An Analyst for the Bank of England - Example

An analyst for the Bank of England and you have been asked to analyse and critically evaluate the causes and consequences of the world financial crisis of 2007/2008 in the UK January 19, 2013 EXECUTIVE SUMMARY The report has researched the subject of financial crisis of 2007-2008 and analysed three main reasons that caused the market crash. The paper also presents responses of capital and money markets and the response and effectiveness of the macroeconomic policies. The main causes for the research are important and cataclysmic events of the preceding years rise in risk premium on interbank borrowing and dates on which some cataclysmic events occurred. It is apparent that events in the previous years such as the dotcom crash, bankruptcies and frauds of large firms such as Enron and the sub prime crisis all lead to successive weakening of the financial markets. The money and capital markets showed extreme distress selling and in the crash, assets were depreciated to the extent of 300 trillion USD. Money supply and demand underwent some dynamic changes with banks reluctant to release funds to borrowers for fear of that the loans would not repaid. The UK government attempted to correct the problems by bring in a number of measures and methods. These included macroeconomic instruments and quantitative easing that was used for the first time in UK financial history. The market reacted in a diffident manner to these economic policies and some slight recovery is apparent in the GDP, inflation and other indicators. Table of Contents An analyst for the Bank of England and you have been asked to analyse and critically evaluate the causes and consequences of the world financial crisis of 2007/2008 in the UK 1 January 19, 2013 1 1. Introduction 5 2. Causes and consequences of the financial crisis 6 3. Response of capital and money markets 11 4. Response and effectiveness of the macroeconomic policies 16 5. Conclusions 26 References 28 List of Figures Figure 2.1. LIBOR-OIS Spreads (Kacperczyk and Schnabl, 2012) 7 Figure 2.2. Rise in risk premium (McKibbin and Stoeckel, 2009) 8 Figure 2.3. Euro Area Government Bond Rate (Kacperczyk and Schnabl, 2012) 10 Figure 2.4. The US housing bubble and crash (McKibbin and Stoeckel, 2009) 10 Figure 3.1. UK market index FTSE100 (Stockcube 2012) 11 Figure 3.2. Global financial assets value reduction (McKinsey, 2009) 12 Figure 3.3. Dispersion in Money Market Funds (Kacperczyk and Schnabl, 2012) 13 Figure 3.4. Asset holding and their spread (Kacperczyk and Schnabl, 2012) 14 Figure 3.5. M2 Multiplier and the ratio of M2 to reserves (Hodson and Mabbett, 2009) 16 Figure 4.1. GBP response to policies (Benford, et al, 2010) 17 Figure 4.2. UK Percent Change in GDP (Benford, et al 2010) 18 Figure 4.3. Central Banks Asset Holdings (Benford, et al 2010) 19 Figure 4.4. Transmission mechanism for purchase of assets (Benford, et al 2010) 20 Figure 4.5. Desired movement of the LM curve (Thomas, 2010) 21 Figure 4.6. Actual movement of the LM curve (Benford, et al 2010) 22 Figure 4.7. New equilibrium point in the IS-LM model (Athey, 2009) 23 Figure 4.8. Impact of QE on the economy (Joyce, et al, 2011) 24 Figure 4.9. UK Money Multiplier (Bank of England, 2010) 25 Figure 4.10. UK GDP growth (ONS, 2012) 25 Figure 4.11. UK CPI Inflation rate (Benford, et al, 2011) 26 1. Introduction The previous decade saw one of the worst and most widespread financial crisis in modern history when global financial markets crashed from 2007-2008. The financial loss across the world measured in terms of devaluation of assets, insolvencies of banks and asset depreciation is estimated at 290 trillion Dollars (Barrel, 2011). According to a report by Rose and Spiegel (2009), the recession was fallout of the sub prime crisis that originated in 2005 and the market crash occurred in 2007. Mishkin (2008) is of the opinion that the years before 2007 that saw the dotcom boom and bust, the peak in crude oil prices and the high value of the stock market were signs that a crash was coming. Nothing was done to prevent the market crash since US, Europe and other markets operate in the free and open economy and the government does not intervene unless the situation is too serious. Nickell (1996) argues that an open market economy is subject to economic cycles of growth and decline and such cyclic variations are acceptable when the changes and spikes are not very steep and quick. Some authors (Hunt and Gauthier, 2010; Furceri and Mouragane, 2009) argue that such cataclysmic events and a global crisis is not due to market forces but due to the greed of speculators and bankers. Such economic variations are seen to cause extreme misery and losses and the economy has still not recovered from the effects of the recession. This paper will analyse and critically evaluate the causes and consequences of the financial crisis of 2007/2008 with the focus on UK. Two other issues are covered and these are the effect of the financial crisis on the money and capital markets and the responses and effectiveness of the macro economic policies that were brought in by the UK government. A number of peer reviewed journals, books and reliable websites are reviewed and critically analysed to research the subject. 