Abstract
The paper involves an analysis of Britain’s banking sector rescue plan. Various strategies are considered by the government. These include increasing banks liquidity, loan guarantees, deposit ensure, quantitative easing, reduction of value added tax and the interest rate. The analysis also considers the benefits and weaknesses associated with the rescue plan. The benefits considered include enhancing economic recovery, boosting public confidence, and an increase in bank lending to the small banks. The possible weaknesses of the rescue plan are also considered. There will be an increase in moral hazard amongst the banks due to government protection. On increasing the VAT, the country’s rate of economic growth will be reduced due to an increase in price of goods. The effects of the rescue plan will be felt in the long term and not in the short term. Reduction in the rate of interest may not stimulate the rate of economic recovery forcing the government to consider other policies. Banks will also be required to increase their minimum capital requirement. The rescue plan will result into an increase in government deficit. The various implications of the bank’s rescue plan to Britain’s economy are also considered.
Introduction
The economic crisis has resulted into a devastating impact on the global economy. The crisis has resulted into devastating impact on the global economy. As a result, various governments are faced with increased demands to stabilize their financial, goods and labor markets.According to Gustav(2009,p.3), the collapse of the financial market affected other markets since these markets mutually support each other. For instance, the increase in the 2007 US subprime crisis resulted into an increase in housing prices in US culminating into an increase in loan default rate. According to Carmen and Kenneth (2008, p.4), increase in loan default rate resulted from the fact that the US banks had issued loans to borrowers with a low credit rating.
The banking industry has played a significant role in the economic growth of Britain over the past decade. In addition, there has been emergence of various derivatives as alternative financial investment vehicles. For instance, there has been increased investment in credit derivatives in the form of Residential Mortgage Backed Securities in UK. With the decline in the performance of the real sector industry as a result of the economic recession, the UK banking industry was adversely affected and is currently in a serious structural crisis (Nadeem, 2007, Para. 3). In addition, Britain banking industry has lost its importance during this period. For instance, the financial crisis affected the Royal Bank of Scotland (RBS) which is the second largest financial institution in UK. This resulted into a reduction in the volume of trading which is the worst in a period of 20 years. From the collapse of the Asset Backed Security (ABS) market, it was paramount for the Britain government to formulate a safety plan for its banking sector. This crisis was evident from the case of Northern Rock whereby the government responded by adopting a nationalization of the banking sector (Gustav, 2009, p.3). Some of the banks which were to be nationalized by the government include Northern Rock, Bradford, Bingley and RBS (Sylvester, 2009, Para. 7). The discussion of this paper involves an analysis of UK recovery plan for its banking industry. The objective of the analysis is to identify the possible benefits, weaknesses and implications of the plan to the British economy.
Recovery plan
The British government has formulated a comprehensive economic recovery plan. One of the sectors that it has considered is the banking sector.
Bank rescue plan
As a rescue plan, the Bank of England considered increasing the liquidity capacity of commercial banks in UK. This was undertaken by injecting 200 billion British pounds into the US banking industry. This represented a 14% of the country’s GDP. In addition, the government through the BoE has set up a special fund for asset purchase whose worth is 50 billion British pounds. However, banks can get money from this fund by exchanging with their private assets that are of high quality. According to Gordon Brown’s bank rescue plan; what key measures really mean (Anon., Para. 7), the British government has formed a Special Liquidity Scheme (SLS) by injecting 200 billion British pounds. The SLS scheme will allow the banks to swap their less liquid assets with government assets that are more attractive. The objective of these plans is to enable the banks increase their lending capacity by increasing their liquidity level.
Reduction of interest rate and quantitative easing
The government through the BoE has reduced the rate of interest to a low of 0.5% which is the lowest rate of interest set by BoE since its inception. However, the reduction in the rate of interest did not stimulate the country’s economic recovery by attaining the inflation target rate of 2% (Julia, 2009, Para. 3). The British government considered adopting the quantitative easing strategy in its rescue plan. Quantitative easing refers to the process by which the government increases the amount of money supply in an economy through the central bank. This is mainly undertaken if reduction in the rate of interest does not stimulate the country’s economic growth rate (Shane, 2009, p.1). In its quantitative easing strategy, the British government intends to increase money supply through purchasing of corporate and government bonds. This quantitative easing does not result into an increase in the rate of inflation. This is due to the fact that there are no additional notes which are printed. The concept behind quantitative easing is to increase electronic money circulation. This is due to the fact that the government credits the accounts of the financial institutions from which it has bought the asset from.
Through quantitative easing, the government will be able to increase its lending to businesses and households thus stimulating economic activity.
Loan guarantee
The British government has also set $ 3 billion for loan guarantees through the Small Firms Loan Guarantee Scheme (SFLGS) that was established in 1981 (Mark, 2009, Para. 10). Loan guarantee refers to a commitment by the government to take the debt obligation of a private entity in the event of default. By increasing loan guarantees, the financial institutions will be able to lend to a large number of investors in various economic sectors. This is due to the fact that the degree of default risk will be minimized. This means that the country’s rate of economic growth will be stimulated. For instance, the loan guarantees will benefit the small scale enterprises which are paramount in Britain’s economic growth.In addition; there will be a reduction in the amount of loss that banks incur due to increased loan defaults (Marc, 2007, p.2).
Deposit ensure
The British government has also increased the amount of guarantee in relation to private savings from 35,000 British pounds to 50,000 British pounds. This strategy was implemented so as to increase the level of confidence amongst the depositors. The British government adopted this strategy to counter the reaction to Irish government which had increased its deposit ensure. The Irish depositors in the UK banking industry threatened to withdraw their deposits in these banks and deposit in their domestic market. In the event of such a mass withdrawal occurring, the banking industry would have negatively impacted. Through increasing the deposits ensure, there would be a reduction in the probability of bank run occurring (Gustav, 2009, p. 5).
