The Working of Banking System in Pre-Recession Phase: The Case of Barclays - Essay Example

? BARCLAYS The paper examines the working of banking system in pre-recession phase and tries to find out the reasons, which created the environment for credit crisis. It explains the problems, which should have been addressed to prevent it from happening, and also, the effectiveness of steps taken by the regulatory authorities to handle credit crisis and its effect on global financial institutions. The paper proposes certain structural changes in banking system and the regulatory guidelines to prevent credit crisis in future. The case of Banking giant Barclays is discussed, the bank that presented a full year profits rise by 92% in the year 2009 despite banking crisis and examines how the policies of Barclay bank to not to take government aid was beneficial in handling mortgage crisis. TABLE OF CONTENTS Introduction………………………………………………….4 Financial Innovations and Explosive Growth…………4 Regulatory Reforms………………………………………..5 Role Change of FSA……………………………………….6 Structural Issues……………………………………………7 Funding Issues……………………………………………..8 Support Issues……………………………………………...9 Bailout and Competition………………………………….10 Ownership Issues…………………………………………10 Business Environment Issues………………………….11 Political Issues…………………………………………….12 Public Issues………………………………………………12 Economic Issues………………………………………….13 Conclusion…………………………………………………13 References…………………………………………………15 Introduction Innovations in banking sector, which accelerated in last 15 years are partly responsible for micro imbalances, which emerged when the developing nations accumulated large current account surplus and the large current account deficit emerged in USA, UK, Ireland, Spain and other countries. According to Dennis Blair , director of U.S. National Intelligence , the implications of financial crisis “ the primary security concern of US, longer it takes for recovery , the greater is the likelihood of serious damage to US strategic interests”( Blair, 2009). Barclays PLC is a universal multination banking and financial services company, which was 10th largest bank in 2010 and has operation in more than 50 countries. The bank has total assets of €1.94 trillion (as on June 2010) and it organizes two businesses Corporate & Investment Banking and Wealth Management, and Retail & Business Banking. In 2007, the bank was forced to borrow ?1.6bn from the Bank of England. UK government planned to induce over ?7 billion in Barclay (Reuter reports) in 2009, but the bank rejected the government offer and instead raised ?6.5 billion of new capital through cancellation of dividends and private investors. The bank cut 1400 jobs in first half of 2011 and another 1600 in 2011 and the CEO, Robert Diamond claimed the bank is now back on track. Financial Innovations and Explosive Growth of Securitized Credit Model During the banking crisis Barclays invested of ?800million i.e. $1.64bn in risky US home loans and it cut 2,130 positions across its investment banking and investment management divisions, and about 2,000 job cuts in retail. In U.S. securitised credit corporate bonds played a major role in mortgage lending and it also led to the formation of Fannie Mae, in 1930, and it saw an explosive growth in terms of scale and complexity from mid-1990, which supported - 1. High growth in the stock value and total stock credit securities. 2. The rise in complexity of securities, which were sold and the growth of structured credit products. 3. Explosion of volume of credit derivatives, which enabled investors and traders to hedge underlying credit exposure, which created synthetic credit exposures The financial innovations which were sought to satisfy the demand was creating value by offering investors risk, returns and liquidity, which was attractive due to the direct purchase of credit exposure, and it created massive growth of securitised credits and it also changed the nature of securitized credit model. The securitised credit was bought by property trading desk of another bank and sold by the first bank, but with parts of risk retained in the form of credit derivatives and it was re -securitised in a complex and opaque instrument, which was later used as collateral to raise short term liquidity. The key factors increasing systemic risk and contributing to the credit crisis were - Growth in financial sector - The growth in size of the financial sector which increased the impact of financial system on destabilizing the real economy. Increasing leverage - The leverage of commercial and investment bank rose with the rise in growing assets and derivative positions. Changing forms of maturity transformation - The complex securitised credit and the increasing scale of banking and investment increased the total system leverage, which was backed by changes in maturity transformation patterns, which created huge inadequately appreciated risks. One of the key function of banks is maturity transformation, which involves handling long term assets than liabilities, and enabling non-banking sectors to hold short term assets than liabilities, and this helps to absorb risk arising out of uncertain cash flows of corporate or households, but if somebody requires money on a contractual date, the bank may not be able to repay all. The misplaced reliance on complex mathematical formulae - Complex calculations were used to measure the risks and it made difficult for the management and board to judge the real risks. The hard wired pro-cyclicality - The shift to the securitised form of credit intermediation and the high complexity of securitised credit, which was dependent on market practices. The system failed to capture fat tail risks (i.e. short term observation period and the assumptions of normal distribution) and systemic risks- which involves interconnected