Financial Crisis Analysis - The Great Recession of 2008

UNIVERSITY OF WESTMINSTER

Financial Crisis Analysis The Great Recession of

2008 Financial Markets and Institutions BEQM 509.1

ANH PHAN

Financial Crisis Analysis The Great Recession of 2008

Financial Markets and Institutions BEQM 509.1 Page 1

Table of Contents

I) Commercial bank during the crisis period: the roller coaster effect .......................................................... 2

II) Government regulations: the string to hold the giant not to fall .............................................................. 5

III) Banking and sovereign debt cries: the devil twins ................................................................................. 8

References ................................................................................................................................................... 11



I) Commercial bank during the crisis period: the roller coaster effect

“I have always been afraid of banks.”

Andrew Jackson-seventh President of the United States (Brainz, 2013)

Despite taking the quote from Andrew Jackson, former president of the United States,

who strongly distrusted with banks’ involvements in the economy, we cannot deny many

contributions of the financial sector to the greater development of the society. However, as

globalization has become a remarkable trend, for over the last ten years, the banking system has

been exposure to many fluctuations, such as the 2008 Global Financial Crisis. Through the

performance of Barclays over the last ten years, a top UK commercial bank, in term of its

services and products offered, banking system’s developments from 2001 to 2011 will be

examined.

For Barclays, due to the fact that it has become a multinational bank, this company not

only provides clients with retail bank services, but also wholesale banking, investment banking,

wealth and investment management services, and insurance (Financial Times, 2012). Barclay has

diversified their markets into eight segments, including UK Retail and Business Banking (UK

RBB), Europe Retail and Business Banking (Europe RBB), Africa Retail and Business Banking

(Africa RBB), Barclaycard, Barclays Investment Bank, Barclays Corporate Banking, Wealth and

Investment Management (Financial Times, 2012). Therefore, Barclays has been following the

trend which is under the impact of deregulation and globalization that transform banks into an

entire new model. Since 1979, net interest margin for Barclays Group in the UK had decreased

from 3.9% to 1.1% in 2006; meanwhile UK banks’ non-interest income has a significant increase

to 57.6% of gross income in 2006 (University of Westminster, 2012). Non-interest incomes are

those which came from trading, securitization, advisory fees, and brokerage commissions

(Brunnermeier and Dong, 2012).

To examine Barclays’ performance, we will divide their operational process into three

stages: the pre-crisis era (2001-2006), the crisis era (2007-2008), and the post-crisis era (2009-



2011). During the pre-crisis era, Barclays had a steady growth, which was shown in the slightly

increase of profitability, earning per share, and growth margin. Within six years, Barclays’ profit

before tax raised from £3,425m to £7,136m, which was 23% average increase per year,

especially 35% at the end of 2006 (Barclays, 2006). The earning per share also showed a strong

development of Barclays, from 36.8 pence in 2001 to 71.9 pence in 2006 (Barclay, 2006). The

Tier 1 capital ratio of the company was always above 7%, as well as total net capital resources

above 11%, demonstrated the strength in core capital base of the bank following the regulation

under Basel 1. However, as Bessis (2010) debated, the 8% capital ratio of Basel 1, which is

considered capital as the last “line of defense,” could not prevent the crisis to happen in 2008. On

the stock exchange market, shares of Barclays increased its value steady during this pre-crisis

period. Only after 2002, due to the slightly decrease in profit, the margin went down; yet after

positive signals of 2006 annual report, Barclays’ stock index reached the peak of 755.59 on

January 2007 (Graph 1).

Chart 1: Barclays’ stock index (Source: Financial Times)



The crisis period would begin when the subprime market in the United States started to

expose problems in mid-2007 (Bessis, 2010). However, the collapse of Northern Rock on

September 2007 had shocked the entire financial system in the UK. In Chart 1, we can clearly

observe the dramatically decline of Barclays’ stock index since the last quarter of 2007. At the

end of 2008, Barclays’ profit before tax decreased to £6,077m and earning per share decreased to

59.3 pence (Barclay, 2008). The stock index touched its trough on Feb 2009 at the value of 89.20

