Dissertation. Impact of Sub-prime Mortgage Crisis on Major UK Banks

Contents

Content Page1. INTRODUCTION 4

1.1. Overview 41.2. Research Questions 41.3. Research Structure 4

2. LITERATURE REVIEW 52.1. Business Cycles in the Economy and Bank Credit Cycles 52.2. Globalisation and International Capital Flows 112.3. Causes of the Subprime Mortgage Crisis 132.4. Process of Securitisation (ABS, MBS, CDOs) 62.5. Contribution of Credit Rating Agencies to the US Subprime Mortgage

Crisis 172.6. Transmission of the Subprime Mortgage Crisis to the EU 23

3. METHODOLOGY 273.1. Overview 273.2. Research Design 273.3. Research Approach Selection 273.4. The benefits of the combination of inductive and deductive approaches 293.5. Research Strategy 293.6. Data Collection Method 313.7. Data Collection Techniques and Methods 323.8. The Research Procedure 32

4. FINDINGS AND ANALYSIS 334.1. UK Banking Sector Analysis 334.2. Financial Performance of the Major UK Banks 34

4.2.1. Northern Rock 344.2.2. HSBC 384.2.3. Lloyds Banking Group 424.2.4. Barclays 454.2.5. Royal Bank of Scotland (RBS) 48

4.3. Banks’ Share Price Performance 524.4. Managerial and Organisational Issues 53

4.4.1. Northern Rock 534.4.2. HSBC 564.4.3. Lloyds Banking Group 574.4.4. Barclays 584.4.5. Royal Bank of Scotland 59

5. FINAL DISCUSSION AND CONCLUSION 605.1. Limitations and Future Recommendations 62

APPENDICES 63

List of Figures

Figures  Figure 1: Northern Rock Profitability 35Figure 2: Northern Rock Impairment Losses on Loans (in £’m) 36Figure 3: Northern Rock Return on Equity 37Figure 4: Northern Rock Return on Assets 38Figure 5: HSBC Profitability 39Figure 6: HSBC Return on Equity 40Figure 7: HSBC Return on Total Assets 41Figure 7: HSBC Impairment Losses on Loans (in $’m) 41Figure 8: Lloyds Banking Group Profitability 42Figure 9: Lloyds Banking Group Return on Equity 43Figure 10: Lloyds Banking Group Return on Total Assets 44Figure 11: Lloyds Banking Group Impairment Losses on Loans (in £’m) 44Figure 12: Barclays Profitability 45Figure 13: Barclays Impairment Losses on Loans (in £’m) 46Figure 14: Barclays Return on Equity 47Figure 15: Barclays Return on Total Assets 48Figure 16: RBS Profitability 49Figure 17: RBS Return on Equity 50Figure 18: RBS Return on Total Assets 51Figure 19: RBS Impairment Losses on Loans (in £’m) 51Figure 20: Share Prices of Banks 52Figure 21: Bank of England Base Rate 55Figure 22: Lloyds Banking Group Debt Ratio (Leverage) 58

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

and providing resources to developed countries. The latter started running large budget deficits

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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

organizational performance. The paper presents a critical argument over the factors that led to

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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

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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

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reduces cumulative demand even more. The process becomes cyclical. Lower demand prompts

businesses to cut prices and reduce production. Cost cutting strategies imply that more labour

force should be laid off. The rise of unemployment is accompanied by a decrease in the

disposable income of households. Consequently, consumer demand falls even deeper and

recession may worsen.

Saurina et al. (2006) argue that the credit sphere also develops in cycles. This happens because

of the imbalances between the demand for loans and their supply. Changes in interest rates shift

the demand for credit. High interest rates attract more depositors and liabilities of the banks

increase. Demand for credit, on the other hand, decreases because fewer business and individuals

want to pay higher interest on the loans. The cost of investing and spending would go up. So,

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 phase of expansion is characterised by restoration of volumes of manufacturing and its

further increase. The commodity prices considerably grow and unemployment becomes lower.