2. Causes and consequences of the financial crisis Many causes and chains of events are blamed for the financial crisis. These causes are some important dates when cataclysmic events occurred that triggered the crisis. Other reasons are increased distrust between banks and a rise in the risk premium on interbank borrowing to 5% while this risk is usually zero. Some other reasons are the preceding years of excessive and inflationary spending. These reasons are analysed as follows. 2.1. Important dates and related events According to Demirguc-Kunt and Luis (2009), five dates are critical in perpetrating the financial crisis of 2007-2008. These dates are 9 August 2007, 15 September 2008, 2 April 2009, 9 May 2010 and 5 August 2011. However, the discussion will restrict itself to 9 August 2007 and 15 September 2008. On 9 August 2007, the banking system faced a seizure when BNP Paribas announced that it was stopping trading activity in three hedge funds that were devoted to handling US mortgage debt. The immediate implication was that the US had floated trillions of dollars worth of derivatives and bonds and these were not worth than even the face value. The net result was that banks stopped trusting each other and inter-bank trading slowed. The financial crisis continued with a tightening of the money market until 15 September 2008. On this date, the US government allowed Lehman Brothers, the US investment bank to go bankrupt. Until this time, it was assumed that government across the world would step in to bail and support their banks so that confidence in the banking system was retained (Doms, et al, 2007). Fratzscher (2009) indicates that USA had supported Bear Stearns while UK has supported Northern Rock. However, when the extent of exposure of the banks was clear, it was evident that governments would have to go into a deep financial crisis to bail out all the banks. The notion that Lehman bank was too big to fail was overturned. The US government did intervene and bailed out a number of banks and prevented them from folding over. Huge sums of money of more than a trillion dollar were injected into the financial system to keep the liquidity. However, there was little that the government could do to prevent a global financial crisis. Credit to customers was choked off while consumer and business confidence also dropped. High oil prices had forced banks to maintain high interest rates as a support against inflation and not to cut it in anticipation of the financial crisis from spreading to the real economy (Mayer, et al, 2009). 2.2. Rise in the risk premium on interbank borrowing One of the causes for the worsening financial crisis was due to the rise in risk premium between banks for the inter bank trading and a risk reappraisal by households who discounted their future labour income and increased savings while reducing consumption. During the market crash, the financial institution Bear Stearns was also involved. The bank had a number of subsidiaries and dependents in its networks and so it was bailed out. However, a spate of bankruptcies such as the one by Lehman Brothers in September 2008 and other banks meant that the burden of bailing them out would be too heavy. Investors panicked and there was a spate of selling. Please refer to the following figure that shows the sharp increase in selling of the stock. Figure 2.1. LIBOR-OIS Spreads (Kacperczyk and Schnabl, 2012) Risk premium increased from zero to 5%. When there is a rise in the risk premium, it means that the transaction will have a loading of 5%. Therefore, if a deal was made for 100 GBP, the selling party must accept 95 GBP (Fratzscher, 2009). The latter behaviour was observed with people who still had a job and some income. Commodity prices and the stock market index were steadily rising from 2003 and it reached a peak in 2006. There were concerns about the increase in inflation and the US reversed its monetary policy and tightened lending overnight. The reversal of the monetary policy along with the fall in housing prices created a situation where banks feared lending to one another. The reason was that many banks in UK and USA had taken up third party mortgages from other banks at a discounted price (Taylor, 2009). Please refer to the following figure that shows the rise of risk premium. Figure 2.2. Rise in risk premium (McKibbin and Stoeckel, 2009) This means that if bank A has entered into a mortgage agreement with an individual, for 1000 GBP due after five years, the bank would sell the mortgage to bank B at say 995 GBP. When the mortgage matured, bank B would make a profit of 5 GBP. There was nothing to stop bank B from further discounting and selling it to bank C and so on. Due to the collapse of Northern Rock and Lehman Brothers, the banking sector was saddled with a huge number of such non-performing assets. This story was even repeated with stocks, bonds of various firms and even treasury bills of government such as Greece and USA (Rose and Spiegel, 2009). The very fact that the banks were holding securities that had no value created a huge fear psychosis and increased the risk premium when banks traded with one another. The risk premium that was zero rose to 5% for interbank trading and to 6% for inter-corporate bond trading. This increased fears in the banking sector and even the public who placed their funds in savings deposits rather than spend it (Poole, 2010). The liquidity position was further tightened and this is one of the reasons for the crisis. 