(Chart 1). Beside systemic risk, banks are vulnerable due to their balance sheet structure. On the

balance sheet, unlike manufacturing firm, banks hold a lower amount of equity assets (Casu and

other authors, 2006). If some loans cannot be repaid, banks will have to accept these losses by

their capital buffer; thus, bank will be technically insolvency if the losses exceed the capital level

(Casu and other authors, 2006). Despite the decrease in profit, asset on Barclays’ balance sheet in

2008 was nearly doubled due to the significant increase of derivative assets (from £248,088m in

2007 to £984,802m in 2008) (Barclay, 2008). The reasons were the Pound Sterling depreciation

against both US Dollar and Euro, as well as the Goldfish acquisition of Barclaycard (Barclay,

2008).

In the post-crisis period, despite a spectacular increase in profit before tax to £11,642,

more than 100% increase compare to 2008, year of 2010 and 2011 would be more difficult for

Barclays (Barclay, 2009). Moreover, since 2009, the Tier 1 capital ratio raised up to more than

10% to deal with potential failures. The earning per share suffered from the crisis that only

valued at 24.1 pence in 2009 (Barclay, 2009). The unstable development of Barclays throughout

three years is the result of public confidence decreasing, especially in mortgage lending area.

In 2007, Barclays and other banks were having the same problem with securities backed

by bad debt and risky mortgage loans (Economist, 2007). However, any changes were

impossible right before crisis broke out. Barclays, as well as other commercial banks around the

world, should reexamine their management, especially risk management, to avoid future failures.



II) Government regulations: the string to hold the giant not to fall

“Financial crisis requires governments”

Timothy Geithner, United States Secretary of the Treasury (Brainy Quote, 2013)

The quote from Timothy Geithner, the Unites States Secretary of the Treasury, has

explained the important presence of governmental interventions during crisis period in

reestablishing the financial stability. To many people, the financial system should be liberated

from many governmental regulations, believing that competitions will be refrained under such

condition (Bessis, 2010). However, the 2008 Global Financial Crisis raises public question

whether the government should expand a greater regulation towards the banks. Nevertheless, it

is necessary to understand the rationales and objectives of regulation to answer the above

question.

The most important objective of the regulation is to sustain systemic stability of the

financial sector (Casu and others authors, 2006). Casu and other authors (2006) believe the major

ideology behind this objective is due to the greater costs of bank failures compared to private

costs. Although the core activity of banks is to act as intermediaries, they are responsible for a

payment mechanism for the economy, as well as unaccountable amount of money of investors

and savers (Pilbeam, 2010). However, externalities problem arises when financial system

dominates economical activities, which means the financial sector problems will cause a severe

damage to the economy (Pilbeam, 2010).

Following Bassis (2010), after experiencing a period of price increasing in real estate

market that helped people transform sub-prime loan into prime mortgage, the housing prices in

both the U.S. and the UK began to decline from the mid of 2007. Due to the decline of the

market, banks’ assets value (from loans issued to investors) would be fall below the liabilities,

and their net worth (capital) became negative value (Ball, 2011). Banks’ assets are illiquidity,

thus difficult to be sold in the absence of the secondary market and usually banks are pushed to

sell at the loss, pushing the house prices even lower (Casu and other authors, 2006).



Furthermore, banks were interconnected, which meant they borrow from each other for capital

(Casu and other authors, 2006). Thus, when one bank falls, a contagion effect, or “domino

effect,” will happen and lead to a systemic risk, the potential failure of many others (Bassis,

2010).

The Northern Rock was the victim of this crisis scenario. Northern Rock had chosen the

strategy in which dependent on the wholesale market’s liquidity and transformed loans into

mortgages, which later became a trap of maturity mismatch that created liquidity risk (Brummer,

2008). When people could not repay their borrowings, capital was hardly to be motivated and

banks significantly decreased the amount of lending, which is considered as credit crunch (Ball,

2011).Credit crunch was what Northern Rock had to face when banks stopped lending each

other. Nevertheless, even though Basel 1 (set up minimum requirement capital) and Basel 2

(enhanced credit risk regulations) had been designed in order to use capital as a last “line of

defense” for avoiding failures under such difficult circumstances, it failed to achieve the goal

during the 2008 crisis (Bassis, 2010). The concept of “too big to fail” should also be considered

to minimize influences towards the economy when big financial institutions fail (in the case of

Northern Rock).

