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Impact of Sub-prime Mortgage Crisis on Major UK Banks
Content 1. INTRODUCTION 1.1. Overview 1.2. Research Questions 1.3. Research Structure 2. LITERATURE REVIEW 2.1. Business Cycles in the Economy and Bank Credit Cycles 2.2. Globalisation and International Capital Flows 2.3. Causes of the Subprime Mortgage Crisis 2.4. Process of Securitisation (ABS, MBS, CDOs) 2.5. Contribution of Credit Rating Agencies to the US Subprime Mortgage Crisis 2.6. Transmission of the Subprime Mortgage Crisis to the EU 3. METHODOLOGY 3.1. Overview 3.2. Research Design 3.3. Research Approach Selection 3.4. The benefits of the combination of inductive and deductive approaches 3.5. Research Strategy 3.6. Data Collection Method 3.7. Data Collection Techniques and Methods 3.8. The Research Procedure 4. FINDINGS AND ANALYSIS 4.1. UK Banking Sector Analysis 4.2. Financial Performance of the Major UK Banks 4.2.1. Northern Rock 4.2.2. HSBC 4.2.3. Lloyds Banking Group 4.2.4. Barclays 4.2.5. Royal Bank of Scotland (RBS) 4.3. Banks’ Share Price Performance 4.4. Managerial and Organisational Issues 4.4.1. Northern Rock 4.4.2. HSBC 4.4.3. Lloyds Banking Group 4.4.4. Barclays 4.4.5. Royal Bank of Scotland 5. FINAL DISCUSSION AND CONCLUSION
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5.1. Limitations and Future Recommendations APPENDICES
List of Figures
Figures Figure 1: Northern Rock Profitability Figure 2: Northern Rock Impairment Losses on Loans (in £’m) Figure 3: Northern Rock Return on Equity Figure 4: Northern Rock Return on Assets Figure 5: HSBC Profitability Figure 6: HSBC Return on Equity Figure 7: HSBC Return on Total Assets Figure 7: HSBC Impairment Losses on Loans (in $’m) Figure 8: Lloyds Banking Group Profitability Figure 9: Lloyds Banking Group Return on Equity Figure 10: Lloyds Banking Group Return on Total Assets Figure 11: Lloyds Banking Group Impairment Losses on Loans (in £’m) Figure 12: Barclays Profitability Figure 13: Barclays Impairment Losses on Loans (in £’m) Figure 14: Barclays Return on Equity Figure 15: Barclays Return on Total Assets Figure 16: RBS Profitability Figure 17: RBS Return on Equity Figure 18: RBS Return on Total Assets Figure 19: RBS Impairment Losses on Loans (in £’m) Figure 20: Share Prices of Banks Figure 21: Bank of England Base Rate Figure 22: Lloyds Banking Group Debt Ratio (Leverage)
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Abstract The UK economy has been greatly impacted by the subprime mortgage crisis that started in the middle of 2007. The causes of the crisis are subject to arguments and there is no single party that is responsible for what happened in the US and UK economy. The decade before the crisis was prosperous. Asian countries and Russia started accumulating much wealth producing more goods 2
and providing resources to developed countries. The latter started running large budget deficits and accumulated national debt. The former, on the other hand, enjoyed trade and budget surpluses. The period of low interest rates stimulated investors to seek assets with higher yield than what was offered by the US Treasury bills. Demand for collateralised debt obligations (CDOs) increased. A number of large banks in the UK were involved in the process of securitisation and had operations in North America. The collapse of the market for structured investment products that had subprime mortgages as underlying assets caused substantial write downs and losses among the banks in the US and UK. Banking sector was one of the most vulnerable parts of the economy. The period of economic growth in the early 2000’s was notable for the development of housing market bubbles and unprecedented rise of commodity prices. Emerging economies have become richer and developed countries such as the US have accumulated large budget deficits and national debts. In this period, many financial innovations were introduced. Securitisation was becoming more and more complex and risk was difficult to estimate. In these conditions, the increased defaults on the US subprime mortgages started a chain of catastrophic events in the economy. Mortgage backed securities reduced in value and demand for structured investment vehicles immediately fell. This left a number of investment banks with huge losses. Five largest UK banks are analysed in this research project. The findings suggest that the impact of the crisis was not felt identically by the lending institutions. Those banks that relied heavily upon funding from mortgage backed securities were the major victims of the crisis. Ordinary operations of the majority of the banks were found to be profitable. The losses and decrease in profits was primarily due to high impairment losses on loans and trading losses. Non-resilient planning and managerial decisions are found to be the primary determinants of banks’ failures. Those financial institutions that originally had diversified operations and different sources of funding were the least impacted by the crisis.
1. INTRODUCTION 1.1. Overview The present research paper discusses the current situation of the major UK banking institutions in face of the credit crunch and the recessionary economic conditions. It represents an analysis of the main trends in the performance of five major UK banks: the Royal Bank of Scotland, Northern Rock, Barclays, Lloyds Banking Group and HSBC. This research project aims to establish the relation between the resilience of the management of the banking institution and the 3
organizational performance. The paper presents a critical argument over the factors that led to the subprime crisis and eventually dragged the economy of the most of the developed countries into a recession. It attempts to identify who is to blame for the current state of the UK economy and provides a complex picture of the events that took place shortly before the economic crisis began to unfold in the US and UK banking sectors. The study analyses the performance data for each bank and provides an insight into the management practices and managerial decision making in each of the named banks. It then attempts to establish a match between the two and provide a critical evaluation of managerial approaches and decision making strategies at play. It then provides managerial recommendations as to the preferable risk evaluation and risk management practices so as to avoid or at least reduce the possibility of future crises of the same nature. 1.2. Research Questions
The research project aims to answer the following questions: 1. Did the “freezing up of the money supply” (credit crunch) lead to weakening of the organisational performance among major UK banks? 2. Did the “non - resilient planning and decision making mechanisms” lead to weakening organisational performance among major UK banks? 1.3. Research Structure
This paper begins with an extensive critical literature review that attempts to establish what were the main factors that lead the global economy to its current state. In trying to do so it analyses the recently published literature and articles on the subject so as to provide the sum of knowledge on the subject to the present day. The literature review demonstrates the complexity of the reasons behind the subprime mortgage crisis and the downturn of the economy of the developed countries. Chapter Three provides the justification for the methodology used to carry out this research project. Through a critical consideration of the possible options it identifies the most suitable research design and describes the data collection methods and the sources used to collect the data for the purpose of this research. Chapter Four presents the research findings based on the data sourced from various sources described in the Methodology. It provides visual representations of the trends discussed through a wide use of graphs for the sake of clarity of the 4
findings. The analysis of the research findings is the main focus of Chapter Five that also includes the conclusions, the managerial implications and the limitations of the research project.
2. LITERATURE REVIEW 2.1. Business Cycles in the Economy and Bank Credit Cycles Despite the abundance of works on the recurrence problem in the economy, there is no exact uniform concept concerning the reasons of existence of this phenomenon. It is necessary to understand recurrence as a form of movement in the world economy assuming change in revolutionary and evolutionary stages of economic development and economic progress. There are many approaches to an explanation of the reasons of business cycles. There are many opinions of representatives of different economic schools and directions. In a business cycle structure, Garcia-Ricco et al. (2006) allocate the highest (peak) and the lowest (trough) points of activity. The phases between them are called recession and expansion. In the economy, recession obtained a uniformly recognised definition as a period of negative economic growth during at least two quarters in a row. The ongoing credit crunch and the subprime mortgage crisis caused the UK economy to suffer from economic recession since the second half of 2008. This crisis signified a change in the phase of a long-term business cycle. The highest employment, business activity, high price levels and rates of salary correspond to a cycle peak. Recession is characterised by a situation when the capital does not find applications in the industry and trade. Fewer commercial and consumer loans are taken from banks and the level of spending and investing becomes lower. As consequence, Koopman et al. (2006) argue that if the economy appears to enter this phase of the business cycle development, the following reaction of central bank is natural. The monetary policy of the government represented by the central bank becomes focused on reduction of interest rates and stimulating spending and investing. The lowest point of recession is characterised by following lines. There is an overproduction of the goods in comparison with solvent demand for them. As a result of the supply that exceeds demand, there is a falling of prices and a consequent reduction of volume of manufactured goods. The given process provokes unemployment growth, reduces the standard of living and 5
The reason for excessive savings lies in non-uniform distribution of the income: higher income leads to more savings up. As a result of increase in demand for the loan capital. 2007). Knoop (2004) considers Sismondi to be the founder of the theory of underconsumption. prices grow and so does the 6 . 2006 and Saurina et al.. trade extends. The cost of investing and spending would go up. Fluctuations of business activity are connected to underconsumption of the population and overproduction of the goods and services. Changes in capital flows are the unique and sufficient reasons of fluctuations of economic activity. (1998) argue that crises arise because of disproportions in the economy. recessions in economic systems are caused by savings of a large part of the current income and lower consumption compared to the previous periods. Hartley et al. Changes in interest rates shift the demand for credit. Demand for credit. Knoop (2004) argues that the problem can be solved by raising wages and changes in redistribution of the national income. Mitchell (1970) asserts that in order to reduce the negative impacts of economic slowdowns in economy. levels of interest rates rise (Koopman et al. on the other hand. If demand for the goods increases in money terms. The process becomes cyclical. Saurina et al. there are phases when banks make more loans and the cost of credit is cheap and phases when banks make fewer loans because of the decreased demand for credit. The commodity prices considerably grow and unemployment becomes lower. The rise of unemployment is accompanied by a decrease in the disposable income of households. This happens because of the imbalances between the demand for loans and their supply. Lower demand prompts businesses to cut prices and reduce production. consumer demand falls even deeper and recession may worsen. it is necessary to stimulate household consumption and spending. Consequently. According to Knoop (2004). He concludes that savings of households distort the balance between manufacturing and sales. High interest rates attract more depositors and liabilities of the banks increase.reduces cumulative demand even more. So. (2006) argue that the credit sphere also develops in cycles. decreases because fewer business and individuals want to pay higher interest on the loans. The phase of expansion is characterised by restoration of volumes of manufacturing and its further increase. Cost cutting strategies imply that more labour force should be laid off..