market events. In November 2008, impaired banks could not extend credits to real economy and it created globally synchronized downturn, which was further threatened by recession. Regulatory Reforms The credit crunch created a need for regularity reform, which can help to create - A new global financial system, which can combine the macroeconomic imbalances and help to create unsustainable credit boom as well as asset price inflation. The regulatory reform should address the factors, which resulted in over extension of credits, and factors which were crucial in increasing the severity and length of crisis. Provide fundamental changes in capital, accounting and liquidity. Increasing the quantity and quality of bank capital. Instead of giving protection to senior creditors and depositors, the regulators and macroeconomic policymakers should be concerned over the implication of bank capital from the behaviour of banks and implications on the whole economy. This will help the future banks to better absorb shocks and lower return on equity, which will reduce risk of banking industry. The regulatory reforms were designed to fulfil - 1. Need for fundamental review of trading book capital- The changes will reduce the scale of proprietary risk taking, and drive simplification and de-risking of securitised credit model. 2. Reduce procyclicality in Basel 2 implementation - It will reduce the extents to which lending capacity is impaired during economic downturn. 3. Create counter cyclical capital buffers - It will reduce dangers and instability in banking system as the economy cycles is reduced. 4. Offsetting procyclicality of published accounts - The influence of management and remuneration should less influence exuberance. 5. A gross leverage ratio backstop - It will prevent under estimation of risks. 6. Constraining liquidity risk at systemic level and in individual banks - This will reduce the reliance on risky liquidity and marketability. It will constrain aggregate maturity transformation and change term structure of interest rates. Role Change of FSA Before credit crisis FSA regulatory and supervisory rate was based on principles where market was believed to be self correcting and primary responsibility was to manage risks lying with board of the firm, and it was believed the customer protection was ensured through proper business conduct. FSA concentrated on supervision of individual institution, system and process, and took oversight of approved people. The changes in FSA role involved shift in supervisory style focusing on key business outcomes, risks and sustainability, and increasing resources. The main shift took place in the relation with published and accounting judgement, and FSA is still working towards information gathering and internal analysis. For banks operating in UK, FSA consulted to achieve strengthened liquidity framework, and FSA proposed the review of trading book risk measurement and requirement for capital adequacy. FSA measured liquidity on management proposals and managed liquidity risks and extensive requirement of the firms to provide maturity ladders, analysis of liquidity of assets and analysis of off balance sheet positions. In UK, FSA defocused on supervision of individual institution and not on the system wide risks. The Bank of England and FSA together are working on macro, sector wide and firm specific analysis, and the Bank of England is supported by FSA which assesses macro prudential risks and take measures. Currently, FSA supports the regularity changes formulated by the European Union, and it plays the supervisory role, which will be coordinated with European colleges, and ensure procedure to manage conflicts and reinforce analysis independence from commercial revenue maximising objectives. In future, FSA will include strong focus on risk consequences of remuneration policies within a firm, although, FSA does not have any impact on the policies of foreign firms operating in London. Structural Issues According to Holmstrom and Tirole (1998)- there are three points of shocks in credit crunch - the collateral squeeze, credit crunch and the saving squeeze. Calomiris (2008) found the banking crisis can be traced back to financial intermediary’s lack of capital. Mervyn King’s said Britain was on the brink of second credit crisis by the end of 2011. Today, there is a need to address the different types of banking and securities market activities. Banks in retail and commercial banking, and financial institution are involved in risky trading. Financial institutions can be allowed to grow in unregulated fashion and it will not receive fiscal support in crisis as it is not credit in world of interconnected markets. Gorton (2008) found financial assets are getting complex due to asymmetric information between borrowers and lenders. The current arrangement in banking regulation and supervision in EU are 1. Financial services regulations are expressed in European Union directives and the directive can set minimum standard, which should not exceed the super equivalence basis. 2. Supervision of banks and other financial service firms is entirely in the hands of national supervisory and regulatory authorities. 3. Banks are headquartered in one member state. 4. Deposit insurance is organized at member state level. 