As a result of increase in demand for the loan capital, levels of interest rates rise (Koopman et

al., 2006 and Saurina et al., 2007).

Fluctuations of business activity are connected to underconsumption of the population and

overproduction of the goods and services. Knoop (2004) considers Sismondi to be the founder of

the theory of underconsumption. According to Knoop (2004), recessions in economic systems

are caused by savings of a large part of the current income and lower consumption compared to

the previous periods. He concludes that savings of households distort the balance between

manufacturing and sales. The reason for excessive savings lies in non-uniform distribution of the

income: higher income leads to more savings up.

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, it is necessary to stimulate household consumption

and spending.

Hartley et al. (1998) argue that crises arise because of disproportions in the economy. Changes in

capital flows are the unique and sufficient reasons of fluctuations of economic activity. If

demand for the goods increases in money terms, trade extends, prices grow and so does the

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volume of manufacturing. If demand falls, trade calms down, prices fall and manufacturing is

reduced. Thus, recession is caused by a decrease in consumption, changes in capital flows and

cost of borrowing. At the same time, inflation is observed in the period of expansion. If it was

possible to stabilise capital flows and demand for money, business cycles would not exist.

However, it can be argued that capitalist societies are heavily dependent on debt and credit.

Credit has a risk and a price for the risk. So, as long as debt plays a crucial role in the economy,

there will be no stability. Ups and downs will be inevitable. The subprime mortgage crisis

occurred when credit risk substantially increased and default rates went up. Changes in interest

rates or the price of credit prompted cyclical development of the economy.

Banks are important elements in the system of international capital flows. The bank system has

ability to create money. All commercial banks are required to keep a fraction of their reserves

with the central bank. Since the loans of one bank eventually become deposits in another bank,

the banking system as a whole can multiply the amount of money in the economy (Krainer,

2001).

Lown et al. (2006) argue that in critical situations massive withdrawals of bank’s deposits can be

observed. Banks then lose their liabilities that allow them to increase liquidity. The loans become

greatly affected. Instability of the banking system can quickly transmit to the rest of the

economy. And vice versa, any instabilities in the other sectors of the economy eventually

become reflected in the banking sector. So, the business cycles in the economy and bank credit

cycles are strongly correlated.

Chari et al. (2004) argue that business cycles are stimulated by the frictions in financial markets

and rates of employment. In their study, they have modeled fluctuations in the US economy in

the period of Great Depression and the post-war period. The uniqueness of their investigation

was that they found investments to be a secondary factor in causing economic recessions. The

primary role was given to changes in labour and efficiency.

Mitchell (1970) argues that the theories of Marxists also explain the phenomenon of business

cycles in the economy. They are deduced from the basic contradiction between public character

of manufacture and the private-capitalist form of assignment of its results. It conducts to a

mismatch of actions of managing subjects and to the occurrence of macroeconomic

disproportions. Marxists believe that capitalism is only a transitory state of economic formation.

The ultimate destination is assumed to be communism. Therefore, recent failures in the capitalist

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system connected to the subprime mortgage crisis may seem to support the ideas of Marxists.

Excessive use of leverage and poor risk management prompted one of the severest financial

crises of the recent decades.

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. 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. Recessions are provoked when the massive mood changes to

pessimism. During economic expansion, people invest more freely (buy more goods and

services, spend larger amounts of money etc.). In the period of recession, investing and spending

decrease as people become reluctant to part with their money. 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. As a result, the economy has more fluctuations.

However, the positions of this theory can be challenged. Psychological factors such as mood

have to be caused by some events. Successes or failures can change the mood and attitude of

investors and households. Failures are often connected to real losses suffered in the economy

(e.g. during a market crash). On the other hand, the crashes occur because people start to panic

and sell their assets in high volumes. This is a psychological factor, too.