And vice versa. inflation is observed in the period of expansion. they have modeled fluctuations in the US economy in the period of Great Depression and the post-war period. recent failures in the capitalist 7 . Banks then lose their liabilities that allow them to increase liquidity. The uniqueness of their investigation was that they found investments to be a secondary factor in causing economic recessions. At the same time. trade calms down. changes in capital flows and cost of borrowing. 2001). the business cycles in the economy and bank credit cycles are strongly correlated. Banks are important elements in the system of international capital flows. In their study. there will be no stability. it can be argued that capitalist societies are heavily dependent on debt and credit. If demand falls. Since the loans of one bank eventually become deposits in another bank. Instability of the banking system can quickly transmit to the rest of the economy. Therefore. So. It conducts to a mismatch of actions of managing subjects and to the occurrence of macroeconomic disproportions. Credit has a risk and a price for the risk. recession is caused by a decrease in consumption.volume of manufacturing. Changes in interest rates or the price of credit prompted cyclical development of the economy. the banking system as a whole can multiply the amount of money in the economy (Krainer. The bank system has ability to create money. If it was possible to stabilise capital flows and demand for money. Thus. However. All commercial banks are required to keep a fraction of their reserves with the central bank. Mitchell (1970) argues that the theories of Marxists also explain the phenomenon of business cycles in the economy. So. as long as debt plays a crucial role in the economy. The ultimate destination is assumed to be communism. They are deduced from the basic contradiction between public character of manufacture and the private-capitalist form of assignment of its results. any instabilities in the other sectors of the economy eventually become reflected in the banking sector. (2004) argue that business cycles are stimulated by the frictions in financial markets and rates of employment. prices fall and manufacturing is reduced. (2006) argue that in critical situations massive withdrawals of bank’s deposits can be observed. Lown et al. The subprime mortgage crisis occurred when credit risk substantially increased and default rates went up. business cycles would not exist. The primary role was given to changes in labour and efficiency. Marxists believe that capitalism is only a transitory state of economic formation. Chari et al. Ups and downs will be inevitable. The loans become greatly affected.
upgrading of the past methods and strategies. the positions of this theory can be challenged. revolutions and other political shocks create changes in aggregate demand and production and also lead to a crisis.g. Excessive use of leverage and poor risk management prompted one of the severest financial crises of the recent decades. the economy has more fluctuations. Optimism and pessimism are considered in this theory as the factors that cause and strengthen growth or fall of investing and spending in various spheres of the economy. too. spend larger amounts of money etc. The changes are made in such a way that reorganisation of prices. Zarnowitz (1996) argues that the set of innovations appearing in prosperity is the factor that breaks balance and changes conditions of the industrial life. 8 . Zarnowitz (1996) draws a conclusion that the determinants of economic dynamics and cycles are new technologies. during a market crash). prompts the cyclical development of the economy (Knoop. changes in the global population and powerful breaks in the technologies allow radical changes in the structure of production. This is a psychological factor. This.system connected to the subprime mortgage crisis may seem to support the ideas of Marxists. Successes or failures can change the mood and attitude of investors and households. in turn. However. people invest more freely (buy more goods and services. costs and volumes of production become inevitable. Knoop (2004) explains the occurrence of business cycles by so-called external reasons such as the following. As a result. Development of new territories and the population migration that is connected with it. A number of researchers such as Punzo (2001) emphasize that there are also psychological explanations of the business cycles. They connect business activity with changes in mood and transition from mass optimism to pessimism. Psychological factors such as mood have to be caused by some events.). investing and spending decrease as people become reluctant to part with their money. Punzo (2001) argues that one of the basic studied phenomena of psychological theory is the fact that people adhere more to optimistic views during the economic boom. On the other hand. Wars. Recessions are provoked when the massive mood changes to pessimism. During economic expansion. appearance of new instruments of production and overall progress. Occurrence of stains on the sun may lead to a poor harvest and the general economic recession. Failures are often connected to real losses suffered in the economy (e. 2004). In the period of recession. the crashes occur because people start to panic and sell their assets in high volumes.
House prices started falling as banks attempted to sell the collaterals as quickly as possible. (2008) insists that in these circumstances banks reconsider the credit standards and change their risk management strategies. Gorton et al. Banks wish to receive their money back.. there is a necessity of careful check of collateral and definition of its real value in credit boom. 2008:1184). (2008) allocate some forms of an unfair competition between banks (for example. Further it will allow to reduce losses from substandard loans. therefore. more pieces of property appeared in the market and supply increased. (2006) argue that the beginning of the “credit crush” is caused by distinction of interests of creditors and borrowers. There is an opinion suggested by Gorton et al. the quantity of “nonperforming” credits increases. The credit risk increases and after a rise of default rates banks return to more conservative lending policies to cut their losses and reduce risk. First. When the number of foreclosures increased. Businesses to whom banks made loans that had higher credit risk more frequently become incapable of paying debts. Banks predict substantial growth of cost of their assets and. Lown et al. (2008) that the reason of fluctuations in the credit market is the human factor. reduce the credit standards. Borrowers demand to increase volumes of given credits to finance their business in such a way. The question of inevitability of the bank losses connected with delivery of credits is rather disputable. Secondly. Collateral is sold for low prices to receive the funds that were lent. Hence. This drives assets values down and crashes occur. This was the case with the US housing market in 2007. The crash was inevitable. Managers’ reputations suffer if they fail to expand credit while other banks are doing so. Gorton et al. (2009) asserts that development of a credit cycle begins at the moment when demand for credit resources increases. in boom 9 . “…the fluctuations in credit availability by banks are driven by bank managers’ concerns for their reputations (due to bank managers having short horizons) and that consequently bank managers are influenced by the credit policies of other banks. illegal agreements on an increase of interest rates. granting of the incomplete information about conditions of crediting to borrowers and others) as the reasons of credit cycles occurrence.Ozcan et al. implying that expansions lead to significant increases in losses of loans subsequently” (Gorton et al.
defaults may increase and stimulate a crisis. “In sum. 2006:1587). It is possible to carry the following 10 . To understand preconditions of occurrence of today’s financial crisis.. In support of the offered opinion. Lown et al. The theory of cycles offered by Lown et al. If interest rates are reduced to too low. (2006) therefore represents a vicious circle of interdependence of business and credit cycles. If the lack of income is so great that an enterprise appears to be on the verge of bankruptcy. excessive spending will cause higher inflation rather than an increase in real production. the Netherlands and others undertake various measures for constant maintenance of the stability that can prevent financial crises. an establishment of loan limits will have a fatal impact. Kocherlakota (2000) declares that the establishment of credit restrictions does not render considerable influence on a business condition in the event that the situation is not critical. Germany. Various opinions concerning their mutual influence are expressed. As a result. The question of interrelation of business and credit cycles is debatable. Changes in interest rates cause a shift in demand for credit. banks undertake reciprocal measures. it is necessary to present a picture of a credit cycle within the limits of financial interaction between developed and developing countries. Mitchell (1970) argues that the government can often provoke the rise of inflation by regulating the money supply and conducting monetary policy. Hence. he argues that the problems caused by the internal reasons of business considerably reduce demand for credit resources. At the same time. France.period banks should predict and estimate the future credit risk and at the same time pawn reserves of losses decrease in the subsequent periods (Saurina et al. Bordo (2007) argues that the developed countries of Europe such as the UK. The availability of cheap loans prompts businesses to undertake more investment projects that may include those with higher rates of risk. the significance of the business failure rate in explaining credit standards provides some support for the idea that standards are altered in response to changes in firms’ financial health” (Lown et al. 2006).. (2006) insist that the credit cycle appreciably defines a business cycle and influences the direction of its development.
so-called “sudden stops”.measures: the effective fiscal policy providing effective tax systems. Chairman of HSBC listed globalisation and increased international capital flows as one of the most important preconditions of the US subprime mortgage crisis (Annual Reports of HSBC. “The rapid growth of emerging economies created a macro-economic triangle. Often they were unable to raise sufficient tax revenues to service the debt with their inefficient procyclical tax regimes based on indirect excise taxes and customs duties” (Bordo. “In addition. International capital flows were given more freedom and the borders between countries and economies seemed to be nearly erased. Latin America and Asia enjoyed a great stream of financial resources flow from the developed countries until the moment of financial crisis. The activation of trade between countries and strengthening of globalisation was connected to the recent well-being of emerging economies such as India and Russia. 2008). The countries of Southern Europe. balanced budgets. 2. Emerging economies started gaining strength in the last decade as their production increased. 2007:4).2. creation of effectively operating credit institutes and others. the increase of imbalances between the developed and emerging economies were the original causes of the subprime mortgage crisis and the global slowdown of business activity. many emerging countries were prone to debt crises when their economies collapsed consequent upon a lending bust and banking crisis. At the same time. banking systems of these countries have suffered strongly. As emerging countries lost the opportunity to receive financial assets. Partially. Consumers were mostly the western developed countries such as the US and European Union. Globalisation and International Capital Flows The past decade was notable for the wide spread of the processes of globalisation in different areas such as the labour market. major producer nations – notably a number of fast-growing emerging markets 11 . manufacturing and financial services. These imbalances are connected to the process of globalisation and international capital flows. emerging economies have faced fluctuations in the financial sphere. in particular the US but also a number of other Western economies. made up of: the major consumer markets.
