Project’s overall aims and objectives
The combination of major economic shocks and the unprecedented global policy response to the banking crisis has generated exceptional uncertainties for households, businesses and governments across the world, and therefore economic forecast. Forecasts made at times when economies are reaching cyclical peaks or troughs typically exhibit larger errors than those when developments are more stable, even at times when underlying supply potential remains steady. Given the current content of shocks that are likely to affect supply potential as well as demand, current economic forecasts inevitably involves an even greater reliance on judgment.
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Global economic prospects have been hit hard since summer 2007, and particularly since Budget 2008. The credit shock described above caused credit conditions to tighten across advanced economies and growth to slow (Frankel, 2009). The surge in commodity prices in the first half of 2008 lifted inflation, squeezing real incomes and pushing many advanced economies into recession. The escalation of the global banking crisis in recent months has increased uncertainty over prospect for growth in advanced economies and the risk of contagion to emerging markets. But the global financial policy response has limited the downside risks from systematic banking collapse and an increasingly number of countries have eased monetary policy and announced fiscal stimulus measures. At the same time, lower commodity prices should provide support for real incomes in the following years. In short, the global; economic crisis has negative affected many banks and financial institutions (Garrett & Geoffrey, 2007).
In the run-up to the crisis, financial institutions became increasingly overleveraged. This was not always transparent as banks kept assets off balance sheet (for example in Structural Investment vehicles) to avoid regulatory capital requirements and thereby increase profitability. Subsequent large losses and write downs on mortgage-linked assets exposed this problem and left financial institutions even more over-leveraged (Frankel, 2009). To repair their balance sheets, banks have raised new capital but have become increasingly difficult due to failing share prices and losses suffered by inventors who contributed to the earlier capitalizations. Banks have also attempted to sell off mortgage linked assets, but a lack of liquidity in these markets and increased risk aversion since 2008 have led to prices to fall sharply to levels that, taken literally, would imply extremely high rates of default by historical standards. This in turn has required further write-downs of assets, exacerbating capital inadequacy and amplifying the deleveraging process.
Although there were growing imbalances in the UK economy and the housing market began to lose momentum around the end of 2007, the most immediate negative impact on the economy came from the turmoil in international financial markets starting in August 2007, triggered by higher than expected default rates on US subprime mortgage lending (Jeremy, 2007). Liquidity in interbank money markets was severely curtailed and interbank lending rates rose sharply above policy rates as a lack of trust developed amid institutions as the result of uncertainly about the scale of losses on holds of US subprime mortgages and the lack of transparency about the distribution of losses across institutions. The spread amid the future expected policy rate and the three-month unsecured interbank lending rate has been well above historical norms since the crisis took hold, and this measure is likely to understate the actual increase in cost for the average bank.
The UK financial system was particularly vulnerable to the money market turmoil. Firstly, UK banks were more heavily exposed to US subprime mortgage instruments than institutions in many other European countries, and thus experienced relatively heavy losses. Secondly, UK banks had been more reliant on borrowing in financial markets, rather than on deposits, compared with many other countries. Disruption in the interbank market therefore had a big impact. In addition, regulatory liquidity requirements were modest by international standards (Garrett & Geoffrey, 2007). Thirdly, securitization played a large role in funding mortgagees and other loans. Following the problems with securitized subprime mortgages in the UK, the appetite for securitized mortgages fell across the board and issuance slumped. In particular, US institutions were no longer willing to purchase UK residential mortgages backed securities; Banks thus had to hold a larger share of the new mortgage loans on their balance sheets. In addition, some special investment vehicles connected to banks required financial, as they were unable to obtain funds from capital markets, and some were consolidated on their parents’ balance sheets. Theses tensions led to a bank run and the failure of the Northern Rock bank, the fifth largest mortgage lender at that time (James, 2008).
From the start of the financial crisis in August 2007, UK banks’ demand for precautionary balance rose. Under the Bank of England’s system of voluntary reserves targeting, banks were able to reflect this by setting higher reserves targets at the start of a maintenance period. The Bank mechanically supplied those additional reserves within maintenance period; the Bank supplied additional reserves via fine-tuning Open market Operation in four maintenance periods in 2007 and 2008, firstly in September 2007. The Bank also expanded the range around banks’ reserves target supplied and keep markets rate in line with the Bank rates. These ranges were maintained at a wider than normal level in order to provide banks with additional flexibility in managing their liquidity. That was necessary, in part, because there appears to have been a “stigma” attached to borrowing from the Standing Facility (Frankel, 2009).