Knoop (2004) explains the occurrence of business cycles by so-called external reasons such as

the following. Occurrence of stains on the sun may lead to a poor harvest and the general

economic recession. Wars, revolutions and other political shocks create changes in aggregate

demand and production and also lead to a crisis. Development of new territories and the

population migration that is connected with it, changes in the global population and powerful

breaks in the technologies allow radical changes in the structure of production. This, in turn,

prompts the cyclical development of the economy (Knoop, 2004).

Zarnowitz (1996) argues that the set of innovations appearing in prosperity is the factor that

breaks balance and changes conditions of the industrial life. The changes are made in such a

way that reorganisation of prices, costs and volumes of production become inevitable. Zarnowitz

(1996) draws a conclusion that the determinants of economic dynamics and cycles are new

technologies, upgrading of the past methods and strategies, appearance of new instruments of

production and overall progress.

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Ozcan et al. (2009) asserts that development of a credit cycle begins at the moment when

demand for credit resources increases. Banks predict substantial growth of cost of their assets

and, therefore, reduce the credit standards. 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.

Lown et al. (2006) argue that the beginning of the “credit crush” is caused by distinction of

interests of creditors and borrowers. Borrowers demand to increase volumes of given credits to

finance their business in such a way. Banks wish to receive their money back. Gorton et al.

(2008) insists that in these circumstances banks reconsider the credit standards and change their

risk management strategies. Businesses to whom banks made loans that had higher credit risk

more frequently become incapable of paying debts. Hence, the quantity of “nonperforming”

credits increases. Collateral is sold for low prices to receive the funds that were lent. This drives

assets values down and crashes occur. This was the case with the US housing market in 2007.

When the number of foreclosures increased, more pieces of property appeared in the market and

supply increased. House prices started falling as banks attempted to sell the collaterals as quickly

as possible. The crash was inevitable.

There is an opinion suggested by Gorton et al. (2008) that the reason of fluctuations in the credit

market is the human factor.

“…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. Managers’

reputations suffer if they fail to expand credit while other banks are doing so, implying

that expansions lead to significant increases in losses of loans subsequently” (Gorton et

al., 2008:1184).

Gorton et al. (2008) allocate some forms of an unfair competition between banks (for example,

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.

The question of inevitability of the bank losses connected with delivery of credits is rather

disputable. First, there is a necessity of careful check of collateral and definition of its real value

in credit boom. Further it will allow to reduce losses from substandard loans. Secondly, in boom

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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., 2006).

The question of interrelation of business and credit cycles is debatable. Various opinions

concerning their mutual influence are expressed. 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. If the lack of income is so great that an

enterprise appears to be on the verge of bankruptcy, an establishment of loan limits will have a

fatal impact.

In support of the offered opinion, Lown et al. (2006) insist that the credit cycle appreciably

defines a business cycle and influences the direction of its development. At the same time, he

argues that the problems caused by the internal reasons of business considerably reduce demand

for credit resources. Hence, banks undertake reciprocal measures.

“In sum, 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., 2006:1587).

The theory of cycles offered by Lown et al. (2006) therefore represents a vicious circle of

interdependence of business and credit cycles.

Mitchell (1970) argues that the government can often provoke the rise of inflation by regulating

the money supply and conducting monetary policy. Changes in interest rates cause a shift in

demand for credit. If interest rates are reduced to too low, excessive spending will cause higher

inflation rather than an increase in real production. The availability of cheap loans prompts

businesses to undertake more investment projects that may include those with higher rates of

risk. As a result, defaults may increase and stimulate a crisis.

To understand preconditions of occurrence of today’s financial crisis, it is necessary to present a

picture of a credit cycle within the limits of financial interaction between developed and

developing countries. Bordo (2007) argues that the developed countries of Europe such as the

UK, France, Germany, the Netherlands and others undertake various measures for constant

maintenance of the stability that can prevent financial crises. It is possible to carry the following

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measures: the effective fiscal policy providing effective tax systems, balanced budgets, creation

of effectively operating credit institutes and others.