The second important objective of regulation is to protect customers and small retail

clients from being exploited by the monopolistic (Casu and other authors, 2006). Asymmetric

information is one of the rationales that explain why regulation must be implied. Credit ratings

are among ways in which governments try to minimize the negative outcomes of asymmetric

information. However, there are two problems originated with rating agencies. In 2006, rating

agencies failed to estimate the default rates of subprime mortgages because it was just invented

in 2000 (Ball, 2011). Another problem arises from conflict of interest because these agencies are

in fact paid with high prices to rate mortgage-backed securities; therefore agencies have to

compete with each other that somehow led to an easy grading (Ball, 2011).

Moral hazard, a problem that the insured event is more likely to occur compared to if it is

not insured, is another rationale for the regulation (Pilbeam, 2010). A deposit insurance

protection has been an argument for this problem. Even though the deposits will be guaranteed to

be repaid in a certain amount if banks fail, it stimulates both depositors and banks’ managers to

gamble by investing their money into riskier business ventures. Under IMF research, it showed



that countries with deposit insurance fall into crisis more often (Ball, 2011). Therefore, deposit

insurance must be reformed, in which must return the deposit to depositors as soon as possible;

and it is needed to ensure investors are not so protected that they are tempted to ‘predatory

lending,’ which customers are encouraged to take on more debt (Pilbeam, 2010).

Governmental regulations can be considered as a double-edged blade, which yield

positive and negative outcomes for the financial system. It is argued that this is an expensive way

of protecting the fair business environment. However, the 2008 Global Financial Crisis once

again affirms the role of the government in stabilizing the financial system. Without the

government interferences, the fall of banking system will entail by the collapse of economy.



III) Banking and sovereign debt cries: the devil twins

Can the people unquestionably believe in everything that the government(s) propagates?

Even though governments are legal representatives of their people, they do make mistakes.

Furthermore, outcomes of governmental decisions affect not only an individual or a group of

people, but also an entire nation and the whole world. Sovereign debt has been always a

controversial issue when policymakers pursue a legal piece of governmental spending.

Unfortunately, the relationship between banks and governments over this issue has been a

hotspot after the dramatic 2008 Global Financial Crisis.

Following Nelson (2012), sovereign debt, or public debt, is the debt that the government

incurs throughout their spending activities. It appears that sovereign debt has substantially

increased after the 2008 crisis, especially in developed countries such as Eurozone countries and

the United States. In future, among those countries, the significant shift in amount of aging

population will expand health care costs, the major budget spending of government. Moreover,

by providing fiscal stimulus packages and nationalizing private-sector debt, as Nelson (2012)

believes, sovereign debts have been boosted up. After the subprime market collapse in 2007,

Bear Stern bail out in March 2008 and the Anglo Irish nationalization in January 2009 are

examples of governmental measures to preserve the whole system from systemic risk, the

propensity of entire system collapses due to the interconnections among financial institutions

(Bessis, 2010). While these aids need time to be effective, Mody and Sandri (2011) argue that

the weak financial sector will reduce the growth speed that leads to the rise in debt-to-GDP ratio;

thus the enforcing relationship between sovereign debt and banking crises would be difficult to

be resolved.

Towards the Eurozone, Greece is facing these hard-chewing twin crises. Despite the

membership of EU, as an emerging economy, Greece suffered a tremendous increase of

sovereign debt after the 2008 crisis (Ball, 2011). Obviously, when the public debt reaches a

threshold, there is an incentive that governments are going to default, which likely to decrease

their credibility (Mody and Sandri, 2011). Losing the faith in Greece’s situation, assets holders

and creditors punished Greece with new debt, increasing the interest rate of Greece government’s

bonds from 4.7% to 8.0% (Ball, 2011). Due to the downgrade of government credibility,



domestic banks will also be graded lower that makes it more difficult and costly to obtain funds

from wholesale funding and deposits (CGFS, 2011). Moreover, in countries with high sovereign

debt, there is an incentive that banks hold larger percentage of government bonds as capital

(CGFS, 2011). Recall that when the financial system is working inefficiently, households, firms,

and the governments are less likely to channel capital to others in an effective way. Therefore,

both public and private sectors are affected by high debts due to the lack of capital that

eventually add to the sovereign vulnerability (CGFS, 2011).