They conducted a study of the UK using Vector autoregression (VAR) approach and found that short-term interest rates in other countries were significant variables that affected the UK economy. 2006) and Mumtaz and Surico (2009). investment banks. according to Stiglitz (2003. subprime borrowers. credit rating agencies.which have been manufacturing a vast range of goods for consumption in the West. The phenomenon of globalisation and international capital flows was studied by a number of researchers such as Stiglitz (2003. US dollar is the world’s reserve currency. Particularly. Interest rates were cut by the Federal Reserve and returns on the risk-free assets were minimal. 2008. institutional 12 . At the same time.8). Mumtaz and Surico (2009) find that an individual economy is greatly affected by international levels of short-term interest rates. Causes of the Subprime Mortgage Crisis One of the features of the US sub-prime mortgage crisis is that there is no single entity responsible for it. The emerging countries started accumulating the US denominated Treasury bills. producers and exporters accumulated budget surpluses and increased foreign reserves. This demand was met by the increased volumes of securitisation and sales of collateralised debt obligations and asset backed securities. This prompted institutional investors to seek and demand other low risk securities with higher returns. International Monetary Fund (IMF). 2. 2006). Excessive consumption of foreign goods and services led to accumulation of national debt in the developed countries including the US. 2009).3. However. this foreign capital represented by the entrance of international banks and other foreign institutions drives local banks out of business. and resource providers whose wealth of hydrocarbons and other commodities have helped power the producer economies and have thus commanded such high prices until recently” (Annual Reports of HSBC. 2006) argues that globalisation in the banking sector increases instability. This finding explains why a local crisis in one of the developed countries can transmit to the rest of the world. It occurred as a result of cooperative work of several bodies such as commercial banks. The banking sector becomes more monopolistic and this creates precondition for riskier operations such as making loans to subprime borrowers (Elstob. Stiglitz (2003. p. creates this instability by making loans to emerging economies and requiring them to be more open to foreign capital that is supposed to increase stability in the countries.
mistakes and unethical behaviour. Adjustable rate mortgages allowed controlling the amounts of 13 . Every loan should be tested for different types of risks that may be present. They started making home loans to the borrowers with inadequate credit history or inconsistent income. and to the smartest of investment bankers and risk managers” (Pattanaik. from regulators in advanced financial markets. subprime borrowers could not present such information. Hence. When demand for money increases. The trust of the public was lost and it may take some time until it is restored again. Nonetheless. In the literature.investors and the US government. the matter of banks’ exposure to market risk with the subprime loans can be argued. “This sub-prime crisis has exposed almost every responsible entity in the market. So. 2009). An attempt will be made to critically review the literature that blames one or the other entity for initiating the subprime mortgage crisis and the global credit crunch as an outcome. Knowing the causes will also help to prevent the occurrence of similar financial mistakes in the future. The truth is it is very difficult to single out the major cause or the most responsible party. to central banks. It may be done by tracking the records of past earnings and job consistency. So. to rating agencies. the credit risk of such borrowers was very high. It may be because they were first time buyers. the lender should estimate the probability of such default. While prime borrowers normally have a good credit history and sufficient income to make monthly payments on the loans. Interest rates are the price of using borrowed funds. to international standard-setting bodies. There is credit. Banks offered adjustable rate mortgages to the subprime borrowers that had to be refinanced within the next several years. 2009:22). However. interest rates are pushed upwards to restrain it. young and thus without a long credit history or without a permanent job that would offer a steady income. banks and lending entities offered them loans to buy residential property (Pattanaik. It implies that interest rates are not constant and they tend to change as the government conducts the monetary policy to stimulate or restrain economic growth. Fixed rate mortgages increase the market risk since the banks and lending entities cannot adjust the rate to the new market interest rates. Identifying the causes of the financial crisis is very important since they may shed light on the most responsible entities that should be blamed. it is valid to argue that the subprime mortgages did not have fixed rates. all these bodies are criticised for their flaws. The second type of risk that was mismanaged is the market risk. Credit risk implies that a borrowing party may default on the debt. Pattanaik (2009) argues that the key factor that caused the subprime mortgage crisis was mismanagement of risk by commercial banks and lending entities. liquidity and market risk associated with any lending.
The presence of subprime loans among the assets of commercial banks would have increased liquidity risk since these loans are potentially less liquid than prime mortgages. banks would risk failing to sell the collateralised property at the price sufficient to cover the amount of the loan. So. The subprime borrowers themselves can be blamed for taking the loans on which they were likely to default. Even if they could afford to make monthly payments on the loan with an introductory low interest rate. There was no backup. This raises liquidity risk of commercial banks and lending entities (Whalen. The probability of several subprime borrowers to default is greater than the probability of prime borrowers’ default. any changes in the interest rates on their loans will affect their solvency. refinancing of subprime mortgages would not be possible. So. However. the adjustable rate mortgages increased the credit risks of the banks and lending entities. the lenders should have foreseen that all markets. Moreover. the bank would have to wait until the property used as collateral is sold. When mortgage loans were made to the subprime borrowers. 2008). in order to turn the defaulted loan into cash. it would be difficult and nearly impossible for them to serve loans when they are refinanced at a higher rate. The other type of risk faced by lending entities is the liquidity risk. This risk was even higher since the subprime borrowers could not afford to make substantial downpayments or initial deposits on property. tend to fluctuate. It is valid to argue that at least two of the observed types of risks increased with the introduction of subprime mortgages to the banks books. Moreover. However. So. In case of property depreciation. However. Thus. risk was poorly managed since the lenders had a strategy that was suited only for the growing housing market. So. very few people would reject an opportunity to own a home when 14 . Neither real estate nor securities increase in value perpetually. whether it is the property. the house prices should not have been taken too optimistically by lenders. the banks issued them against the deposits of households that were more liquid than the mortgages. stock or commodity market.cash flows and they protect banks against fluctuations in the market. It is valid to argue that banks’ managers can be justified in their decisions to lend to subprime borrowers since they were creating a cash inflow for the banks and in case of a default the property used as a collateral could be sold at an auction. it should not be forgotten that many of the subprime borrowers did not have a steady income. the risk was minimised especially when the real estate prices were going up until 2007. The risk could be managed well if they had a strategy for both the upward and downward direction of the housing market.
2. The increasing default rates among subprime borrowers left more houses foreclosed and placed at auctions. In order to save themselves from this situation. A level of liquidity had to be maintained to back deposits and new loans could not be made. Commercial 15 . this is exactly what happened in 2007. In a very short time during the year 2007. the natural human desire for better life and personal home cannot be blamed for the crisis. a secondary market for mortgages has been operating. banks did not necessarily expect that these customers would pay off the loans. However. Since 1938. This would put pressure on the house prices and they would go down. It can be argued that it was not only subprime borrowers that defaulted on mortgages that caused the housing market collapse. they should be blamed for making unethical deals with the subprime customers. they expected to sell collaterals while the house prices were high. This would leave prime borrowers with high monthly payments and low equity. one thing that was underestimated is that the defaults could be massive instead of individual or local. Thus. MBS. Process of Securitisation (ABS. So. Otherwise. Banks and lending entities that could not sell collaterals found liquidity problems that created credit constraints. Other homeowners could see that the value of their property decreased and situations arose when the mortgages on the houses might exceed the actual value of the equity. prices had to be dropped. In fact. Supply of foreclosed properties started exceeding demand and in order to sell. the subprime mortgage market caused a credit crunch that eventually spread overseas. a panic was created when there were many sellers in the real estate market and very few buyers. Since the risk of their default was high. They were interested in receiving cash flows and if defaults occurred.4. the housing market in the US underwent a massive crash. The responsibility lies on those who used subprime borrowers to earn more money.lenders offer special deals to finance the property. some of the prime borrowers also started putting their homes on sale expecting that prices could go further down. Banks became even reluctant to make short-term loans to each other. If managers knew that property prices would fall sooner or later. Thus. This corporate greed drove banks’ managers to take on more risk and capitalise on the opportunities offered by the growing housing market. the mortgages held by the banks would have become illiquid. CDOs) It is valid to argue that not all subprime (and even prime) mortgages appeared on the books of the lenders.
these borrowings contributed to the national debt. Now. Fannie Mae used borrowed funds to buy mortgages from lenders or originators. If this is the case. the mortgages were financed through the corporation. Instead of borrowing. This eliminated or reduced all types of risks discussed above. The diversified portfolio allowed managing risk better than it would have been managed by individual lenders. All types of risk (credit. Originally. the banks invested their excessive cash in the mortgage-backed securities (MBS) and thus were left with some of the risk. 2007).banks could easily sell the risky mortgages to investment banks and corporations such as Fannie Mae. thus. Although mortgages were sold to other parties. Fannie Mae was the first entity that started buying mortgages from commercial banks and other lenders and thus created a secondary market for them (Randall. 2007). Some of the risk could return back to commercial banks and lending entities if they acquired these mortgage-backed securities to diversify their portfolios. taking this into consideration. financing of mortgages acquired from originators changed. 2007). So. When defaulted homeowners could not provide monthly payments to the investors in MBS (that included commercial banks). Around this time. 2007). banks’ managers can hardly be blamed for taking on excessive risk since they shifted it to other entities. liquidity problems in the 16 . It was the reason why a decision was made to privatise the corporation back in the late 1960’s. However. So. In 1970. this explains why credit constraints were faced by commercial banks in 2007 and 2008. It was called Freddie Mac. they were no longer on the books of banks. In this way. Simply. Originally. liquidity and market) were carried by Fannie Mae. the size of the corporation allowed bearing more risk (Randall. it is valid to argue that the risk itself was not eliminated. In order to make the mortgage market more efficient and allow banks and loan associations to provide more home loans to customers. This allowed banks to meet liquidity requirements set by the US government and make more loans to customers (Randall. This risk was treated as less significant since the corporation was large and held a great amount of mortgages from all parts of the US. then how did the credit crunch develop and why commercial banks ran short of liquidity? The answer lies in the process of securitisation and further distribution of mortgages. the risk was transferred from the lenders to investment banks and. investment banks that buy mortgages are exposed to the risk. another similar corporation appeared on the scene. it was a governmentowned corporation that bore official name Federal National Mortgage Association. Since it was a government corporation. the corporations created mortgage-backed securities and sold them to investors (Randall. Lenders received payments for the mortgages and shifted them to Fannie Mae.