At the same time, emerging economies have faced fluctuations in the financial sphere. The

countries of Southern Europe, Latin America and Asia enjoyed a great stream of financial

resources flow from the developed countries until the moment of financial crisis, so-called

“sudden stops”. As emerging countries lost the opportunity to receive financial assets, banking

systems of these countries have suffered strongly.

“In addition, many emerging countries were prone to debt crises when their economies

collapsed consequent upon a lending bust and banking crisis. 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, 2007:4).

Partially, 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.

These imbalances are connected to the process of globalisation and international capital flows.

2.2. 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, manufacturing and financial services. International capital flows

were given more freedom and the borders between countries and economies seemed to be nearly

erased. 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. Emerging

economies started gaining strength in the last decade as their production increased. Consumers

were mostly the western developed countries such as the US and European Union.

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,

2008).

“The rapid growth of emerging economies created a macro-economic triangle, made up of:

the major consumer markets, in particular the US but also a number of other Western

economies; major producer nations – notably a number of fast-growing emerging markets

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which have been manufacturing a vast range of goods for consumption in the West; 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, 2008, p.8).

Excessive consumption of foreign goods and services led to accumulation of national debt in the

developed countries including the US. At the same time, producers and exporters accumulated

budget surpluses and increased foreign reserves. US dollar is the world’s reserve currency. The

emerging countries started accumulating the US denominated Treasury bills. Interest rates were

cut by the Federal Reserve and returns on the risk-free assets were minimal. This prompted

institutional investors to seek and demand other low risk securities with higher returns. This

demand was met by the increased volumes of securitisation and sales of collateralised debt

obligations and asset backed securities.

The phenomenon of globalisation and international capital flows was studied by a number of

researchers such as Stiglitz (2003, 2006) and Mumtaz and Surico (2009). Particularly, Stiglitz

(2003, 2006) argues that globalisation in the banking sector increases instability. International

Monetary Fund (IMF), according to Stiglitz (2003, 2006), 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. However, this foreign capital represented by the

entrance of international banks and other foreign institutions drives local banks out of business.

The banking sector becomes more monopolistic and this creates precondition for riskier

operations such as making loans to subprime borrowers (Elstob, 2009).

Mumtaz and Surico (2009) find that an individual economy is greatly affected by international

levels of short-term interest rates. 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. This finding explains why a local crisis in one of the

developed countries can transmit to the rest of the world.

2.3. 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. It occurred as a result of cooperative work of several bodies such as

commercial banks, subprime borrowers, investment banks, credit rating agencies, institutional

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investors and the US government. Identifying the causes of the financial crisis is very important

since they may shed light on the most responsible entities that should be blamed. 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.

“This sub-prime crisis has exposed almost every responsible entity in the market, from

regulators in advanced financial markets, to central banks, to rating agencies, to

international standard-setting bodies, and to the smartest of investment bankers and risk

managers” (Pattanaik, 2009:22).

In the literature, all these bodies are criticised for their flaws, mistakes and unethical behaviour.

The trust of the public was lost and it may take some time until it is restored again. 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.

Pattanaik (2009) argues that the key factor that caused the subprime mortgage crisis was

mismanagement of risk by commercial banks and lending entities. They started making home

loans to the borrowers with inadequate credit history or inconsistent income. Every loan should

be tested for different types of risks that may be present. There is credit, liquidity and market risk

associated with any lending. Credit risk implies that a borrowing party may default on the debt.

So, the lender should estimate the probability of such default. It may be done by tracking the

records of past earnings and job consistency. While prime borrowers normally have a good credit

history and sufficient income to make monthly payments on the loans, subprime borrowers could

not present such information. It may be because they were first time buyers, young and thus

without a long credit history or without a permanent job that would offer a steady income.

Hence, the credit risk of such borrowers was very high. Nonetheless, banks and lending entities

offered them loans to buy residential property (Pattanaik, 2009).

The second type of risk that was mismanaged is the market risk. 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. Interest rates are the price of using borrowed funds.