As Mody and Sandri (2011) believe, in fact, governmental recapitalizations for banks will

reduce debt rations because capital injections will minimize banks’ equity loss on GDP, hence

limiting the raise of debt. However, it is difficult in balancing both GDP fall prevention and

recapitalizing fiscal costs avoidance. Government could only leverage financial sector at some

degree, which satisfies regulatory requirements; yet investors usually demand a larger capital

buffers during the crisis time (Mody and Sandri, 2011). As a result, it is suspected that in several

circumstances, governmental recapitalizing funds will be creditable (Mody and Sandri, 2011). In

case of Greek, government could have pursued expansionary monetary policy; however,

monetary policies of the Eurozone countries are decided by the European Central Bank (Ball,

2011). Thus, Greece government, as well as Eurozone countries that are having a similar

situation, such as Italy, Portugal, and Spain, can only cut their spending and wait for aids from

others EU nations. This aspect has revealed a weakness of mutual currency system. Due to the

different characteristics, obviously, there will be imbalance between developed and developing

countries in EU. Mody and Sandri (2011) analysis showed that weak competitiveness and low

growth countries will lengthen the crises. Moreover, with Eurozone, due to the close connections

among financial institutions, sovereign tensions can create a spillover problem to foreign banks

and governments that are holding bonds of a crisis country. With Eurozone, cross-border

interbank exposures and claims on non-financial entities are key channel which could lead to the

contagion over the financial system of entire Eurozone. The uncertainty of the Eurozone

countries should be examined with careless reforms in both private and public sectors because

sovereign debt and banking crises enforce each other. At the point when it reaches worldwide,

this blend crisis must be resolved at international stage.



In conclusion, through the current Eurozone crisis, we have explored some aspects of its

relations with the past 2008 crisis, as well as pointing out how banking and sovereign debt crises

have an enforcing relationship. Nevertheless, this crisis has sparked a problem among developed

economic around the world. The combination of governmental overspending and bubble values

of the market has shaken the foundation of capitalism economy. It is essential for governments

around the world, especially developed countries, to correct errors not only in banking system,

but also in governmental system.



References

Academic sources

Ball, L., (2012). Money, banking, and financial markets. 2nd ed. New York: Worth.

Bessis, J., (2010). Risk management in banking. 3rd ed. West Sussex: John Wiley & Sons.

Brummer, A., (2008). The crunch: how greed and incompetence sparked the credit crisis. Great

Britain: Random House.

Casu, B., et al., (2006). Introduction to banking. Essex: Pearson Education.

Pilbeam, K., (2010). Finance & financial markets. 3rd ed. Hampshire: Palgrave Macmillan.

Online resource

Barclays, (2006). Barclays PLC: Annual report 2006. [online] Available from:

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Barclays, (2009). Barclays PLC annual report 2009. [online] Available from:







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best-andrew-jackson-quotes/> [Accessed 6 Jan 2013].

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<http://www.brainyquote.com/quotes/authors/t/timothy_geithner.html> [Accessed 6 Jan

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CGFS, (2011). The impact of sovereign credit risk on bank funding conditions. [online] BIS.

Available from: <http://www.bis.org/publ/cgfs43.pdf> [Accessed 26 Dec 2012]

Economist, (2007). Barclays and the Bank of England: The bank that cried fire. [online]

Available from: < http://www.economist.com/node/9769619> [Accessed 27 Dec 2012].

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Mody, A. and Sandri, D., (2011). The Eurozone Crisis: How banks and sovereigns came to be

joined at the hip. [online] IMF. Available from:

<http://www.imf.org/external/pubs/ft/wp/2011/wp11269.pdf> [Accessed 26 Dec 2012].

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Online picture source

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<http://markets.ft.com/research/Markets/Tearsheets/Business-profile?s=BARC:LSE>


Financial Crisis Analysis - The Great Recession of 2008

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