The reality showed that even highly rated CDOs were in fact much riskier than what was assumed by investors. 2009). When the defaults on mortgages increased and house prices started going down. But could these ratings be trusted? 2.banking sector started to show up and the credit crunch developed (Trimbath. Contribution of Credit Rating Agencies to the US Subprime Mortgage Crisis Nowadays. In the past decade.5. a number of investment banks such as Lehman Brothers and Merrill Lynch were involved in securitisation of subprime mortgages and selling collateralised debt obligations (CDOs) and other asset-backed securities (ABSs). there is a conflict of interest arising (Rom. Since higher rating helps to sell security to more institutional investors that are risk averse and prefer safe investments. Lander et al. Secondly. And since the rating agencies are paid by the issuers of the securities. Is their role in creation of the sub-prime mess really significant? CRAs are the intermediaries in advancement of securities on the market between the issuers and investors. firstly. The existence of CRAs is natural because of the presence of a great number of consumers that need CRAs’ services. 2009. 17 . the contribution of Credit Rating Agencies (CRAs) to the development of the US sub-prime mortgage crisis is widely discussed. The least risky tranches were acquired by pension funds and similar institutional investors that were risk averse and invested for long term. CRA is a necessary link in a chain of life cycle of residential mortgage-backed securities (RMBSs) and collateralised debt obligations (CDOs). the market for CDOs became inactive as there were no buyers willing to acquire failing securities. lower rating complicated such deals. Even the least risky tranches started losing their value and institutional investors such as pension funds and hedge funds suffered losses. The riskiest ones were demanded by hedge funds. 2008. it was difficult to assess the risk of the investments accurately and buyers had to rely on the ratings provided by large credit rating agencies such as Standard & Poor’s. Gorton. 2009). they render consulting and advisory services. Their activity is based on. Since the tranches of CDOs were very complex. providing ratings to the securities issued by investment banks and corporations. The tranches of CDOs were sold to different investors. Companies that issue securities need to rate them for selling to investors.
and analyst compensation was based on accuracy. the SEC was unable to determine whether the CRA ratings were consistent with their own internal policies. After all. Thus. Finally. 2008:535). he argues that rating agencies were actually involved in repackaging of mortgage-backed securities and provided consultancy services to the issuers. In this case. “Unlike the smaller agencies. so that losing an issuer to a competitor CRA would have little impact on the bottom line” (Rom. Moody’s. fees were based on a fixed schedule. “They [CRAs] have established appropriate policies and procedures (e. 2009:644). not commission) to ensure that their ratings were independent and objective. Rom (2009) argues that the main stimulus of CRAs activity is to keep their reputation by providing accurate. reliable and authentic ratings to the securities. Rom (2009) also confirms that complexity of the process of repackaging of MBSs did not allow for perfect assessment of their true intrinsic value. rating agencies were assumed to be giving credit ratings without proper investigation about underlying risks of each individual mortgage that comprised the securities and CDOs in general. if reputation of a rating firm is lost.There are different opinions about the basis of the CRA’s ratings. As a result. and Fitch – are paid almost all of their fees by the issuers of the bonds being evaluated… Simply put. generating less than 1 percent of the CRAs’ revenues. “Moreover. the Big Three – Standard & Poor’s. individual issuers tend to be small. the SEC review determined that none of the major CRAs had specific written procedures for rating RMBSs and CDOs. Moreover. it will not be able to find clients and its commissions will automatically fall.g. ratings were made by committees. they noted. even for the Securities and Exchange Commission (SEC) it was impossible to check the correctness and accuracy of the provided ratings. Strier (2008) argues that credit rating agencies overvalued the safety of the issued CDOs because they were not interested in losing their long-term clients. and there is substantial evidence that ratings were at times ad hoc. Looking at this problem on the other hand. the suspicion is that CDO issuers may have essentially bought their AAA ratings from the Big Three” (Strier.. the CRAs did not 18 . Moreover. Rom (2009) considers that CRAs undertake numerous actions to avoid a conflict of interests.
The potential users of ratings. Champsaur (2005) argued that CRAs performed their work effectively. the institutional investors have enough resources and competence to make their own assessment of risks. 2003). CRAs argued they should not be held responsible for failing to detect fraud. such as mutual funds and brokers. there were investors who unconditionally accepted CRAs’ credit ratings 19 .have specific policies or procedures to learn about and correct flaws in their rating models” (Rom. since verifying the accuracy of financial and other information through a due diligence process was not part of their work” (Champsaur. providing fair and adequate credit ratings prior to 2005. Past studies of rating agencies suggest that there were no problems with fraudulent ratings although the CRAs were paid by the issuers. 2003). in cases such as the Enron collapse. The following question can be asked: Are the credit ratings of CRA’s really accurate and reliable? Champsaur (2005) arguments are as follows: “Studies conducted by CRAs themselves as well as other empirical studies tend to show that credit ratings are usually reliable. None of the well respected investment firms should get involved in the projects without proper assessment of risks. rating agencies cannot be blamed for causing the crisis. take the rating CRAs’ information with a view of carrying out their internal analyses and decision making on capital investment (SEC. failed to provide correct ratings. in fact. In addition. Undoubtedly. “These firms typically have their own internal credit research department staffed with analysts who use rating issued by credit rating agencies as one of several valuable “inputs” to their independent credit analysis” (SEC. 2009:647). Since the mutual funds and other entities had special staff that was employed to conduct analysis of mortgage backed securities and CDOs. Using ratings only as a guide for investment decisions does not seem to be professional. 2005). it is important for users to receive authentic credit ratings. Rom (2009) argues that among the participants that contributed to development of the US subprime mortgage crisis. in the sense that they generally provide a correct assessment of an issuer’s or debt instrument’s credit risk. Although the large credit rating agencies.
without any checking. as well as more specific disclosure about the information and documents reviewed by the rating agency” (SEC. 20 . many investors undoubtedly relied on the ratings rather then doing their own due diligence on the composition and quality of the products they were buying. So. for the most part. there is a conclusion that issuer-agency conflict should be successfully operated by CRAs. Also. SEC (2003) has noticed that conflict of interest is based on “issuer-fee-model” that means that the amount of CRAs’ compensation (fee) is in a conclusive dependence on credit ratings that they provide. there is a chain of errors made firstly by the CRAs and then by investors that led to aggravation in the market. Investment decisions were made in the absence of any original research. SEC (2008) has found a lot of errors (which generated troubles and mess) that CRAs had done in the course of their activity. During the sub-prime boom. time horizons for achieving certain financial goals. They would like more information about the assumptions underlying the rating (e. company and industry expectations. it would have been difficult for them to do so. 2003). has been effectively addressed by the credit ratings agencies” (SEC.g. They did not always even follow their own methods. But even if the investors had sought to conduct due diligence. “Given the securities’ complexity. At times making “out of model” adjustments” (Rom. specific events or financial triggers that would prompt a rating action). “Buy-side representatives generally felt there should be more public disclosure from rating agencies about the reasons of their rating decisions. and they did not do so. 2009:646).. most were of the view that this conflict is manageable and. Conflicts of interest between issuers and CRAs are wildly discussed in the literature. There was no public disclosure of the rating process and methodologies that were applied. “While the issuer-fee-model naturally creates the potential for conflict of interest and ratings inflation. The ratings seemed to be unexplained and appearing out of thin air without proper grounding. 2003). the CRAs were not specifically obligated to disclose their detailed ratings methodologies or complete information about the underlying assets.
The problem – conflicts of interest – is also considered in the empirical research of Strier (2008). Even absent consolidation. The opposite opinion belongs to Partnoy (2008). He allocates three types of problems with accurate ratings. which could lower their costs for this service. that measures on competition increase are not effective. Greater competition also could stimulate innovation in the technology and methods of analysis of issuing credit ratings. “Nor is it clear that opening the market to competition would generate any new information value. 2008). The first type is concerned with providing consulting services to the issuers whose securities are rated by the same agencies. Champsaur is convinced that credit rating market will receive an opportunity to reduce and control (to a lesser degree) the conflicts of interest. 21 . The influence of competition could be both positive and negative. And the third one is based on the observation that rating agencies tend to be unwilling to downgrade the securities they have rated. and perhaps counterproductive. Overall. there are no considerable advantages to pay attention to. choice. He argues. There are many approaches that can be suggested to create a healthy credit rating market. The second conflict is that CRAs may be inclined to provide higher ratings to their customers in order to keep them. There is a great necessity of credit rating market changes to minimise its negative influence on the mortgage crisis. opening the market to new NRSROs seems a weak. “Issuers would be provided with more choice in terms of selecting NRSROs to rate their debt securities. The greater competition on the market for credit ratings and analysis could provide for more credible and reliable ratings. This creates a conflict of interest. A great attention is paid to the question of possibility for new agencies to enter the market to reduce the monopoly of the Big Three. there is an argument that opening the market to competition could make regulatory licenses more important. 2005). by creating incentives for rate shopping among issuers. even if it would be superior to the current approach” (Partnoy. The appearance of competition on the market will impact on CRAs’ activity by limiting their privilege state. which could further lower barriers to entry” (Champsaur.
2009). 22 . the government can eliminate the problem of misleading ratings and restore the confidence and trust of investors.In order to reduce the conflict of interest Barwick (2008) suggests a new form of CRA’s compensation to be adopted such as subscribers’ fees. By taking this measure. government-owned agencies may be formed as independent bodies that will not be motivated to please issuers of securities they rate because there will be no buyer-seller relationships between them. They (agencies) would remain accountable to Congress. financial markets would be required to obtain a rating by the public agency before they could be conducted legally. 2008). they seemed to be preferable investment for institutional clients such as pension funds. financial market has been overflowed by sub-prime mortgages underlying RMBSs and CDOs and their risk was underestimated.6.S. 2. when mortgage-backed securities lost much of their value. It will allow investors to be assured of the quality of the ratings and financial markets will therefore become more transparent. the U. This proposition of a government-owned or government-sponsored rating agency was offered by Diomande et al (2009). Transmission of the Subprime Mortgage Crisis to the EU The sub-prime mortgage crisis started in the U. For the last five years.S. They would receive no benefits as such from providing either favorable or unfavorable ratings” (Diomande et al. The staff of the public agency would be compensated as high-level civil servants. including through providing annual public reports on their operations. S. Alternatively. “We propose that all private business issuing securities that are to be traded publicly in U. The problems began when “foreclosure and default rates went up and housing prices went down” (Aalbers. It has been argued that the creation of a public credit rating agency would help to avoid conflicts of interest and eliminate incentives to receive an incredible fee. Since the securities were rated safe (AAA rating) and had property pledged as collateral.