When demand for money increases, interest rates are pushed upwards to restrain it. Fixed rate

mortgages increase the market risk since the banks and lending entities cannot adjust the rate to

the new market interest rates. However, it is valid to argue that the subprime mortgages did not

have fixed rates. Banks offered adjustable rate mortgages to the subprime borrowers that had to

be refinanced within the next several years. So, the matter of banks’ exposure to market risk with

the subprime loans can be argued. Adjustable rate mortgages allowed controlling the amounts of

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cash flows and they protect banks against fluctuations in the market. However, it should not be

forgotten that many of the subprime borrowers did not have a steady income. So, any changes in

the interest rates on their loans will affect their solvency. Even if they could afford to make

monthly payments on the loan with an introductory low interest rate, it would be difficult and

nearly impossible for them to serve loans when they are refinanced at a higher rate. Thus, the

adjustable rate mortgages increased the credit risks of the banks and lending entities.

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. So, the risk was minimised especially

when the real estate prices were going up until 2007. However, the lenders should have foreseen

that all markets, whether it is the property, stock or commodity market, tend to fluctuate. Neither

real estate nor securities increase in value perpetually. So, the house prices should not have been

taken too optimistically by lenders. The risk could be managed well if they had a strategy for

both the upward and downward direction of the housing market.

The other type of risk faced by lending entities is the liquidity risk. When mortgage loans were

made to the subprime borrowers, the banks issued them against the deposits of households that

were more liquid than the mortgages. 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. The probability of several subprime borrowers to default is greater than

the probability of prime borrowers’ default. So, in order to turn the defaulted loan into cash, the

bank would have to wait until the property used as collateral is sold. This raises liquidity risk of

commercial banks and lending entities (Whalen, 2008).

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, risk was poorly managed since the lenders

had a strategy that was suited only for the growing housing market. There was no backup. In

case of property depreciation, refinancing of subprime mortgages would not be possible.

Moreover, banks would risk failing to sell the collateralised property at the price sufficient to

cover the amount of the loan. This risk was even higher since the subprime borrowers could not

afford to make substantial downpayments or initial deposits on property.

The subprime borrowers themselves can be blamed for taking the loans on which they were

likely to default. However, very few people would reject an opportunity to own a home when

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lenders offer special deals to finance the property. So, the natural human desire for better life and

personal home cannot be blamed for the crisis. The responsibility lies on those who used

subprime borrowers to earn more money. This corporate greed drove banks’ managers to take on

more risk and capitalise on the opportunities offered by the growing housing market.

If managers knew that property prices would fall sooner or later, they should be blamed for

making unethical deals with the subprime customers. Since the risk of their default was high,

banks did not necessarily expect that these customers would pay off the loans. They were

interested in receiving cash flows and if defaults occurred, they expected to sell collaterals while

the house prices were high. However, one thing that was underestimated is that the defaults

could be massive instead of individual or local. This would put pressure on the house prices and

they would go down. In fact, this is exactly what happened in 2007. The increasing default rates

among subprime borrowers left more houses foreclosed and placed at auctions. Supply of

foreclosed properties started exceeding demand and in order to sell, prices had to be dropped.

Otherwise, the mortgages held by the banks would have become illiquid.

In a very short time during the year 2007, the housing market in the US underwent a massive

crash. It can be argued that it was not only subprime borrowers that defaulted on mortgages that

caused the housing market collapse. 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. This would leave prime borrowers with high monthly payments and low equity. In

order to save themselves from this situation, some of the prime borrowers also started putting

their homes on sale expecting that prices could go further down. Thus, a panic was created when

there were many sellers in the real estate market and very few buyers.

Banks and lending entities that could not sell collaterals found liquidity problems that created

credit constraints. A level of liquidity had to be maintained to back deposits and new loans could

not be made. Banks became even reluctant to make short-term loans to each other. Thus, the

subprime mortgage market caused a credit crunch that eventually spread overseas.

