Home > Free Essays > Economics > Finance > The UK Banking Practice that led to financial crisis

The UK Banking Practice that led to financial crisis Research Paper

Exclusively available on IvyPanda Available only on IvyPanda
Updated: Sep 18th, 2019

Introduction

The issue of the global crisis is of great importance to business management and aspects of finance in any country. Crisis of the magnitude that was experienced is a real threat to the economy of any country and it is imperative for people to learn as much as they can to avoid the circumstance that lead to the crisis.

In The UK the financial crisis was less hard hitting than it was in the USA. The crisis is attributed to the mortgage business and chiefly to the lending services of banks. The culprit was banking practices that were not adequately regulated and not well adapted to changes.

As a result, when the problems started arising it was too late to make any real changes. The government has tried its best to cushion the economy and has been successful in getting things back to normal little by little.

It is only when the banking problems that led to the crisis are understood that measures against such a future problem can be anticipated and prevented. In the UK the crisis affected businesses as well as individuals. With a sluggish economy many consumers felt the pinch in spending and as a result, the economy suffered even more as spending became limited.

Organizational context

The research will be carried out in the organizational context of policies that govern the banking industry. This will reveal more directly the role that banks play and examine whether the policies facilitated in creation of the crisis. When the crisis was a phenomenon of banks in general it follows that there are certain characteristics of their practices that lent themselves to the crisis.

Literature review

According to Demirguc-Kunt and Detragiache (2002), one of the most important factors in banking is deposit insurance. Deposit insurance provides security in financial circles and enable economic crisis to e handled in ways that are not debilitating to the country. Demirguc-Kunt and Detragiache (2002), examined evidence taken from sixty-one banks between 1980 and 1997.

Demirguc-Kunt and Detragiache (2002), found that for bank stability deposit insurance is necessary. These insurances are especially helpful in circumstances where there exists little regulation of interest rates. Additionally if the institutional environment is not strong, the insurance serves to create stability.

In the case of UK crisis, the banking practices did not require explicit insurance that was relational to the risk taken. As a result the risks far outweighed the insurance. Even with the insurance compensation, the banks fell short of the amounts they needed to recoup.

Goodhart (2008) offers the basic reasons why the crisis happened. What was reported in the USA had similarities with what was going on in the UK. Goodhart (2008) states the main reasons behind the crisis was mortgage backed securities, seemingly surpluses in global savings and macrostability (Goodhart 2008).

As a result the market was overconfident and investments were not carefully construed. The UK drive to the crisis was the credit crunch. The credit crunch however was itself a direct result of the defaults in mortgage repayment and falling prices for the houses (Goodhart 2008). In addition, investor confidence was shaken and many tried to make withdrawals form banks and even long term securities.

According to LaBrosse (2008), one of the reasons that the UK authorities decide to review the financial safety net was because of the crisis witness in the Nothern Rck Plc. The crisis revealed major failings in provision of adequate financial safety in cases of need. According to LaBrosse, the UK authorities responded by issuing recommendations for the protection of depositors and in addition they suggested some reforms to the banking practices.

According to LaBrosse (2008), one of the reasons for the crisis was due to no mandated regulators to minimize risk. This led to banks taking aggressive risks which did put the depositors’ accounts into risk. These choices were made without the appreciation of the long-term consequences of such risks.

The taxpayers have also been furnished with little awareness and as a result they wee not able to make financially sound decisions. One of the consequences was that as soon as many realized the financial difficulties of financial institutions, they went ahead to withdraw their money from banks and other institutions.

As a result, financial institutions were pushed towards bankrupts. In order to deal with the problem, one of the recommendations by UK authorities is for the use of a financial agency that is independent and which will work to minimize risk (Lacrosse 2008). The FSCS can then liaise with parliament to come up with effective means of protecting depositors and tax payers. Public awareness would also be increased to avoid panic among depositors and increase sound judgment.

Mcllroy (2008), also found that the reason for the crisis was the lack of sufficient trigger mechanisms in the financial sector. Had the triggers been in palace, the safety systems would have been able to respond in a timely manner and avoid further threats to the economy. According to Mcllroy (2008), to fully ensure financial stability the system lacked sufficient credible approach.

Such an approach is important in order to regulate standards, supervision and management of smaller institutions so that they do not affect the entire system. However failure to have these support in pace aggravated the financial problems and instigated the crisis. Additionally Mcllroy (2008), states that due to the taxation procedures institutions that were taking excessive risks did not pay more taxes for their insurance. Had they paid more there would have been an easier way to recover losses for banks.

Crick (1927) discussed the various ways in which banks manage their reserves. As they get investment, banks also lend money out. However they retain a certain amount so that their clients can also make withdrawals. It is the balance between the money lent and the money available for withdrawal that banks need to balance to ensure smooth running of their institutions.