5. Crisis management is done at national level. Some believe if illiquidity is connected with insolvency, there is the role of central bank in reducing it and central banks should extend discount windows to individual banks whose distress may affect the whole system. The injection of taxpayer’s money to resolve banking crisis raises moral hazards and it should be prevented. The changes in financial institution structure requires 1. Improved professionalism and independent risk management functions 2. Risk management integrated to remuneration policies 3. Improving the skill level and time commitment of the management 4. Creating shareholders discipline over corporate strategies 5. There is a need to create relationship between different types of banking and securities market activities. Funding Issues The European economic recovery plan called for EU members to contribute 1.5% of the GDP towards economic growth and observers argued the size of economic stimulus should address the size and nature of relevant economic crisis. The British government announced to induce $850 billion rescue to banking sector where the central bank planned to acquire the preferred share of banks for some time, instead of nonperforming loans of the banks. The plan involved reducing the interest rate and investing $87 billion to acquire preferred stocks of eligible banks and societies. British government also provided recapitalizing scheme on short term and medium term debts, and it announced to provide $352 billion through special scheme of liquidity for improving liquidity in the banking industry (Financial Stability Report, April 2008, Bank of England. P. 10). The government agreed to provide funds and restructure the leadership of the banks. Also it agreed to improve regulation and provide guarantee for new debts. It provided recapitalization by buying share of certain banks. The UK government provided support in the ways - Recapitalization to provide funds to banks, to raise capital and to pursue restructuring of leaderships in banks. State ownership where the government planned to buy share of banks seeking recapitalization. Government debt guarantee was offered to new debts including the interbank loans, which was issued by the banks in the euro zone area. Improved regulations which involved forming regulation to permit assets to be valued on default risk instead of market price. The central banks of countries announced to cut rates and provide liquidity by injecting capital directly in banks and through currency swaps, and the banks of Ireland, Greece and Germany increased guarantee to deposit holders to improve liquidity. Barclay bank needed to raise ?1.5bn in share pricing but only found buyer for ?1.25bn. The banks later raised raise 7bn which was 0.5 billion more than what was promised to the government. Barclay did not ban executive bonuses or paying dividends and is offering an interest rate of 14% until June 2019. Support Issues In UK there is no clear regulatory prohibition on clearing banks, becoming universal banks. Today there is needed to create appropriate relationship between banks and securities market activities. Banks performing classic retail and commercial functions are restricted to their abilities to conduct risky functions, and EU crisis started when the policy makers assisted individually to troubled banks and financial institutions. In the second phase of crisis, central banks moved to address issues related to liquidity, which raised widespread concerns over the viability of the financial system and in the first phase, government finance ministries adopted policies to deleverage their position and reduce the holding of troubled assets. In the last phase the government, legislative bodies tried to address the problem which had already created the financial crisis. Edwards and Mishkin (1995) found the excessive risk taking in 1980s in US was a response to the erosion of profits, mainly, because of competition in financial markets. Carletti et al. (2002) addressed the effect of bank merger on liquidity and competition in banking sector, and suggested a model where banks compete for loans and engage in interbank lending to deal with liquidity shocks on liability side. Matutes and Vives (2002) explained the link between imperfect competition in deposit market, and banks risk taking, where the banks are subjected to limited liability, which causes failure, which also raises social costs. Paroush(1995) explain how mergers helps to diversify risk. Bailout and Competition Barclays was the one of the banks which opted not to join the UK government bailout scheme and it decide to rebid its fund through middle expansion and through investment provisions in Abu Dhabi and Qatar. UK shareholders even complained of generous terms given to the Middle Eastern investor but Barclay made the right decision to raise capital in market instead of from government which allowed the bank to persuade its strategy of expansion in Middle East. Giving bailout reduces the private marginal cost of certain banking activities below it actual cost and it encourages social undesirability excessive risk taking, which ultimately reduces competitive strategies. There are certain banks using the state guarantee to attract deposits while, reducing aid can make a bank to grow through acquisitions and it will force its balance sheet and such banks will have a strong impact on economy. Banks involved in rapid expansion and having many dependent entities should use the aid as a tool to turn back, or the crisis may force banks to downsize or liquidate. Large banks if are not provided aid, would have to lead regulatory uncertainty created by the new crisis. But in such condition, the moral hazards argument is important where the aid to banks should be provided in a way to prevent growth of anti-competitive ways. Banks failure policies aim for mergers of failing banks with growing banks, which increases the incentive to banks to take prudent risks (Perotti and Suarez, 2001) Ownership Issues If the government provides bailout to a bank it will have its domestic agenda but Barclay boosted the balance sheet without taking taxpayer’s funds although was criticized for allowing 30% shares in Middle East. The integration of financial services sector across borders has been irregular and integrating money, bond, and