2.3. Events from the preceding years The millennium saw many realignments and changes in the market when the Euro zone was formed. The new Euro zone combined and integrated the economies of many European nations other than UK and it was supposed to provide a huge competitive advantage for the nations. However, when the crash occurred, the integrated economies saw the recession spread quickly across all the Euro zone nations. The millennium also saw the emergence of the dotcom sector when a large number of Internet firms were established with very flimsy and unsustainable business models. When the dotcom boom began in 1999, the NASDAQ index was at 1500 and at the peak in 2000, it had reached a valuation of 5132. After the crash occurred, the index plunged to 1441. The crash caused a loss of 1.3 trillion USD in 2000 and about 8% of the US stock market was lost. It is estimated that the 78% of the stock market value across exchanges from London FSTE and NASDAQ was lost (Cassidy, 2002). Money that was lost was lent by a banks, financial institutions and venture fund capitalists. As a result, banks lost their operating cash and saw a reduction in the liquidity (Kindleberger and Manias, 2005). Please refer to the following figure. Figure 2.3. Euro Area Government Bond Rate (Kacperczyk and Schnabl, 2012) Even as the losses from these events were being absorbed, a number of events occurred that further increased the burden on the financial system. These were the attacks of 9/11, the fraud in reputed organisations such as Enron, WorldCom. NorthPoint Communications, and many others. Many of these firms closed down and banks were faced with losses of more than 5 trillion dollars from advances and funds lent to the bankrupt firms (Abramson, 2005). These events had almost drained the financial systems and banks when the sub prime crisis occurred and the housing bubble burst in USA. Since banks and financial systems across the world are integrated, the losses in USA caused the collapse of banks in other nations also (Bezemer, 2009). Please refer to the following figure that shows the housing bubble formation, rise and crash of the housing market. Figure 2.4. The US housing bubble and crash (McKibbin and Stoeckel, 2009) 3. Response of capital and money markets The responses of the money and capital markets are discussed in this section. The financial crisis created risk choices for the investors and fund sponsors. It was seen that money market funds that were sponsored by financial institutions with greater standing had a lesser risk appetite that the ones that were sponsored by smaller institutions. Results differ for funds that were supported by independent investment managers and the funds that were affiliated with financial conglomerates. Please refer to the following figure that indicates the manner in which investors dumped risky assets. Figure 3.1. UK market index FTSE100 (Stockcube 2012) 3.1. Response of Money and Capital market funds It was noticed that after the bankruptcy of Lehman Brothers, one important fund called the Reserve Primary Fund was faced with a bull run since it had Lehman Brother holdings in the portfolio. This created a panic among investor and the run spread to other funds that were safe. As investors dumped the funds in the market and opted for redemptions, money market funds saw an erosion of more than 300 billion USD in a few days after the bankruptcy. Please refer to the following figure that shows the reduction in asset value. Figure 3.2. Global financial assets value reduction (McKinsey, 2009) A worried US government, more concerned about stability of the US financial system bailed out and intervened by providing an unlimited, explicit deposit insurance for all investors who played the money market funds (Chen, et al, 2010). Due to this assurance, the run on the funds stopped. However, the full risk of the money market fund, valued at 3 trillion USD was transferred to the government. The crash of Lehman brothers and the run on money funds was a surprise since these instruments are low risk instruments and regarded as cash. The yield from these funds was always steady with small variation and ensured capital protection. However, investors noticed that during the initial phases of the financial crisis, from August 2007, the funds started giving much higher yields than expected (Cornett, et al, 2011). Please refer to the following figure. Figure 3.3. Dispersion in Money Market Funds (Kacperczyk and Schnabl, 2012) It can be seen that the cross section dispersion