This is what is known as fractional reserve banking. This was one of the critical mistakes that banks in the UK made. They took too much risk and minimized their reserve. This in turn affected the mortgage sector. It is this practice that led to seeming surplus of cash in the world and the subsequent crisis.

Shin (2009) explains the cause of the financial crisis to have had its origins in the Rock’s Bank depositor run. This had a negative effect on other banks with investor confidence shaken. The main cause of the Rock Bank problem was as a result of dependency on short term investment it took with investment institutions

Lastra (2008) agrees with the effect that Bock bank had and the subsequent response of investor. According to Lastra (2008), bank regulations played a big part in the progression of the crisis. If there had been sufficient measures to aid the banks which were undergoing distress the crisis might not have progressed at the rate or extent that it did.

According to Bicksler (2008), two factors have been proposed as the causes of the crisis and in particular the sub prime mortgage problems. One of this of the reasons has been given as inappropriate incentives that were geared towards securitization. The second reason given has been that there was mismanagement of information whereby financial institutions, investment securitizes and investors did not have adequate information to sufficiently balance the flow of money in the mortgage sector.

Haubrich and Thomson (2008) state that due to the collective role that banks play in the financial industry it is by umbrella regulation that crisis can be effectively evaded. Accordingly having the government as part of the regulating team is beneficial so that there is more cohesion in regulatory measures.

According to Bicksler (2008), a study into the issue has given evidence that indeed the securitization caused significant risks to be taken when determining the mortgages to approve. As a result greater risks were taken. In due course because of lack of sufficient management of risk there were more cases of default.

Bicksler cites studies conducted that indicated that mortgages were given to increasingly less income applicants and with the loans came higher cases of default than would have occurred of the approval had not been lowered. In addition Bicksler states that loan borrowers were often not aware of the transactional cost and interest rates and as a result, they made decisions that were too taxing increasing default rates.

Bicksler (2008) examined studies that have been done regarding homeowners and found that indeed many of them were not sufficiently informed about the taxes, fees and interests that their purchases would accrue. According to Bicksler (2008), economics attribute much of the financial crisis in the mortgage sector to the homebuyers’ financial illiteracy.

Another important contribution to banking practices and the crisis is what Schwartz and Seabrooke (2008) regarded as relationship between the political and economic realities with finances. According to Schwartz and Seabrooke (2008), there exists a strong relationship between the financial institutions and politics.

As a result, banking financial institutions can be influenced by the politics of the land and negatively affect their activities or practices. Additionally, the UK insurance which is mostly managed by government is not as effective as those run by private sector. This is because negative impact in the deposits is higher government run schemes.

One of the points that Schwartz and Seabrooke (2008) make is that housing finance which is mostly conducted by banks has ballot box implications. As a result politicians are not always quick to respond to the situation and downplay the extent of the crisis for political reasons.

The crisis was an indicator of problems that the UK authorities would want to deal with before losing public confidence. The public reaction is also tied in with preference for interest taxes, taxation and spending. The banking system which ought to be more accountable relied on the government to cushion their losses. However, it is important for banks to have independent overseers who can be expected to be neutral and respond to financial issues with the investors’ interest.

Schwartz and Seabrooke (2008) argue that in an economy where there are housing ownership inequalities, many people take advantage of additional mean to get loans so that they can escape taxes or defer their loan payments. This presented problems to banking systems which require the repayments for their running.

As Schwartz and Seabrooke (2008) found out some of the people who acquired new mortgage loans were purchasing second homes or refinancing. There was therefore a financial burden placed on banks leading to the financial crisis. Honohan and Klingebiel (2003) support Schwartz and Seabrooke (2008) in stating that banking lending and repayment is a delicate procedure.

Honohan and Klingebiel (2003) states that all economies that face crisis find that they need to drastically reform their banking system. This underscores the importance of banking systems to the stability of a country’s financial stability. In the face of a crisis like the one in UK, banking practices did not rise up to the occasion as they required accommodating policies.

These policies are inclusive of limited recapitalization, government bail out, open-ended liquidity support and blanket deposit guarantees. These measures spread over to several banks led to fiscal cut backs. As government spending was limited the effect was further passed to tax payers leading to aggravation of the financial crisis.

The Office for National Statistics (2010) has released correction notice that is mean to serve as an indicator of measures that will be used in future to generate intervention to prevent crisis. This is because the government realized that early intervention is critical to containing the effects of financial instabilities. The bank sector for example is one in which information to users can greatly enhance their knowledge of changing economic situations. This can help people to make better decisions and be aware of the trends.

Sample

The sample will consist of several banks in different towns and of different sizes. The sample will be selected randomly to ensure that different types of banks are represented. The sample will consist of Mortgage loans data from banks and lending repayment. In addition it will include the policies regarding mortgage loans.

Methods

The method to be used will be data from banks and economic statistics. The survey will examine banks policies in issuing mortgage loans, interest rates and rates of defaulting.