equity and cross border mergers, and acquisition in Europe have played important role in internationalizing banking groups. The Icelandic financial crisis showed the European Union single market rules needed the banks to recognize the home country as supervisor, which had the right to operate in member states but this created depositors in one country to suffer from failure of bank in another country. When Icelandic bank collapsed the government indicated it was not in the position to meet the liabilities of Icelandic deposit insurance and national powers allowed the power of host country to supervise the capital and liquidity of the banks operating in the country. The government of Iceland and Latvia collapsed during the crisis, and Iceland was especially hard hit as major Icelandic banks closed. In 2008, Iceland entered an agreement with IMF on economic stabilization and got a support of $2.1billion under 2 years standby agreement. Lehman’s bankruptcy raised issues of CDS contracts and Federal Reserve purchased commercial paper of Lehman and short term money market securities. AIG was closely linked to Lehman and fed got 80% equity stake in AIG from $85 billion credit facility. Institutions can change the ownership status to varying degrees only if it raises profits to buy back the government share. Business Environment Issues Capital was injected into the banks directly and mergers were sought to provide liquidity. The purpose of providing support was to strike a balance between supporting the financial system during crisis and to set in motion to prevent future crisis. ECB provided funds through short term open market operations and long term market operations. Post crisis ECB extended the strategy of longer term refinancing operations (Bernanke, Ben S., 2008), which offered greater flexibility to Federal Reserve, which made it possible for ECB to provide liquidity within the current framework without adopting extraordinary measures (Borio, 2008) EU proposed a new financial market architecture where continued support was provided for financial system from European Central Bank. It involved rapid and consistent implementation of bank rescue plan. Measure was designed to contain the crisis from spreading to other member states. The proposals included deposit guaranteed and capital need, change in accounting standards, executive pay, credit rating agencies, capital market supervision and risk management. The policy was designed to address rise in unemployment and short term actions such as increasing R & D, education, freeing business for building markets internationally or at home and improving the competitiveness through the promotion of green technology to attain environmental goals - are some ways adopted by EU members for economic growth. The regulatory changes involved Improving international regulatory standards and in coordination with financial supervisor Improving measure to coordinate macroeconomic policies Generating capability to handle financial crisis at national and regional levels The financial architecture plan involved handling efficiency, transparency, accountability and inclusion of representation from leading emerging economies. The European commission also aimed to establish guidelines to recognize “bad banks” to restrict competitive movement. It is developing plan to guarantee the bad assets remained on books (Perry, 2009, p. 19.) Political Issues The current financial and economic crisis in EU developed deep philosophical difference amidst EU member and EU members have responses differently to banks on “toxic loans.” The downturn was a global event, which dominated the attention of policymakers and government expanded their resources making use of tools in fiscal monetary policy to provide boost to economies and to stabilize financial system, which are required to be different to provide better incentive for the particular economies and handle the political turmoil in the domestic sphere. EU members were highly concerned over the crisis and economic recession had great impact on prospects of political stability and economies of East Europe (Pan, 2009, p, A1.). The countries of East Europe are currently facing depreciation of currencies relative to the Euro, which will increase government deficit and restrict these countries from joining the Euro zone because the countries need to keep government budget deficit. The overall level of government debts and rate of price inflation should not be above a limit. During the financial crisis, certain East European countries tried to get financial assistance, while other expressed low interest rates to get financial assistance (Forelle, 2009.). European Union issued two reports on supervision of financial markets. The first on February, 25, 2009 (The High-Level Group on Financial Supervision in the EU, 2009), and second to reform the international financial governance system (Driving European Recovery, 2009) Public Issues Although, different individuals and organization view the crisis from different perspective, it is seen as series of policy events proceeding the four periods, when the policy response differed (Fender and Jacob, 2008). In the mature market credit crunch had large impact on reputation of banks and in emerging markets the impact was limited. Customers are dissatisfied with remuneration policies of banks and banks need to rebuilt trust, focus on brand building, segmentation of the customer base to personalize product offering and make enhancement in service quality. Banks raise funds from deposits and invest in long- term assets, and the maturity mismatch created crisis. For long, competition has been seen with suspect in the banking sector, and the sector requires strong regulations and limitations on competition rules. There is great need for consumer protection