indicates the funds yields at below 30 basis points before August 2007. After August 2007, it can be seen that there was s sudden spike of more than 150 basis points. This rise continued until March 2008 when suddenly the yield crashed to around 100 basis points. This spike and sudden rise in the yield indicates that some money market funds saw an appreciation of their underlying assets and this caused a fundamental change in the financial crisis. Money market funds are very important for the economy of a nation. They provide short-term funds for the government. In many cases, these funds are equal in size to the whole equity mutual funds and the demand deposits of commercial banks. Money markets also provide for a method to take up the study of risk taking incentives (Kelly, et al, 2011). Please refer to the following figure that represents the spread between eligible money market fund instruments and treasuries. The spread was maximum at 25 basis points before August 2007 hence there was not much of a need and scope for risk taking. However, after August 2007, the values for the collateral and liquidation for the money market fund instruments started shrinking. This contraction was due to the sub prime crisis in the mortgage market. Due to this, the spread of unsecured bank obligations and other risky money market fund instruments appreciated quickly. The growth was almost up to 125 basis points. Variation in risk taking of different funds was analysed and it was seen that this depended on the pricing. To negate the danger of self-fulfilling runs by manipulative fund managers, money market funds depend on large financial institutions (Panageas, 2010). Figure 3.4. Asset holding and their spread (Kacperczyk and Schnabl, 2012) As seen in the above figure, the spread and holdings are plotted from January 2005 to August 2008. Each point in the figure shows the plot of interactions between the months fixed effects and different indicators. The indicators are repurchase agreements - repo, bank deposits - deposits, bank obligations - obligation, floating rate notes - FRNS, commercial paper - CP and asset backed commercial paper - ABCP. All measurements are done on percentage basis points, relative to the Treasury bills and agency debt. A closer analysis gives some important results. It is clear that money market funds underwent an increase in their risk taking opportunities from August 2007. As per government regulations, money markets can invest only in secure and high rated short-term debt securities (Kacperczyk and Schnabl, 2012). 3.2. Money Supply and Demand Banks borrow money from central banks and they raise funds through deposit schemes where interest rate is used as an attraction. This is the deposit expansion multiplier and it increases the money from extra reserves. However, the power to create or deplete reserves rests with the central bank. The financial crisis of 2007 shows that when the crisis was at its highest in September 2008, the deposit expansion multiplier dropped. The reason is that in normal times with the standard process of deposit expansion, banks would not wish to hold on to more funds than required that are supplied by the central bank. Banks prefer to earn a return on the extra funds by lending it. With multiple deposit expansion, banks continue to lend the extra assets until the excess reserves are utilised (Oxford Economics, 2009). After the collapse of Lehman Brothers, banks changed their behaviour and depressed the deposit expansion multiplier schemes. They in fact preferred to hold on to excess reserves, disregarding the deposit expansion plan. With the financial crisis, banks could not easily sell assets to meet the rush of withdrawals from customers. With less liquidity, banks had to sell assets to meet operational expenses. They were not willing to lend due to fear that the loans would become non-performing assets. Reserves that the banks held were liquid and they could be used to meet any urgent claims. Fearing failure, banks raised a huge demand for excess reserves from the central bank. From August 2008 to December 2008, more than 813 billion USD were added to the reserves to meet this increased demand. Banks sat on the excess reserves and showed very little inclination to lend. Please refer to the following figure that gives the ratio of M2 to reserves (Oxford Economics, 2009). Figure 3.5. M2 Multiplier and the ratio of M2 to reserves (Hodson and Mabbett, 2009) 4. Response and effectiveness of the macroeconomic policies During the financial crisis of 2007-2008, the UK government saw drop in consumer and business spending. This reduction was brought by firms closing down and cutting down jobs. Unemployment then rose to 10% by the beginning of 2008 and this led to further cuts in spending (Feature Analyses, 2009). To meet the challenges, the government introduced a number of micro economic policies. These included macroeconomic instruments and quantitative easing – QE (Oxford Economics, 2009). Microeconomic imbalances were seen in the form of large deficits in the current account balance payment of many nations including UK and USA. The move to introduced QE was brought in since the conventional policy options were exhausted (Hodson and Mabbett, 2009). The effectiveness of these measures is discussed in this section. 