Constrains, limitation and ethical issues

One of the constrains of the research is that it cannot cover all the areas that would be poignant to the study. Financial situations are affected by more than just one factor. As a result, interdependent factors should be examined to ascertain the proper conclusions are reached. A limitation for the study will be finances.

In order to undertake a good research the research would require a lot of finances to study as many banks as possible. In addition, a study of government and its financial policies would enrich the study and make it comprehensive. Limitation of time will also be experienced. With a limited time frame the study can not be as broad as it could be. The sample will have to be representative of other banks.

One of the ethical issues will be confidentiality. Since the financial transactions of bank customers are supposed to be confidential and private, the study will need to come up with a way of ensuring that personal information is excluded from the study. Personal or identifying data will be exempted form the study.

Another ethical issue will be maintaining confidentiality of bank information. Banks also have information that they like to keep private. The study will ensure that all confidential materials are kept confidential. The research will provide confidential agreements so that those they deal with can be assured of their privacy and confidentiality.

References

Bicksler, J., (2008) The sub prime mortgage debacle and its and its linkages to corporate governance. International Journal of Disclosure and Governance, 5 (4), pp. 295-300.

Crick, W. F., (1927) The genesis of bank deposits. Economica, 7 (20), pp.191–202.

Demirguc-kunt, A. and Detragiache, S., (20020 Does deposit insurance increase banking system stability? An empirical investigation. Journal of Monetary Economics, 47 (7), pp 1373-1406

Goodhart, C. A., (2008) The background to the 2007 financial crisis. International Economics and Economic Policy, 4(4), pp. 331-346.

Haubrich, J. G. and Thomson, J. B., (2008) Umbrella supervision and the role of the central bank. Journal of Banking Regulation, 10 (1), pp. 17-27.

Honohan, P. and Klingebiel, D., (2003) The fiscal cost implications of an accommodating approach to banking crises. Journal of Banking and Finance, 27 (8), pp 1539–1560.

LaBrosse, J. R., (2008) Time to fix the plumbing: Improving the UK framework following the collapse f Northern Rock. Journal of Banking Regulation, 9 (4), pp 293-301.

Lastra, R. M., (2008) Nort Rock UK Bank insolvency and cross-border bank insolvency. Journal of Banking Regulation, 9 (3), pp.165–186.

Mcllroy, D. H., (2008) Regulating risk: a risk measured response to the banking crisis. Journal of Banking Regulation, 9 (4), pp. 284-292.

Office for National Statistics., (2010) Financial crisis and recession: How ONS has addressed the statistical and analytical challenges. Economic and Labor Market Review, 4 (1), pp. 30-35. 10.

Schwartz, H. and Seabrooke, L., (2008) varieties of residential capitalism in the international political economy: old welfare states and the new politics of housing. Comparative European Politics, 6 (3), pp. 237–261.

Shin, H. S.,(2009) Reflections on Northern Rock: the bank run that heralded the global financial crisis. Journal of Economic Perspectives, 23 (1), pp. 101–119.

This research paper on The UK Banking Practice that led to financial crisis was written and submitted by your fellow student. You are free to use it for research and reference purposes in order to write your own paper; however, you must cite it accordingly.
Removal Request
If you are the copyright owner of this paper and no longer wish to have your work published on IvyPanda.
Request the removal

Need a custom Research Paper sample written from scratch by
professional specifically for you?

Writer online avatar
Writer online avatar
Writer online avatar
Writer online avatar
Writer online avatar
Writer online avatar
Writer online avatar
Writer online avatar
Writer online avatar
Writer online avatar
Writer online avatar
Writer online avatar

certified writers online

Cite This paper
Select a referencing style:

Reference

IvyPanda. (2019, September 18). The UK Banking Practice that led to financial crisis. Retrieved from https://ivypanda.com/essays/the-uk-banking-practice-that-led-to-financial-crisis/

Work Cited

"The UK Banking Practice that led to financial crisis." IvyPanda, 18 Sept. 2019, ivypanda.com/essays/the-uk-banking-practice-that-led-to-financial-crisis/.

1. IvyPanda. "The UK Banking Practice that led to financial crisis." September 18, 2019. https://ivypanda.com/essays/the-uk-banking-practice-that-led-to-financial-crisis/.


Bibliography


IvyPanda. "The UK Banking Practice that led to financial crisis." September 18, 2019. https://ivypanda.com/essays/the-uk-banking-practice-that-led-to-financial-crisis/.

References

IvyPanda. 2019. "The UK Banking Practice that led to financial crisis." September 18, 2019. https://ivypanda.com/essays/the-uk-banking-practice-that-led-to-financial-crisis/.

References

IvyPanda. (2019) 'The UK Banking Practice that led to financial crisis'. 18 September.

More related papers