The problem of keeping bank’s activity going became the primary issue for the fifth-largest mortgage lender of the UK – the Northern Rock. The main task for German banking system was to rescue IKB Deutsche Industriebank that incurred losses despite cash injections. Liquidity problems took over the bank. 2008). Freddie Mac and Bradford and Bingley. suffered greatly and became incapable of surviving without support of the governments (Woods. Investors all over the world were confident of low risk of the CDOs and MBSs portfolios and since they offered higher returns than US Treasury bonds (although their rating was the same). The German banks have also suffered because of holding a numerous part of resources in mortgage-backed securities. Hall (2008) argues that the British banking system felt negative influence of sub-prime mortgage crises not to a less degree than other countries. The other German banks such as HSH Nordbank. Since other banks were also hit by the subprime mortgage crisis. When the rates of default started to increase. The case of Northern Rock 23 . It was saved by the government that temporarily nationalised the bank (Hall. As a result. They had the rating of Treasury Bills but it can be argued that the risk was significantly higher. 2008). Most of them were reluctant to lend. Coleman (2008) argues that the geography of sub-prime mortgage crises covered banking systems “from Norway to China and the Middle East”. The main mortgage lenders in the US and UK. the lending institution found the securities it held rapidly losing their value.Securitised assets with underlying subprime mortgages had different level of risk. US residential mortgage backed securities went out to the international credit markets. it was difficult to cope with the problem by borrowing from other financial institutions. such as Fannie Mae. The lender used asset backed securities with underlying subprime mortgages as one of the important sources of funding. Commerzbank and Deutsche Bank have also suffered substantial losses. the crash of mortgage market covered participants in different countries and the crisis spread beyond the borders of the US. it is valid to argue that even the safest CDOs with underlying subprime mortgages were much riskier than what was perceived by the investors (Aalbers. 2009). The least risky were preferred by institutions such as pension funds. The US sub-prime mortgage crisis has made the market for mortgage backed securities inactive and it was difficult to assess the value of the financial assets held by Northern Rock. Although this division in exposure to risk was present. Other tranches of CDOs contained even more risk and were sold to risk seeking clients such as hedge funds. mortgage backed securities enjoyed high demand.
that there was not any attempt to limit anyone to access his (her) account: the branches were working in a usual way. Recently. By increasing the portion of sub-prime mortgages in its 24 . Hall (2008) argues that Northern Rock officials disagree with the conclusion that their business policy was inefficient. there was no need to do so (BBC News. before the signs of crisis appeared. This can be proved by the run on Northern Rock that happened in 2007. however. “…the Treasury Committee is clear in its assignation of blame: “The directors of the Northern Rock… were the principal authors of the difficulties… (they) pursued a reckless business model which was excessively reliant on business funding. Northern Rock had increased its mortgage market’s share considerably. He argues that other lending companies of the UK were not as much impacted by the crisis as Northern Rock was. The government. He argues that in order to increase earnings. Northern Rock spokesmen. financial institutions operated irresponsibly. access to the accounts through web-site was limited but not closed because of a great number of customers. Several cases concerning refusal of the customers to access their accounts took place. Moreover. They argue that the model of risk testing they have used was effective and reliable. managed to stop it by nationalising the lending institution and making deposit guarantees (BBC News. The reason why Northern Rock lost stable position on the credit market lies in its internal policies and poor management. The Financial Services Authority systematically failed in its regulatory duty to ensure that Northern Rock would not pose a systemic risk” (James. Public confidence and trust in the banking system of the UK was shattered. 2007). James (2008) suggests another opinion about the contribution of sub-prime crisis to the British banking problems of liquidity. 2007b).was the first major example of how the subprime mortgage crisis impacted the UK economy and banking sector. At the same time Brian Giles. They became a victim of a crash that no one expected. declared. James (2008) also argues that there was a lack of transparency in the UK financial institutions. 2008). The origin of all problems they faced consists in unpredictable events. Hall (2008) makes a conclusion on how fragile the banking system of the UK is in the light of all the events. 2007a. The effects felt by other lending institutions were present but not as strong.
. The Bank of England has already conducted loose monetary policy and reduced the base rate to almost zero. Bruno (2009) observes that financial condition of Northern Rock was critical and that is why it had to seek financial help. So. this deterioration of business activity will lead the country into deeper national debt and larger budget deficits will be created. Robins (2009) argues that the local governments in the UK were also unprotected from negative impacts of the crisis. Members of G7 already performed substantive 25 . Europe and Japan. Among the numerous suggested approaches. The revenue from tax collections decreased as businesses were closing and the rate of unemployment was going up.portfolio. it is necessary to allocate the following. Northern Rock was given transfers of emergency loans. S. They were hoarding cash to be able to meet their financial obligations and were not so much concerned with making new loans especially to failing banks. depositors were expected to become more confident and stop the run on the bank. There were no institutions that could offer financial help because credit crunch made banks more cautious and risk averse. the government made a decision of Northern Rock nationalisation for uncertain term. it is valid to argue that in the longer run. Lower interest rates make it easier for banks to raise cash from the lender of the last resort. Northern Rock took excessive risk and put to risk the deposits held by the UK households. these expenses will have to be paid in the following years. Additional cash was injected into the financial system in order to help avoid bankruptcies of financial institutions. After this step. This will help the customers to have more confidence in the banking system and keep their deposits with financial institutions. However. The decision of cooperating efforts to struggle with the tidal waves of the crisis by infusing cash into the market was adopted by the central banks in the U. It is valid to note that coordination and consolidation between countries is very important during the global financial crisis. The tax burden for companies and individuals may be expected to rise when the economy stabilises. Gotham (2009) carries out an analysis of the measures that can return stability in the British banking system. The rescue measures that are currently attempted may have positive results. Since the UK had already accumulated budget deficit prior to the crisis. The only party that could rescue Northern Rock was the Bank of England. The other important measure taken by the government was the insurance of all deposits. The only way to save Northern Rock from liquidity problem was to nationalise it.
Overview The purpose of this chapter is to introduce the methodological approach employed for the conducted research in the context of this paper. The general line of reform was to suggest methods for coping with liquidity problems in the economy and for expanding oversight of financial institutions (Coleman. METHODOLOGY 3.2. 2008).provisions of reforms at the Financial Stability Forum. the data sources employed and the formulation of the research process adopted. through which the most suitable approach to the research question is selected. Research Design 26 . This chapter also presents the data collection methods. It represents an argument.1. 3. Further research will be conductd to access the impact of the subprime mortgage crisis on the five major banks in the UK. 3.
The main focus of the research is on the orgainsational performance of the major UK banks in the period of the credit crunch. Deductive approach is completely different in its nature. The structure of the study that is 27 . (2002) make an emphasis on the fact that the inductive approach is the most appropriate for small samples rather than large. (2007) and Easterby-Smith et al. Inductive approach can be defined as follows: “Research approach involving the development of a theory as a result of the observation of empirical data” (Saunders et al.. The main characteristic of such an approach is that a hypothesis or theory can only be generated after making some observations of qualitative and quantitative data. It can be defined as follows: “Research approach involving the testing of a theoretical proposition by the employment of a research strategy specifically designed for the purpose of its testing” (Saunders et al. Inductive approach is useful in those areas of studies that are not well investigated or there is no available theory to explain certain events. observation of statistical or empirical data will eventually lead to conclusions and the creation of a hypothesis or a theory. There are two major approaches that can be used: inductive and deductive. The result is seen in the changes of financial indicators of banks such as profitability. p. One of the first steps that had to be made were to choose the approach to the investigated phenomenon and the type of philosophy by which the process of investigation will be guided. The main question that should be answered in the course of the research is whether it was the credit crunch and liquidity problems in the banking system or non-resilient planning and decision making mechanism that created financial problems and led to the worsening of the organisational performance. 2007. a research can develop inductively. Deductive approach is primarily associated with the philosophy of positivism that attempts to explain all phenomena by science or scientific methods. This is because it is mostly associated with a case study strategy that involves exploration of the context. Saunders et al. In other words. 3.Research Approach Selection The way the research project is designed often determines its final outcome. 2007. p. If the theories are scarce and an original hypothesis cannot be made. in which a phenomenon develops rather than the content itself.599). The choice of the approach would determine the whole structure of the research project.3.596). Organisational performance can be measured by a quantitative assessment of managerial decisions and planning.