4.1. Macroeconomic Instruments At the beginning of the UK financial crisis of 2007-2008, a number of banks such as Northern Rock bailout, the Bank of England introduced a number of tools to reduce the effects of recession. These tools are Asset purchase facility by issuing treasury bills, Special liquidity scheme, Asset backed securities guarantee scheme, Deposit guarantee scheme, Credit guarantee scheme, Equity injections in banks and Asset protection scheme. However, these tools could not stimulate the economy and the falling value of the Pound made the matters worse. Given below is the fall in UK nominal GDP during the financial crisis. Figure 4.1. GBP response to policies (Benford, et al, 2010) It is seen that during the crisis, the UK GDP fell by -2.49% by the end of 2008. The bank cut the lending rates by 0.5% but still the inflation could not be controlled and consumer spending would not increase. The only choice that UK had now was to use quantitative easing and this is explained in the next section (Benford, et al 2010). Following figure gives the percent change in GDP. Figure 4.2. UK Percent Change in GDP (Benford, et al 2010) 4.2. Quantitative Easing Quantitative Easing - QE is the process used by the central bank such as the Bank of England to raise funds and stimulate the lending activity. The conventional method is to reduce interest rates so that people are encouraged to spend money and not save money. When interest rates cannot be lowered below a certain point, then the Bank of England has only one way of bringing liquidity in the market and this is to pump in money to the economy directly. This method is called QE (BBC, October 2012). The bank carries out this process by purchasing assets such as government bonds from the market by using money that it has created electronically. Institutions and insurance firms that sell the bonds would then have fresh funds and this increase the market liquidity. Such a step had never been attempted in UK before (Benford, et al, 2009). According to Fisher (2010), this is somewhat similar to printing money but doing it electronically. This is a manipulative method to increase the balance sheet and the monetary base even when the bank does not have the assets to back it. By the beginning of 2008, the Bank of England had committed around 200 billion funds into the economy by means of asset purchase from the private sector. This helped the bank to create money electronically and increase the level of funds held by the central banks and the funds in the form of deposits of households and firms. The new funds would then be used in three important economic channels to increase the liquidity and spending of these channels and their liquidity transmission mechanisms. Following graph illustrates the percentage change in GDP and holding of various central banks. Figure 4.3. Central Banks Asset Holdings (Benford, et al 2010) According to Gagnon (et al, 2010), it is different from the practice used by Zimbabwe to print money to ease the balance of payment crisis when Zimbabwe did not have any money. As per the Maastricht Treaty, EU member nations cannot finance their public debts by printing currency. The Bank of England decided to buy government bonds from financial institutions and it had technically acted on its own and not bought the bonds from the government. The bank electronically printed money to prevent deflation and it was a part of the monetary policy. The bank was not printing currency to help the government finance its debt. QE was a temporary policy and the bank would sell the bonds back to the market when the economy came back on track (Kapetanios, et al, 2011). Please refer to the following figure that illustrates the asset transfer mechanism. Figure 4.4. Transmission mechanism for purchase of assets (Benford, et al 2010) 4.3. IS-LM Model – and Keynesian Economics The IS-LM model - investment, saving- liquidity preference, money supply is a macro economic tool that shows the relation between interest rates and the real value of output of goods and services and the money market. The point of intersection of the IS and LM curves gives the general equilibrium and there is equilibrium in both areas of the market. The model tries to explain the Keynesian general theory of employment, interest and money. The effectiveness of QE and other monetary policies of the government are evaluated with the IS-LM model. It is assumed that investment and money demand are inelastic and people do not trust the government in the crisis (Brunnermeier, 2009). If money supply is increased due to QE policies, the LM curve will shift to the right as seen in the following figure. Figure 4.5. Desired movement of the LM curve (Thomas, 2010) As seen in the graph, when QE was brought in, it was assumed that liquidity would increase in the market since the Bank of England was willing to buy government