Reduction in value added tax (VAT)
In its economic rescue plan, the British government also reduced the VAT from 17% to 15%. The objective of reducing the VAT was to reduce the consumer prices. This would culminate into an increase in the consumer’s purchasing power resulting into an increase in the private consumption. Increase in private consumption would compensate into some degree the amount of loss in the country’s Gross Domestic Product due to a decline in export level and other investments (Gustav, 2009, 11).
Benefits of the plan
Through the recovery plan, Britain’s economy will be boosted since there will be increased access to investment capital from the banks. This will result into an increase in the level of investment. In addition, the loan guarantee by the government will increase the commercial banks level of confidence in lending to the public. As a result, banks will be able to increase their lending capacity. Reduction in the bank rate of interest will result into increased dependence of loans as a source of investment finance due to reduction in the cost (George & Robert, 2009, Para. 8). Increased investment in other economic sectors will result into an increase in the level of employment resulting into an increase in consumers’ purchasing power due to an increase in their disposable income.
In addition, the banking sector rescue plan will result into an increase in the public level of confidence. By increasing the amount of deposit ensure, domestic and foreign depositors will have confidence in depositing their money in Britain’s banks. This is due to the fact that the guarantee by the government will increase the security needs of the individual and instititutional depositors. Increase in the amount of deposits to the banks will enable the banks to effectively bridge the gap between the deficit and the supply units in the conducting their financial intermediation role (Edward, 2007, p.2).
The rescue plan will also result into an increase in banks lending capacity to the small scale firms. This will stimulate the country’s economic recovery since SMEs play a significant role in the economic growth of a country.
Weaknesses
Increase in government deficit
Britain’s banking sector will result into an increase in the government’s level of deficit since a substantial amount of money will be required to rescue the banking sector. This will result into a financial constraint in the government’s budget. It is estimated that the Britain’s total debt will increase from 41.2% to 48.2% during 2009. Government fiscal deficit will also increase from 5.4% to 8.1 (Sylvester, 2009, para.13).
Increase in moral hazard and mortgage defaults
The rescue plan will result into an increase in moral hazard amongst the financial institutions. This is due to the fact that the plan will result into an increase in the degree of protection to the banks. As a result, the financial institutions may increase their risky lending behavior in the future. This will pose a risk of recurrence of the financial crisis. For instance, the financial institutions may result into selling the subprime mortgages to individuals with a low credit rating. The financial institution will sell the mortgage with the intention of holding it to maturity. In the event of defaults, the banks will suffer financial loss (Kevin, 2009, p.3).
Future increase in VAT
Upon the government increasing the VAT, there will be a slowdown in the country’s economic growth. For instance, increase in VAT will result into an increase in prices of goods and services. The effect is that there will be a reduction in the level of personal consumption culminating into a reduction in the country’s GDP. In addition, the reduction in the VAT will not stimulate the economy instantly. This is due to the fact that firms will be reluctant to reduce the price of commodities and services. This means that personal consumption will not be stimulated as targeted (Gustav, 2009, p.11).
Low volume of loans due to reluctance of banks to reduce the rate of interest
Despite the reduction of banks interest rate, this monetary policy will take approximately one year to stimulate the economy. This means that the effects of the plan will be felt in the long term and not short term (Gustav, 2009, p. 4). Considering that the banking sector is in a crisis, the reduction in interest rate will take a long time to stimulate economic recovery. In addition, banks will reluctantly transfer the lower interest rates to their customers. This is due to the fact that they will be required to improve on their margins so as to cover their accumulated debts (Gustav, 2009, p. 5). This means that the loans issued will increase slowly.
In addition, banks will be required to increase their minimum capital requirement so as to be able to meet credit demands.
Implication for the UK economy
Strengthening of banking regulation
To ensure that the banking sector economic recovery plan is effective, the British government should ensure that the sector is effectively supervised. In addition, supervision will ensure that there is soundness in the sector. There are a number of supervisions that the government should consider. According to soundness of financial institutions FX soundness strengthened (Anon., 2009), these include regulating the banks liquidity ratio, establishment of new standards in relation to managing liquidity risk, regulating the derivatives issued by the banks and introducing a regulation on the asset limits that a bank should have.
Reduction in UK GDP
Despite the implementation of the economic recovery plan, there was a reduction in the country’s GDP in 2008. In 2008, Britain’s GDP reduced by a margin of 1.5%. The reduction resulted from the fact that the stimulus package required some time for it to stimulate economic growth. In addition there is a probability that the money advanced for the rescue plan might not have been utilized efficiently (Gustav, 2009, p.11).
UK reject EU regulator
In its recovery plan, UK rejected the proposal by European Union to incorporate Financial Accounting Standards as a strategy to promote financial stability. The proposal entailed giving accounting standards an explicit task in the process of ensuring financial stability. UK perceived that financial standards were responsible for exacerbating business cycles that resulted into financial crisis. In addition there are increased concerns that compensation schemes for investment banking have contributed to the current crisis. The United Kingdom Financial Service Authority is of the perception that such regulations result into increased procyclicality (James, 2009, Para. 2).
Conclusion
As a result of effective implementation and control of the recovery plan, Britain will improve on its economic growth in all its economic sectors. This is due to the facts that the banking sector plays a significant role in supporting economic growth. Economic recovery will be stimulated since the banks will be able to effectively conduct their financial intermediation role by linking the deficit and the surplus units. The plan will result into a revival of other sectors of the economy such as the goods and real markets.
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