2002. if the tests demonstrate that statistical observations prove the hypothesis. 3. the study is not being guided by positivist philosophy that has room only for one scientific explanation but rather by interpretivist approach.4. there cannot be one and another. an assumption is made that non-resilient planning and decision making of the managers of large financial institutions caused the current problems in the banking system rather than the subprime mortgage crisis itself. Particularly. Otherwise. the basic approach to this particular research is deductive. the research will evolve around different testing to prove or disprove the hypothesis. However. So. p. So. Creswell (1994) and Saunders et al (2007) argue that a piece of research might have to deal with a topic that cannot be easily disclosed using only one approach. the hypothesis is rejected and a new theory can be built instead to replace it (Robson.approached deductively would be very different from an inductive approach. However. it is being accepted. The testing can be normally conducted using statistical and econometrical tools and instruments. Collis and Hussey. Sauders et al (2007. a theoretical hypothesis or statement has to be set. Finally. Secondly. Firstly. but also in our experience it is often advantageous to do so”. The assumption will be tested but the findings may suggest a different explanation of the current problems in the banking sector. Saunders et al (2007) point out that deductive approach often lacks an alternative for explaining a phenomenon. They imply that all values are absolute. It is rather either one or another explanation of an event or phenomenon. In the context of this research the impact of the subprime mortgage crisis on the major banks in the UK is investigated. Scientific methods do not allow this. 2003). There may be many theoretical works available on the subject and deduction can be used to test one or several theories proposed in the literature. In fact.119) argue that “not only is it perfectly possible to combine deduction and induction within the same piece of research. a deeper investigation can be made by utilising inductive approach as well. the elements of inductive approach will also be present in this paper. Therefore. 28 . The benefits of the combination of inductive and deductive approaches Combination of inductive and deductive approaches in a single study is not a new idea. This assumption will be tested by applying financial data obtained from annual reports of the banks.
This strategy was rejected because simulation would not be accurate since there is much uncertainty over the fact what profitability would be in different economic circumstances. 2000). a simulation could be attempted to project profitability of major UK banks in the conditions without liquidity constraints. All these strategies could have been perfect for exploring other phenomena but. action research and grounded theory. The disadvantage of using a survey strategy for the assessment of the impact of the subprime mortgage crisis on the UK banks is that managers that participate can be biased in their answers and the data would have lacked validity. 2007). The benefit of such a combination is that the research will not have to be limited by a strictly ordered methodology as in the purely deductive studies. none of these was adequate for the purposes of this particular study.5. It allows detecting causal relationships between the events or variables observed in a study (Hakim. there were surveys. for several reasons. Survey strategy offered a variety of data collection methods.So. The results would be compared to the actual profitability and the experiment would have demonstrated to what extend credit crunch undermined financial indicators of banks. this research project attempts to answer the main question set in the introduction to the study by using a combination of the described approaches. experiment. deduction can be singled out as a predominant approach but whenever it is necessary. Among the data collection techniques that could be used in surveys are interviews. a chosen dependent variable is tested for changes by applying the effects of certain independent variables. The emphasis would have been made on the primary data because survey are mostly used in the researches that lack secondary data and there is a need for additional information. Among the strategies that were rejected. For these reasons. in a successful survey quite large samples with many observations would have to be retrieved in order to perform an analysis. Experiment is one of the most commonly used strategies in science. archival research. questionnaires and others (Saunders et al. induction is used to draw the context and disclose the qualitative side of the investigated phenomenon. 3. it will not be a too much of a qualitative investigation and inquiry into the context as in the pure inductive studies. Nonetheless. other strategies had to be reviewed. Moreover. On the other hand. For example. The limited observations of financial data did not allow making valid projections either. In an experiment. Taking into 29 . Research Strategy Multiple strategies have been reviewed in order to choose the one that fits the area of the study and that would allow the most rational process of investigation.
p. This is a quite specific research strategy that does not fit every study. Grounded theory is still more of an 30 . there is no great need to conduct an additional survey to enhance the data with primary sources. this strategy was not appropriate. Archival research is one of the strategies proposed by Bryman (1989). it cannot be treated as archival. studying only one bank would not allow making a valid conclusion as to what extent the banking sector in the UK was impacted by the subprime mortgage crisis. The final argument against the survey strategy is that financial information for major banks in the UK is already available from secondary sources such as the annual reports or websites such as Yahoo! Finance (2009). Action research can be a good strategy for investigating managerial issues and the impact of financial crisis on an organisation such as a bank. A single bank would not be representative of the whole sectors. Grounded theory is another strategy that was viewed as an alternative option. It can be argued that this research strategy has a limitation since only one organisation is being investigated. it would not be possible to assess whether it was non-resilient planning and decision making in the lending institutions that deteriorated their organisational performance or the external factors. The strategy is a theory or hypothesis builder.141). Since organisational performance can be assessed from these reports. For this reason.account the fact that about a half of the questionnaires sent may not return with responses. It relies on the collection of previous historical documents that allow tracing the tendencies and trends over a given period. 2007. A researcher should become a part of an institution to explore its internal processes (Coghlan and Brannick. Action research represents an “involvement with members of an organization over a matter which is of genuine concern to them” (Huxham. It is quite flexible because it allows a combination of deductive and inductive approach in a research project (Goulding. Similarly. So. Although. this strategy was also rejected. The development of a theory occurs by observing and analysing the behaviour of research participants. It is often concerned with testing of different forecasts that are expected by researchers. This strategy was rejected since the aim of this dissertation was not to make predictions but investigate what weakened organisational performance of major banks in the UK. However. 2005). using this strategy would have caused risk of obtaining too small samples that would not be useful in conducting further analysis. It was rejected because the research question is primarily concerned with the fact how banks were impacted by the US subprime mortgage crisis in the present period rather than in the past.75 cited in Saunders et al. p. secondary data is predominant in the study. 1996. 2002).
The dissertation contains all three types of studies provided by Saunders et al. 2003). The next section will present the methods and data collection techniques that were used in the research project. Since the research was meant to include a sample of several banks. It is essential for better understanding of the investigated phenomenon. Elements of descriptive study are present to draw the context of the phenomenon. making generalised conclusions and accessing quantitative information that could not have been retrieved by surveys. Thus. Therefore.inductive study. The data for the period after the subrpime mortgage crisis is already available in the annual reports. It allows observing different cases of different banks. Primary data represents the data gathered solely for the purpose of the research project in question. whereas secondary data can be presented by the sources already available to the researcher from previously carried out research projects (Saunders et al. They are publicly available and audited.. financial statements’ analysis was selected as the primary strategy of conducting the research. 2003). There is an exploratory part in the literature review. The data available and the choice of the data collection method is interrelated with the research strategy.6. 3. although it allows combination with deduction. (2007). It can also be gathered in quite short time because time consuming surveys are not required. a quite different strategy had to be applied. comparing findings. This data can be treated as reliable and valid. Annual reports contain both financial information for the banks and organisational issues such as forecasts. risk management and others.. explanatory study was used to disclose the causes and causal relationships between different variables. The final choice of strategy was made after considering the type of data required and the research objectives.7. This dissertation is more of a deductive study. 3. the most rational source of data would be the annual reports of banks. Finally. Data Collection Method The data that is investigated for the purpose of a research project can be of two kinds: primary and secondary (Saunders et al. Data Collection Techniques and Methods 31 . The secondary data in the context of this research is presented in the literature review that represents the sum of existing knowledge on the research question.
There are multiple techniques available to collect the necessary data for a research project. 3. This research project is concerned with both quantitative and qualitative aspects of major banks’ performance in the pre-crisis and post-crisis period. The effects of managerial planning and decision making will be assessed by analysing the expectations of managers in 2006 before the crisis hit the economy and the outcome in 2008. These findings will be compared among the banks to select the ones that performed worst from the total sample. Regular activities of the banks such as making loans and receiving deposits will be analysed to find out whether they were affected by the crisis.8. The Research Procedure The procedure will be as follows. retrieving statistical data from secondary sources and others (Saunders et al. Impairment losses on loans are connected to the amount of write downs that had to be done by banks. These can be structured interviews. questionnaires. The second step involves the assessment of managerial issues. FINDINGS AND ANALYSIS 32 . As a first step. This will increase validity and reliability of the data collected (because the reports are audited by a third party) and allow finding answers to the research questions. each case can be individually assessed using annual reports published by the financial institutions. expectations of managers in the pre-crisis period and the main sources of funding. profitability of the large banks will be evaluated. 2007). High correlation coefficients in the latter would indicate that credit squeeze in the banking sector was the major influence on profitability of the financial institutions. Since the sample consists of only five largest banks. Calculations will be made using accounting ratios such as profit margins and returns on equity and total assets. Correlation analysis will be undertaken to reveal the relations between the impairment losses and profitability and the amount of loans provided to other banks and profitability. 4.
With the UK government having to resort to temporary partial nationalisation of the UK Banking Sector through the bail outs part of the UK Banking Sector became state-controlled. Further analysis of the UK banking sector (PESTEL and SWOT) is presented in the appendix. whereas the outlook for Northern Rock and RBS is painted in much darker colours. However. Following the subprime crisis the level of regulation in the banking sector is perpetually increasing with new risk management policies introduced. the decrease of the population’s levels of disposable income and the current state of the interest rates suggests that in this volatile economic conditions making reliable forecasts still remains challenging. Lower levels of investing and spending also have a negative effect on the performance of the UK banking sector. Among the unarguable leaders striving amidst the economic crisis are such banking institutions as Barclays and HSBC. it has its leaders and laggards. Another possibility for the UK banks lies in expanding their presence to the developing markets where they could achieve high profits due to the rapid development of the economies of China. India and the Middle East. which is required to fight the economic downturn. which drove up the profits of Barclays and HSBC for the first half of 2009. 33 . In these conditions the Bank of England should be improving the interest rates and stimulating spending and investment so that the UK businesses and banks could show better performance. The recessionary economic conditions are also to blame for the capital being unable to find application in industry and trade. Fewer commercial and consumer loans are taken from banks as the development of the businesses have slowed down and they are now reluctant to invest and are cutting costs instead.UK Banking Sector Analysis Weakened by the current economic conditions UK banking sector does not however represent an even picture. there are some positive trends. The rise of unemployment. This might have a negative effect on the development of the banking sector. It has been noted that the investment banking was doing particularly well amidst recession. too. which has implications on the ways these banks are managed as well as on their performance. Another important concern of the British banking sector lies with the shattered public trust in banks and the ensuing low deposit volumes.