bonds from financial institutions. This would make more money available and help to decrease the interest rate while increasing the borrowing. However, the government brought in measures to decrease government spending by 20%, though austerity measures. To increase revenue collection, VAT was raised from 17.5% to 20%. This produced a shift of the IS curve to the left (Athey, 2009). Figure 4.6. Actual movement of the LM curve (Benford, et al 2010) As seen in the above figure, the decision will only decrease the national income and stop the QE objectives from being met. There is thus a need to revise the fiscal policy by means of interest rate decrease. There is thus the formation of a new equilibrium point as seen in the following point when the point moves from position 1 to 2. The government policy of reduced interest rate gave only a small decrease in the national income. This was because the policies were not aligned to the monetary policy and the inelastic demand. There is a need for the government to revise the fiscal policy so that it is aligned to the monetary policy. Figure 4.7. New equilibrium point in the IS-LM model (Athey, 2009) The IS-LM model shows that the economic policy of the government sometimes contradicted with other policies. The exact shift of the IS and LM curves is difficult to evaluate. Since UK operates in an open market, the impact of external forces is also not very clear. Firms that have sold the bonds are still holding the funds and the Bank of England cannot force these firms to invest in bonds or other instruments. It is expected that the impact of QE will be long term. 4.4. Effectiveness of the policies A report by the Bank of England shows that QE helped to increase the demand for UK government bonds and this increased their value. When the value is increased, they become more expensive and hence less attractive. Therefore, firms that sold the bonds may then use the returns to invest in other stocks or take up lending and not buy more bonds. As a result, banks, pension funds and insurance companies would increase their lending, interest rates reduce and since spending is increased, the economy is strengthened. The annual economic output of UK increased by 2% and so the impacts were significant. While the full impact of QE will not be clear, it is evident that the process helped to save the British Economy from falling into a credit led depression (Joyce, et al, 2011). Following figure illustrated the effect of QE on the UK economy. Figure 4.8. Impact of QE on the economy (Joyce, et al, 2011) Based on the declining Multiplier, QE is a beneficial step taken by the government. The success of QE can also be seen with the slight recovery of the GDP as shown in the following figure. Figure 4.9. UK Money Multiplier (Bank of England, 2010) Given below is a graph of movement of GDP growth percent. The movement is seen from 2006 to Q3 of 2010. Figure 4.10. UK GDP growth (ONS, 2012) The slight recovery in the economy can be due to effects of QE and the decrease in interest rates. The full benefits of QE would be obtained after a long interval, assuming that fiscal policy changes do not interrupt recovery. Given below is a graph of unemployment and inflation. Figure 4.11. UK CPI Inflation rate (Benford, et al, 2011) 5. Conclusions The report has analysed some important facts and features that lead to the financial crisis of 2007-2008. Three main causes were discussed. These included important date and events that triggered the crisis, rise in risk premium on interbank borrowing and events from the preceding years. It is thus apparent that it was not just one event or incident but a chain of events that lead to the financial crisis. The responses of money and capital market funds were examined. It is clear that these funds are regarded as stable and high security instruments that give a consistent return over a time. However, from August 2007 to March 2008, the funds gave a much higher yield that was 150 basis points over the previous average yield. It appears that the asset base of these funds showed a higher appreciation and this resulted in the spike of the prices. The U government had introduced some macro economic policies to counter the effects of the financial crisis. A number of macro economic instruments were brought in and interest rates were cut. However, they could not control the inflation, they could not infuse liquidity and stimulate consumer spending. As a last result, the government brought in quantitative easing where the Bank of England purchased government bonds that were held by financial institutions. The logic was that once the bonds were purchased, demand would rise for the instruments and thus increase the price. However, vary financial institutions were expected to use the funds to invest in the stock market. QE had never been tried before but it did increase liquidity by about 2%. The overall lesson learnt from the research is that financial crisis are triggered by excessive spending, high inflation, stock market and property bubbles. 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