In common with other central banks, the Bank of England took a number of further measures to ease funding pressures on banks. From December 2007, the bank held larger than normal three months log term repo Open market Operations against an expanded range of high quality collateral securities, including residential, mortgagee-backed securities. In April 2008, the Bank launched the Special Liquidity Scheme which allowed banks to swap illiquid securities for liquid UK government bills of a period of up to three years. Accepting mortgage-backed securities helped directly to address the funding problems that hit UK banks as the securitization process dried up. As the financial turmoil intensified in mid-September 2008, further expanding the size of long-term repo operations and further expanded the range of collateral accepted in them; and the Operational Standing Facility to address the stigma issue, and the Discount Window Facility (Jeffrey, 2009). These policy measures helped contain the shortage of liquidity in interbank lending, but, as in other countries, the spread over expected policy rates remained higher than before the turmoil began in 2007 even if the severe tensions of late 2008 have eased.
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Ongoing weaknesses in financial institution balance sheet and increasing uncertainty about whether many are solvent came to a head in mid-September, in the wake of the bankruptcy filing by Lehman Brothers. The result was a sharp increase in the rates of interest that banks charge for lending to one another and a driving of lending. The premium paid to insure against fallen back to pre-September levels (Casson, 2007). Bank-runs at the whole levels, both actual and threatened, have forced the bankruptcy, effective nationalism or merger of many large financial institutions in the UK and Europe. In the UK, the investment banks were merged with other banks under duress, one went bankrupt and the remaining two were forced to become more highly regulated bank holding companies but with permanent access to the Fed’s lending facilities. Large commercial banks were also forced into merges with other institutions and a lager insurance company was rescued by the government. Some or all of the following features appear to be common characteristics of institutions in the United sates and elsewhere that have come under pressure: a heavy reliance on wholesale funding, losses on US mortgage market linked assets, lending to high risk borrowers, high leverage prior to the crisis and exposure to declining housing markets (Jeffrey, 2009).
Bank credit defaults swap also fell from their peaks. The housing market downturn in the United Kingdom has exacerbated pressures on the mortgage market, resulting in the nationalism of two major lenders, the takeovers of a further two under duress and government capital injections into a number of other large institutions. Deleveraging is gathering pace with lending growth to households and non-financial corporation falling sharply (Benjamin & Virginia, 2008). Continental European banks have been less directly affected by the turmoil than their US counterparts. However, the crisis has spread quickly with numerous financial institutions requiring government rescues since the beginning of September 2007: a major Benelux bank and Franco-Belgian bank required capital injections and partial nationalization; a large German real estate lender was recapitalized by a joint government/private sector consortium; the three largest banks in Iceland have been placed in receivership under direct government control; six minor Danish banks have been sold, merged or bailed out by the state; and Switzerland has injected capital into one of its largest banks. The Icelandic example illustrates the potential problems that could face small economies with out-sized banking sectors, even though that country provided an extreme case (Marion & Flood, 2008).
Emerging markets, although not directly hit by exposure to mortgage-linked asset losses, have been affected. Countries with large external financial needs, reliance on crisis-hit banks in Europe, dependence on commodity exports, high foreign currency loan exposure or high exposure to exchange rate risk via derivative contracts have been particularly hard hit. The provision of government lending and deposit guarantees in the advanced OECD economies has also contributed to capital flight away from emerging markets, Investors, increasingly concerned in emerging markets across the world. Indeed, as the financial crisis has worsened that in the advanced economies; the Morgan Stanley Capital International dollar index of emerging market equity prices fell about 40% amid the beginning of September and the first week of November, compared to a fall in the MSCI global dollar index of about 30%. Bond spread for emerging market countries have also increased sharply since mid 2008 to their highest level since 2003. However, a return to historical highs is unlikely without a reversal of improved fundamentals (including lower inflation and debt), which has been an important reason for the reduction in emerging market bond spreads in recent years (Garrett & Geoffrey, 2007).
In response to balance-sheet pressures and, increasingly, risk aversion, commercial banks in the United Sates and Europe have been tightening lending standards to both households and corporations and the cost of capital has been elevated by high interest rate spread. Even after the immediate financial crisis passes, lending standards are expected to remain tight and interest rate spreads wide until late in 2009. These include the International Monetary Fund, the Financial stability Board (an enlarged Financial Stability Forum), the group of Twenty (G-20), the Bank for International Settlements, the World Bank, the Group of 7 (G-7), and other organizations that play a role in coordinating policy among nations, providing early warning of impending crises, or assist countries as a lender of last resort (Benjamin & Virginia, 2003). The precise architecture of any international financial structure and whether it is to have powers of oversight, regulatory, or supervisory authority is yet to be determined. However, the interconnectedness of global financial and economic markets has highlighted the need for stronger institutions to coordinate regulatory policy across nations, provide early warning of dangers caused by systematic, cyclical, or macro prudential risks and induce corrective actions by national government (Edgar & Dauvergne, 2009). A fundamental question in this process, however, rest on sovereignty; how much power and authority should an international organization wield relative to national authorities?