Financial performance of major banks substantially deteriorated in the period since 2007. these goals are not always reached. However.2. The management sets the goals to maintain high profitability and provide the best return on investments. This will demonstrate the impact of the subprime mortgage crisis on the dynamics of income in major UK banks and their ability to retain profits.1. Financial annual result is the most observable indicator of a bank’s organisational performance. Financial performance of the chosen banks can be assessed by analysing profitability ratios and indicators in the period from 2006 to 2008. Changes in its financial performance are shown below. Northern Rock Northern Rock was one of the first banks to be impacted by the subprime mortgage crisis.2. Financial Performance of the Major UK Banks The US subprime mortgage crisis greatly impacted the UK banking sector.4. 4. Figure 1: Northern Rock Profitability 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% 2008 2007 2006 Gross Margin Pre-Tax Margin After-Tax Margin 34 .
it fell to 11 per cent. The number of loans that they can make depends upon the liquidity maintained by the institution and its reserves in the central bank (Bank of England). The overall amount of interest paid on the deposits fell from £6. The cost of sales in a corporation is determined by the prices of materials sourced and labour costs to produce a product. In spite of these measures of the government. There is a steep declining trend observed in the gross profit margin of Northern Rock. When liquidity of Northern Rock was shattered in 2007 as the effect of devaluation of the mortgage backed securities held by the institution. A run on the bank accompanied the panic and the UK government took bold measures to nationalise the lending institution. 2008). 2008). 35 . All deposits were guaranteed and the run on the bank stopped. In 2008. Liquidity is determined by the amount of deposits and current accounts made by individuals and corporations. Liquidity problems started and they were reflected in the pre-tax and after-tax losses suffered in 2007 and 2008. It was driven by the fear that Northern Rock would go bankrupt and customers would risk losing some of their deposits.6 billion in 2008 (Annual Reports of Northern Rock. Gross profit margin is. Profitability of Northern Rock fell to almost -3 per cent (calculated as after-tax net profit margin). Northern Rock was a profitable lending institution with gross profit margin being a little over 17 per cent and net after tax profit margin being almost 9 per cent. the panic occurred in the UK. It can be equivalent to the revenue from sales received by manufacturing companies. In banks.1 billion in 2007 to £5. The reduction of the number of deposits in Northern Rock led to a decrease in reserves held in the Bank of England. In 2008. the indicator reduced to less than 1 per cent. the bank could not make as many loans as in the previous periods. Banks cannot be viewed as regular manufacturing corporations. net profit margin fell further and reached the level of -23 per cent (Annual Reports of Northern Rock. As a result. So. prior to the subprime mortgage crisis. the amount of deposits made with the Northern Rock substantially decreased. They do not have sales but their main activity is to make loans and receive deposits. the gross profit of Northern Rock was calculated as the difference between the interest received (from the loans made to the clients) and interest paid (on the deposits made by the clients). the situation is quite different. The overall amount of interest payments received on the loans made to individual and corporate clients constitutes the gross income of the bank. In 2007. then. the percentage of the gross profit in the interest received.Source: Annual Reports of Northern Rock (2008) In 2006.
2 million.7 million. These write-offs were the reason why Northern Rock suffered such great losses in 2007 and 2008. The overall trend can be visualised in the following chart.000 900 800 700 600 500 400 300 200 100 0 2008 2007 2006 Source: Annual Reports of Northern Rock (2008) Impairment losses are suffered by financial institutions when the book value of loans exceeds the net present value of the future cash flows and therefore the assets have to be devalued or brought to fair value. they constituted only £81. the losses more than tripled and reached £894. The amount of loans made to customers reduced from £99 billion to £73 billion in 2008 (Annual Reports of Northern Rock. Figure 2: Northern Rock Impairment Losses on Loans (in £’m) 1. The projection of future cash flows in the period of credit crunch was pessimistic and substantial write-offs had to be made in order to make the book value and fair value of loans and advances nearly equivalent. In 2006. Large expenses were suffered by the lender as impairment losses on loans.Such a downfall cannot be only attributed to the decrease in deposits and the consequent reduction of loans made to the customers. 2008). Figure 3: Northern Rock Return on Equity 36 . The following two figures demonstrate the changes in returns on total assets and equity of Northern Rock after the subprime mortgage crisis.4 million (Annual Reports of Northern Rock. the impairment losses on loans increased to £239. In 2007. In 2008. 2008).
In 2008. Similar situation is observed with the returns on total assets (Figure 4).211 million. Figure 4: Northern Rock Return on Assets 37 .6 million compared against the value of total equity in 2006 that was £3. Adjusting the book value of loans to their fair value led to the overall decrease in assets and reduction of equity. The impairment loss on loans and the write-off of the assets were reflected in the extremely high negative returns on equity suffered in 2008. total equity of Northern Rock was equal to only £633.50% 0% -50% -100% -150% -200% -250% 2008 2007 2006 Source: Annual Reports of Northern Rock (2008) In 2006.8 per cent. the lending institution had a moderate return on equity that was equal to 13.
Northern Rock experienced substantial losses. In such circumstances nationalisation saved the company from possible bankruptcy in the future and restored the confidence of its customers.1% 1% 0% -1% -1% -2% 2008 2007 2006 Source: Annual Reports of Northern Rock (2008) Total assets of Northern Rock were reduced by nearly £5 billion in 2008. Negative returns were already observed in 2007. In 2008. As an effect of the subprime mortgage crisis. 4. After the write-off had been made. total equity of the institution shrank to less than 1 per cent of the total assets.3. a further decrease in returns was suffered. The rapidly increased book losses made returns on assets negative. large amounts of asset write-offs and became nearly insolvent. announcements of financial and organisational performance and future projections for the company. Banks’ Share Price Performance The price of a company’s shares is an indicator of how the market reacts to the news. The analysed banks are public companies and their shares are traded on stock 38 .
The volume of trade is shown at the bottom of the chart in blue and is estimated in millions of shares traded. The activity of the market increased at the beginning of 2009 when more sellers 39 . the market reacted with even higher volume of sales that caused further devaluation of the shares. when annual financial reports were published and the results were announced. In the early 2009. their equity’s market value substantially decreased during the second half of 2008.exchanges. In fact. The share price indexes in those countries lost much of their value and reached the bottom by the year 2009. However. the stock market crashes occurred in other countries such as the US and Russia. That is when the stock market in the UK crashed. The market was expecting poor organisational and financial performance from the banks and these expectations were reflected in the massive selling of the stocks and decrease in their value. The slope of the trend became steeper in October of the same year. The analysis of the share price dynamics will demonstrate whether the market has had an optimistic or pessimistic attitude towards the financial institutions. it was not only a national phenomenon. The share price of three banks whose performance was analysed is presented in the figure below. The financial data for share prices of HSBC and Northern Rock was not available but the general trend of the market can still be observed. the shares of the three banks were on the declining trend. Regardless of the better or worse profitability of each bank. Figure 20: Share Prices of Banks Source: Yahoo! Finance (2009) Throughout the year 2008.
The share prices of both banks plummeted under the pressure of increased amount of sellers. It is valid to notice that not all of the three banks enjoyed a similar appreciation in value of their stocks.4. We increased lending by 23% taking us to the position of the fifth largest UK mortgage lender by stock. the stock market started correcting upwards. Managerial and Organisational Issues 4. Chairman Ridley announced impressive growth indicators of the financial institution. Barclays that was financially the best performing financial institution saw the value of their shares reach the level of the pre-crash period. In the 2006 Annual Report of Northern Rock. Our assets increased by almost 24% to pass £100 billion and we recorded 40 . So. Northern Rock The role of the managerial decisions and non-resilient planning of the Board of Directors is not least important in originating the financial problems suffered by the bank than the external factors associated with the credit squeeze and reluctant lending at the inter bank level. Even the shares of the banks that suffered unprecedented losses (RBS) began to increase in value. Other banks such as Lloyds Banking Group and Royal Bank of Scotland could not enjoy a substantial appreciation of their shares. Since March 2009. no proper strategy for a possible economic downturn and the fall of house prices was developed. “We reached all of our strategic goals and grew both assets and profits to record levels. It is valid to notice that similar trends were observed for the Royal Bank of Scotland that announced record losses and Barclays that performed significantly better financially. This excessive optimism did not allow them to make corrections to their plans. There is an abundance of evidence from the annual reports of the financial institution that speak of the fact that the management team was overconfident in its optimistic forecasts of economic activity.4. This can be explained by the rise of speculation and the appearance of investors that wanted to buy the shares of the financial institutions while they were at the bottom. 4. The prices have not yet reached the level of the beginning of the 2009.1.entered the market to get rid of the shares of the banks that started suffering losses and financial problems.
higher returns on investments and better performance often have to be connected with higher risks taken.well within our newly upgraded strategic range” (Annual Reports of Northern Rock. 2008. this did not allow reducing the credit. By investing financial capital into the risk-free assets. However. university leavers and a falling average household size. to be a little higher again. In order to proceed with securitisation. Support for the housing market remains strong. Unsecured debts continued rising during the economic boom and in 2006. with increasing demand for property in the UK from first time buyers. This year. For example. the bank would have limited its opportunities to earn in high-yield investments. p. Success often blinds the management team and stimulates overconfident planning for the next period. The expectations of the Board of Directors of Northern Rock about future conditions of the economy were well summarised in the chairman’s statement in 2006: “In 2006. 2008). This happens because managers naturally desire to beat the records in the next period.underlying profit growth of over 19% . more 41 . This is combined with a restricted supply of new housing completions. It can be observed that managerial decisions and planning in 2007 was based on the expectations of economic boom and further rise in housing prices. Possible problems and changes in the economic trends were not properly taken into account. the gross market was larger than originally predicted at about £345 billion.2). 2008. This led to the adoption of the strategy that would imply an increase in securitisation of mortgage loans and the number of individual and corporate loans. Low risk does not pay much. we expect the market to be above this and in 2008. the portfolio was valued at £4. the US Treasury Bills can be a risk-free investment but return would be minimal and the performance of the bank would have significantly deteriorated compared to previous periods. immigrant labour. p. Although there is a risk management team in Northern Rock that continually assesses the appropriateness of making unsecured loans at one point of time or another. The remortgage market also remains buoyant as customers seek to refinance at the end of their “teaser” period” (Annual Reports of Northern Rock.2 billion (Annual Reports of Northern Rock. The increased demand for securitised investment vehicles prompted Northern Rock’s managers to offer more of these tools in the market. liquidity and market risks of the bank.2). reflecting house price growth. It can be argued that the recent evidence of success of the bank in the credit and mortgage markets caused excessive optimism in the managers.
