wong, et al., 2004). The government thus took a lot of reformatory decisions which would lead to the recovery of the condition to a great extent. The government injected huge amount to the banking sector and also acquired large stake in the banks. It has also modified the monetary and fiscal policy so as to regulate the money inflow and outflow. The banks were advised to correct their financial position by giving emphasis on the balance sheet. The investors were informed about the central bank offerings of unlimited loan to the banks. This encouraged the investors to invest in the banks once more. (How they mitigated the risk) Risk is described as a global factor which has affected all the countries over the years. The main risk that was encountered by the UK banks was the market, liquidity and payment risk. All this risk pertains to the international risk since the banks traded internationally and when the financial crisis took place the whole scenario changed. It was observed that there was uneven growth across the countries that had external forecasters which lead to weak growth in euro in the international scenario. The developments in banking sector of UK had led to downside risk. Government of United Kingdom had announced the important plans that consolidated the fiscal condition of the economy. The banks tried to mitigate the above mentioned risk by taking the help of government as there was no other source of fund for them. The market risk was severe for the investors. The investor’s relied on the efficient markets and expected rational behaviour, but this efficient market hypothesis had seen irregularity in the recent past. It can be concluded that the risks are managed through the successful implementation of the rescue plan of the government. It not only saved the banks from the situation but it also rescued the economy from a huge financial setback. The government has taken the right decision of injecting such a huge amount since it helped the banks to recover their position and provided confidence to the investors to invest their shares. Reference List Aggarwal, R., 2002. Demutualization and corporate governance of stock exchanges. Journal of Applied Corporate Finance, 15(1), pp. 105-13. Alfaro, L., Chanda, A., Kalemli-Ozcan, S. and Sayek, S., 2006. How Does Foreign Direct Investment Promote Economic Growth? Exploring the Effects of Financial Markets on Linkages. NBER Working Paper, 12522, September. Arestis, P., Demetriades, P. O. and Luintel, K. B., 2001. Financial Development and Economic Growth: The Role of Stock Markets. Journal of Money, Credit & Banking, 33(1), pp.16-41. Chen, G. M., Firth, M. and Rui, O.M., 2002. Stock market linkages: Evidence from Latin America. Journal of Banking and Finance, 26, pp. 1113-41. Jones, C.M., 2002. A Century Of Stock Market Liquidity And Trading Costs. [online] Available at: < http://ssrn.com/abstract=313681 > [Accessed 19 April 2014]. Kearns, M., Kulesza, A. and Nevmyvaka, Y., 2010. Empirical limitations of high frequency trading profitability. The Journal of Trading, 5(4), pp. 50–62. Linsley, P., 2011. UK Bank Risk Disclosures In The Period Through To The Onset Of The Global Financial Crisis. [pdf] Available: < http://www.icaew.com/~/media/Files/Products/financial-services/cbp-uk-bank-risk-disclosures-in-the-period-through-to-the-onset-of-the-global-financial-crisis.pdf > [Accessed 19 April 2014]. Wong, W. K., Penm, J., Terelle, R. D. and Lim, K. Y. C., 2004. The Relationship between Stock Markets of Major Developed Countries and Asian Emerging Markets. Journal of applied mathematics and decision sciences, 8(4), pp. 201–218. Read More