In a massive effort evident in the doubling of its balance sheet from mid September to early November. The Fed has deployed an increasingly wide range of unconventional tolls to boost liquidity and substitute for faltering private sector credit activity lending to the corporate sector and large increase in the size of lending facilities and the range of collateral accepted. It has acted to boost US dollar liquidity worldwide by expanding the number of central banks it will lends to via swap lines, which in some cases including the ECB have limit (Casson, 2008). These actions have been complemented by central bank action throughout the OECD to boost liquidity including by accepting a very wide range of collateral.
The purpose of this chapter is to present the methodology used to identify the problem of this study, and describe the data collection techniques used to draw the various conclusions. Interview with Bank Manager
This interview took place to clarify some of their answers, to check if their risk management techniques, as revealed by the questionnaire, is close to what they consider as close to reality, to identify other techniques or views not covered by the questionnaire, and to investigate the reasons for some of the techniques. Suggestions on risk management techniques were also discussed (Cleo, 2007). The managers also provide me with valuable information of the current situation pertinent to risk management techniques. Personal contacts offered flexibility and provided information more easily since they were not strictly defined as in the case of the questionnaire.
Concerning the use of all research tools, a question may arise on the correctness of the answers given, or the opinion expressed from the interviews with managers which are done either face-to-face, by telephone, email, or in the completion of the questionnaires. The answers to the questionnaires showed that the managers answered in a fair way and that misleading answers were not given deliberately because the high response rate revealed that the managers showed a willingness to really help the research and had no reason to distort validity (Benjamin & Virginia, 2008).
The questionnaire had many positive aspects: even not exactly correct, the quantitative data it provided were very useful, giving a more precise picture of the risk management issue. Another positive aspect about the use of the questionnaire was that it covered all aspects of risk management, and the answers could be checked again with the managers whether mistakes in its completion were suspected. In general, quantitative methods focus on recording and accounting for the extent of the phenomena researched and do not give emphasis on seeking a deeper understanding of these phenomena (Casson, 2007). The other tools of the research led to a qualitative investigation, which covered the need for emphasis on deeper understanding of the findings.
As already described, the opinion of managers on the current status of their risk management techniques was asked as a double check based on what the managers had answered, in the sense of how results emerged from the questionnaire. Regarding this opinion, the main limitation is that the respondents, who belonged to the managerial level within the organization, may be biased as far as the questions are concerned. It is a common phenomenon for executives mainly to be prejudiced in favour of things and situations under their command. However, during the conducted research, there was not clear evidence suggesting that this was happening. To conclude, studying this work one is necessary to keep in mind the above limitations in order to deduce the right conclusions (Mike, 2007).
The primary research was supplemented by the appropriate secondary research. The target of the secondary research was to set out the theoretical framework of the research undertaken with this project. This required an extensive review of the existing literature in order to find out and take into account the different techniques used by the different managers in dealing with risks management. This review helped in defining the risks management issues to be studied and analyzed in the different banks involved. The secondary research was also to determine the formally established practices of risks management in the banks studied.
The Tools of Secondary Research
Study of the Existing Literature was also essential. A thorough study of literature about bank risks and bank managers risk management was conducted, using books, journals, and articles from the electronic library at the University of Hertfordshire, as well as the internet (search engines: yahoo, emeralds, google, etc). Bank documents have also been used in getting secondary data. Since the officially established practices of the banks on risks management are very important in the investigation of the present status of it, all pertinent documents were studied. These consisted of banks documents pertinent to risks management (Casson, 2007).
The section assesses the impact of the global financial crisis on Chilean banks and pr4oviding a framework for analyzing government measures aimed at reducing systematic risk. Chile, as other open emerging market economies with highly integrated financial systems and capital markets has been affected by the global financial crisis. The crisis raised concerns about spillovers risks from foreign banks to domestic banks and within the domestic banks and within the domestic banking system. Corisk analysis, which focused on the conditional measures of default risk, was used to asses the extent of the spillovers and provide s background frameworks to assess measures implemented to reduce systemic risk. The financial community had erroneously assumed that Lehman Brothers was also “too big to fail” and would therefore be rescued by the government (Fennimore, 2008).
The interbank also collapsed as well like broke down, because an event that hitherto had been considered impossible had become possible. The banks feared that they would not get back the funds they had lent to other banks. After all, it was not known which assets the other banks had on their books, and whether they were robust enough to survive the banking crisis. The long-smoldering crisis became a large-scale fire, because the trust on which financial markets are built had disappeared (Benjamin & Virginia, 2009).