However. If this was taken into account decision making and planning would have been more resilient and the bank would have made an emphasis on other 42 . and we would expect this to remain at or about that level going forward” (Annual Reports of Northern Rock.00 0. remains huge. “The appetite for securitisation. the monetary policy of the UK government at that time was already directed at reducing inflation by increasing interest rates. for example. From this statement. representing 43% of total funding stock. Concentration.00 2. increases the overall risk for the financial institution.00 4. was almost twice as little.00 7.8).00 19 94 Q 19 1 94 Q 19 4 95 Q 19 3 96 Q 19 2 97 Q 19 1 97 Q 19 4 98 Q 19 3 99 Q 20 2 00 Q 20 1 00 Q 20 4 01 Q 20 3 02 Q 20 2 03 Q 20 1 03 Q 20 4 04 Q 20 3 05 Q 20 2 06 Q 20 1 06 Q 20 4 07 Q 20 3 08 Q 2 Source: Bank of England (2009) It can be argued that house prices do not constitute Consumer Price Index (CPI) and therefore the government did not mean to cause a housing market crash. particularly in the US and Europe. it can be noticed that Northern Rock increased the proportion of securitisation in the total funding.00 1.2 billion. The management of Northern Rock chose a strategy of relying heavily on the mortgage market while the prices were rising and this was offering an opportunity for high earnings. p.00 6. The changes in the Bank of England base rate are as follows: Figure 21: Bank of England Base Rate 8. The most emphasis was placed on securitisation and there occurred a concentration of sources of funding rather than diversification. in turn. mortgage rates are dependent on the overall level of short-term interest rates in the country. Retail funding. Nonetheless. We now have a total securitisation book of £40. The UK government started increasing interest rates in 2006 when Northern Rock announced record profits. 2008.00 5.individual mortgages had to be bought and repackaged into mortgage backed securities and CDOs.00 3. The managers should have foreseen that tightened monetary policy might have an impact on the situation in the housing and mortgage market.
the managers of Northern Rock were too enthusiastic about the recent success and did not pay proper attention to the warnings from the monetary policy of the government and that contributed to the negative financial impacts of the subprime mortgage crisis. Whilst interest rates have nudged up. It can be noticed that the management of Northern Rock realised the increase of interest rates but the possible effects were underestimated.our core market. Consumers and homebuyers plan their expenditure based on the recent cost of credit rather than what it was twenty years ago. they remain historically low and longterm unemployment also continues to trend at low levels.9). 5. Chief Executive Officer made the following statement: “UK economic fundamentals are set to remain supportive for the mortgage market . FINAL DISCUSSION AND CONCLUSION Global financial crisis emerged from the US subprime mortgage crisis and has already affected many sectors of the economy in different countries. The arguments were made that the level of interest rates and unemployment remained low compared against historical values. However. p. A speculative bubble had been building and lending institutions started taking more risk by including subprime customers to 43 . meaning mortgage affordability remains good” (Annual Reports of Northern Rock.5% (as it was the case in 2006) could cause a significant shift in monthly payments on the loans and fewer credits would be taken. The US housing market was among them. The period of prosperity was marked by the rise of global commodity price and house prices in many countries. Emerging economies started getting rich and imbalances developed between the western countries running budget deficits and developing countries accumulating the US Treasury bills and foreign reserves. However. in late 1980’s the base rate of the Bank of England was very high and exceeded 10% but almost twenty years have passed since that period. Thus. The roots and causes of the crisis lie deep in the processes that had been developing in the past decade.sources of funding. an increase in the cost of borrowing even by 1. In fact. these warnings from the monetary policy of the government seem to be neglected. 2008.
the amounts of interbank loans were not found to be highly correlated with profitability of each individual bank. Therefore. the diversity of the correlation coefficient among the banks does not allow making a conclusion that the decrease in lending to other banks significantly impacted profitability. On the other hand. a number of banks that were analysed showed a decrease in the amount of loans made to other banks in 2008. Northern Rock was the only exception. the majority of the analysed banks showed good results and the increase of gross profit margin. However. This suggests that ordinary banks’ operations such as making loans to corporate and individual clients continued to 44 . the losses suffered after adjusting financial assets to their fair value undermined profitability of nearly all banks in the UK. investors had to rely solely on the ratings assigned by the agencies such as Standard & Poor’s and Moody’s. these institutions appeared to be very inflexible in downgrading risky securities and the problem of overrating emerged from the conflict of interests between them and investment banks that issued the structured debt investments. Lloyds Banking Group and Barclays were the exceptions. The examples of such institutions are HSBC and the Royal Bank of Scotland. Those banks that relied most heavily on funding from these transactions were hit the most by the crisis. After observing the cases of the five major banks. Although their regular operations remained profitable. This proves the hypothesis that the increase amount of write downs and impairment losses substantially undermined profitability of major banks in the UK. However. Recent innovations in financial products that consisted of CDOs and MBSs became very complex even for institutional investors to assess the credit risk properly. Correlation coefficients between the interbank credits and profitability of the financial institutions are demonstrated in the Appendix. impairment losses suffered by the banks were all highly correlated with profitability. the amount of loans made to the clients and other banks decreased. On the operational level. Credit crunch made banks reluctant to provide loans to each other. However. As a result. The highest correlation was shown by HSBC. Financial obligations that could be expected did not allow many of the banks to lend to each other and to customers. In such conditions.their client base. A number of UK banks were directly involved in the process of securitisation. other strong banks such as Barclays continued to lend more in the international markets and their financial performance was significantly better. A part of their income derived from trading CDOs and other asset backed securities.
improve and could have led to higher profitability of the banks. Hence. However. The following future recommendations can be made. A large sample of smaller banks in the UK should be chosen to run a regression analysis with pre-tax profits being a dependent variable. the banks with the worst managerial performance (e. Attempting such an analysis would be time consuming and irrational. Managerial issues such as decision making mechanisms showed to be significant factors in determination of the banks’ profitability. 5. the level of resilience in management substantially determined organisational performance of the analysed banks. Regressing the variable by factors such as the amount of loans made to banks. Not all cases of the banks demonstrated that managerial decisions and planning lacked resilience. the amount of write-offs and interest rates will demonstrate 45 . The bank increased the provision of credit to other banks in 2008 and other banks’ deposits with Barclays also increased.g. It can be argued that credit crunch is more devastating for smaller banks that cannot enjoy the benefits of the economies of scale and international diversification. It can be concluded that the deterioration of the market for the securities traded by UK banks had the greatest impact on the organisational performance of the financial institutions. The problem was observed in the trading activities of the banks and changes in the fair value of financial securities. Freezing up of the money supply or credit crunch was also a factor of lower profitability. This did not allow constructing a regression and statistically assessing the significance of each factor that could impact profitability of the financial institutions. On the other hand. The impairment and trading losses were the main reason why major UK banks showed such poor financial results in 2008. its importance was less significant in large and financially stable lending institutions such as Barclays. Northern Rock) showed significantly worse financial and organisational results. However. Limitations and Future Recommendations The main limitation of the research is that a small sample of banks was used to perform the analysis.1. the amount of loans made to customers. large sample would have limited the qualitative analysis of managerial issues and disclosing the individual case of each bank. Banks such as Barclays proved to be quite flexible in the period of credit crunch and the management team succeeded in taking measures to smoothen the effect of the asset write-downs that significantly affected the income statement of the financial institution.
9932 -0.118751 Appendix B: PESTEL Analysis of the UK Banking Sector Political Factors • • Governmental bail-outs offered to the banking sector suggest heightened governmental involvement that will help financial institutions but at the cost of higher national debt High budget deficit that will have to be balanced in the future by higher taxation of businesses including the banking sector Economic Factors • • • • • • • • • • • Failing institutions cannot provide support to each other and require governmental intervention Low interest rates Low deposit volumes Troubled economic outlook High unemployment rates Shattered trust in banks Negative publicity from the bonus payouts issues in failing banks Low levels of consumer spending Development of online-banking that helps reduce costs Growing online fraud Innovations in credit card services appealing to consumers 46 Social Factors Technological Factors .81699 -0.472071305 RBS -0.67177682 0.86103 -0. The limitation of the model.99987 -0.97163 0.21292 0. APPENDICES Appendix A: Correlation Coefficients Pre-Tax Income HSBC LBG Barclays -0.99593 -0.3275 -0.87315 Impairment Losses Deposits by Banks Loans to Banks Northern Rock -0.contribution and significance of each factor with t-statistic test.45884 -0.959115011 -0.99972 -0. however. will be the inability to observe qualitative factors that can help assess the level of resilience in managerial decisions.
etc. with banking institutions trying to reduce their CO2 footprint. capital does not find applications in the industry and trade Fewer commercial and consumer loans are taken out Low deposit levels Low interest rates Low levels of investing/spending Threats Possible increase of the tax burden . 47 . inefficient management. Appendix C: SWOT Analysis of the UK Banking Sector • • • Strengths Profits from the investment banking sector Available governmental support Global operations ensure the benefits of economies of scale and diversification of risks • • • • • • • • • Opportunities Growth in the investment banking sector Rapid growth rates in the developing countries and international expansion of the UK banking institutions provides growth opportunities • • • Weaknesses Volatile economic conditions Shattered public trust in UK banking institutions Due to the economic crisis. due to the high level of buget deficits Increasing online fraud Negative publicity with regards to bonus payments.Environmental Factors • Corporate responsibility becomes more and more of an issue. contribute to the local communities and increase charitable giving Legal Factors • New regulations being introduced to reduce the operational risk levels might slow down the banking sector growth rates.
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