rules and the banking regulations should be based on perspective of competition authorities to promote systemic stability and promote consumer welfare. One of the major impacts of credit crisis was panic runs in customer. If the depositor believes the bank will fail and all will withdraw deposits to avoid being the last in not receiving their money back but uninformed customer may not get back the money. Banks need to create confidence amount retails and institution investors and general costumer, and provide better insurance against deposits. Barclay bank was criticised by UK government and customers for providing better deals to foreign investors. Economic Issues Prolonged and expensive government bailout following banking crisis affected the whole world and it is effecting the emerging economies .Goodhart(1995) claimed at least 2 of 3 banks are bailed out during crisis and it is expensive . Honohan and Klingebeil (2000) found countries spend 12.8 % of GDP on cleaning the banking system. In 2011, commodity price surged and the nuclear crisis of Japan’s earthquake shook the financial markets disrupting the global supply chains, while, the surge was further driven by the political unrest in Libya and North America. The trend in oil price is volatile and hard to predict, and these uncertain political factors and influence of financial variables does not warrants a continued upward trend. The demand for oil is growing fast as compared to supply and the forecast is averaged at $90 a barrel in 2012. The surging capital flow to the developing counties and downward trends in major currencies also raises the risks of another crisis. The housing industry is a drag on major world economies and employment rates are slowly stabilizing but the fiscal deficit remains high in developed economies, and the process of economic recovery in Europe is very weak. The governments need to create balance between the fiscal and monetary stimulus. In the current scenario, the capital aid is inadequate and harmonization is needed for providing aid to distressed banks. Conclusion Banks play a major role in market and provide funds to firms to manage risks, cash and foreign transactions. During crisis banking system leads to malfunctioning of lending & payment process and instability of banking system shortens the repayment of loan and also decreases the overall profits. The bailout of large bank is important because many institutions are dependent on large banks. But, banks need to create capital funds’ from various other sources and reduce dependency on government for capital. The case of Barclay shows the banks can explore new horizon during crisis and avoid dependency on specified region to reduce the impact of crisis. The current status in banking industry suggests going back to basics and reducing organizational complexity. The banks capitalizing on too - big - to-fail are basically, too interconnected to fail. A change in banking regulations, business and political environment is needed. The European commission proposed micro prudential and macro prudential structure and European commission is also considering ways for early intervention to provide resolutions to manage banking crisis. A political set up is needed for centralized regulation to prevent future cross border crisis and to provide risk free service to customers in a globalized environment. References 1. Bernanke, Ben S. (2008) Liquidity Provision by the Federal Reserve, May 13, 2008. 2. Blair, Dennis C. (2009) Annual Threat Assessment of the Intelligence Community for the Senate Select Committee on Intelligence, February 12, 2009. 3. Borio, Claudio, and Nelson, W. (2008). Monetary Operations and the Financial Crisis, Quarterly Review, March 2008, Bank for International Settlements. 4. Calomiris, C. W. (2008) ‘The Subprime Turmoil: What's Old, What's New and What's Next’ Mimeo Columbia University. 5. Carletti, E., P. Hartmann and G. Spagnolo (2002), ‘Bank Mergers, Competition and Financial Stability’, mimeo., Mannheim University and ECB, February (http://www.bis.org/cgfs/hartmann.pdf). 6. Commission of the European Communities (2009) Driving European Recovery, Communication for the Spring European Council, April 3, 2009. 7. Edwards, F. and F. Mishkin (1995), ‘The decline of traditional banking: implications for financial stability and regulatory policy’, Federal Reserve Bank of New York Economic Policy Review, 1, 27-45. 8. Fender, Ingo, and Gyntelberg, J. (2008). Overview: Global Financial Crisis Spurs Unprecedented Policy Actions, BIS Quarterly Review, Bank for International Settlements, December 2008. 9. Pan, Phillip P. (2009) Economic Crisis Fuels Unrest in E. Europe, The Washington Post, January 26, 2009, p, A1. 10. Forelle, C. (2009) EU Rejects a Rescue of Faltering East Europe, The Wall Street Journal, March 2, 2009. 11. Goodhart, Charles A.E. (1995), The Central Bank and the Financial System (London,Macmillan). 12. Gorton, G. (2008) ‘The Panic of 2007’ Mimeo, Yale School of Management. 13. Holmstrom, B., and J. Tirole (1998) ‘ Private and Public Supply of Liquidity ‘, Journal of Political Economy, 106(1) 1-40. 14. Honohan, Patrick and Daniela Klingebiel (2000), “Controlling Fiscal Costs of Bank Crises,”World Bank, working paper 2441. 15. Matutes, C. and X. Vives (2000), ‘Imperfect competition, risk taking and regulation in banking’, European Economic Review, 44(1), 1-34. 16. Perry, J. and Walker, M. (2009) Central Bank Mulls “Bad Banks,” The Wall Street Journal Europe, February 2, 2009, p. 19. 17. Paroush, J. (1995), ‘The effects of mergers and acquisition activity on the safety and soundness of a banking system’, Review of Industrial Organisation, 10, 53-67. 18. Perotti, E. and J. Suarez (2001), ‘Last bank standing: what do I gain if you fail?’, mimeo, University of Amsterdam and CEMFI, June. Read More