Banks made a living from credit transfers. Some specialized in collecting funds that the two functions match. In addition, banks conducted maturity transformation. They borrowed short term at low interest rates and lend them longer term at higher interest rates. That, too, is an important economic function that ensures that long-term real investment can be undertaken even when savers wanted to lend their money only on short term. All of this stopped when interbank operations broke down. Banks that had funds were left sitting on them, and banks that needed funds to lend and invest could not get any (Emeriti, 2009). The separation between commercial and investment banks that characterizes the UK financial system proved to offer no advantage in this crisis, because it granted such a preponderant role to the transfer of savings through the capital market.
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To the interbank operations with loans continued despite the loss of trust, the creditors demanded enormously high rates because they feared they would not be able to recover their funds which traditionally could borrow at the most favorable conditions in Europe, suppose they wanted to get loans from other banks. The interest mark-up is a measure of creditors’ fears of not getting their money back because the debtors become insolvent before repaying the loans.
The economy was in a sever downturn. GPD has contracted by over 4% in real terms since the peak in early 2008 and was likely to contract substantially further the following year as the global financial crisis depressed output and employment (Cleo, 2007). The UK was an open economy and heavily influenced by developments in global financial markets, investments and trade. But this was also part of the reversal of unsustainable growth in those years, which had been fuelled by the credit cycle and rising asset prices including housing. The cycle began to turn in 2007 as turmoil hit international financial markets. These effects intensified in the autumn of 2008 with the onset of a full-blown financial and banking crisis in the United Kingdom and internationally, and a sharp fall in world trade (Emeriti, 2009).
Despite the long term period of economic expansion, development in recent years were less robust than in earlier years, suggesting that this god performance might not have been sustainable. The composition of growth changed: export performance weakened while [public expenditure expanded rapidly. Fromm 2000 to 2005, public sector employment rose by around 12% compared with just 3% for private sector employment. The account deficit widened further and reached over 3% of GDP in 2006. The inflation remained close to the target for most of this period. The credibility of the Monterey policy framework ensured that inflation expectations remained anchored to target and wage pressures were subdued. The sharp increase in global commodity prices, which peaked in mid 2008, pushed UK inflation rapidly above target; year-on-year CPI inflation rose from 205% in March 2008 to peak at 5.2% in September, mainly driven by high food and energy prices (Casson, 2008).
A recession entails as a downfall of a countries real economic growth or a situation when there is a decline in growth domestic product for more than a period of two years. The UK has been in recession in the past. This includes the great depression of 1980 and the most recent 2000 recession. The historical recession in UK has been attributed to wars or natural calamities such as weather with infrequent tornadoes and hurricanes. These are external actions to economic system and were not detectable before 19th century since economic statistics had not begun been gathered yet (Fennimore, 2008).
Future recession will force UK to tolerate increased levels of unemployment. The recession that occurred in 2001 greatly contribute to the levels of unemployment in the country to increase steadily. Economists are currently predicting the rate to increase in future recession. The poor especially the African American will be the worst hit since their rate of unemployment is already approaching 10% and they are the greatest majority wit social problems within their context. Goldman estimates that the new recession will increase the national unemployment rate from 7.6% to 10.8% (Casson, 2008).
The income index will also be affected negatively as the price of food and other commodities goes up. In case another recession occurs, it is most likely going to decrease the middle family income by about 4 %, a loss that will impact negatively to the majority who comprise the poor. With the economic drawback, more and more businesses are facing closure. Although trade losses are still mild by the recession standards, the downfall are relentless and they are increasing. In 2008, the department of labor issued a notice that the unemployment rate in UK have risen to 6.1%. 84000 jobs were lost in the month of July with more expected to be lost in coming months.
Crime rates and insecurity is likely to increase. During the strong economy of the 90s, there was momentous decrease in violent crime rate. In particular the black violence declined by 60% between 1993 and 2001. However the rates have gone up the 2001 recession and are expected to rise in the future recessions. Crime causes insecurity which in turn affects the economy negatively. At the community level there exist a correlation according to criminologist between the crime rates and socio-economic downfall leading to high poverty rates. Stagflation and inflation are imminent (Cleo, 2007). The war on Iraq have escalated to a very costly burden for UK in terms of economy and humanity.The fiscal policy of the time is to use more federal spending on reversing the increase trend of fuel and food. The combinations of war and new fiscal policy have led to increased inflation that is likely to cause (Peterson, 2010).
Interest rates are expected to be high as the monetary policy being used tries to keep the money flow as open. This policy is also responsible for high or low inflation rates that are usually being experienced. Many banks especially savings and loan will experience a significant outflow from low interest rate deposits. As interest rates increase due to inflation, most institutions will have most of their money tied in long term mortgage loans at fixed interest rates. Reflecting on Keynesian theory, increase in saving means decrease in aggregate demand which makes things even worse as firms becomes les inclined to investing (Edgar & Dauvergne, 2007).
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