2.4. Process of Securitisation (ABS, MBS, CDOs)

It is valid to argue that not all subprime (and even prime) mortgages appeared on the books of

the lenders. Since 1938, a secondary market for mortgages has been operating. Commercial

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banks could easily sell the risky mortgages to investment banks and corporations such as Fannie

Mae. In this way, the risk was transferred from the lenders to investment banks and, thus, taking

this into consideration, banks’ managers can hardly be blamed for taking on excessive risk since

they shifted it to other entities. This eliminated or reduced all types of risks discussed above.

Now, investment banks that buy mortgages are exposed to the risk. If this is the case, 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. 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). Originally, it was a government-

owned corporation that bore official name Federal National Mortgage Association. In order to

make the mortgage market more efficient and allow banks and loan associations to provide more

home loans to customers, the mortgages were financed through the corporation. Lenders

received payments for the mortgages and shifted them to Fannie Mae. So, they were no longer

on the books of banks. This allowed banks to meet liquidity requirements set by the US

government and make more loans to customers (Randall, 2007).

All types of risk (credit, liquidity and market) were carried by Fannie Mae. 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. The diversified portfolio allowed managing risk better than it would have been

managed by individual lenders. However, it is valid to argue that the risk itself was not

eliminated. Simply, the size of the corporation allowed bearing more risk (Randall, 2007).

Originally, Fannie Mae used borrowed funds to buy mortgages from lenders or originators. Since

it was a government corporation, these borrowings contributed to the national debt. It was the

reason why a decision was made to privatise the corporation back in the late 1960’s. In 1970,

another similar corporation appeared on the scene. It was called Freddie Mac. Around this time,

financing of mortgages acquired from originators changed. Instead of borrowing, the

corporations created mortgage-backed securities and sold them to investors (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. So, this explains why credit

constraints were faced by commercial banks in 2007 and 2008. Although mortgages were sold to

other parties, the banks invested their excessive cash in the mortgage-backed securities (MBS)

and thus were left with some of the risk. When defaulted homeowners could not provide monthly

payments to the investors in MBS (that included commercial banks), liquidity problems in the

15

banking sector started to show up and the credit crunch developed (Trimbath, 2009; Lander et al,

2008; Gorton, 2009).

In the past decade, 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). The tranches of CDOs were sold to different

investors. The riskiest ones were demanded by hedge funds. The least risky tranches were

acquired by pension funds and similar institutional investors that were risk averse and invested

for long term. When the defaults on mortgages increased and house prices started going down,

the market for CDOs became inactive as there were no buyers willing to acquire failing

securities. Even the least risky tranches started losing their value and institutional investors such

as pension funds and hedge funds suffered losses. The reality showed that even highly rated

CDOs were in fact much riskier than what was assumed by investors. Since the tranches of

CDOs were very complex, 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. But could these ratings be trusted?

2.5. Contribution of Credit Rating Agencies to the US Subprime Mortgage Crisis

Nowadays, the contribution of Credit Rating Agencies (CRAs) to the development of the US

sub-prime mortgage crisis is widely discussed. 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. CRA is a necessary link in a chain of life cycle of residential mortgage-backed

securities (RMBSs) and collateralised debt obligations (CDOs). Their activity is based on, firstly,

providing ratings to the securities issued by investment banks and corporations. Secondly, they

render consulting and advisory services.

The existence of CRAs is natural because of the presence of a great number of consumers that

need CRAs’ services. Companies that issue securities need to rate them for selling to investors.

Since higher rating helps to sell security to more institutional investors that are risk averse and

prefer safe investments, lower rating complicated such deals. And since the rating agencies are

paid by the issuers of the securities, there is a conflict of interest arising (Rom, 2009).

16

There are different opinions about the basis of the CRA’s 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. Moreover, he argues that rating agencies were actually involved in

repackaging of mortgage-backed securities and provided consultancy services to the issuers.

“Unlike the smaller agencies, the Big Three – Standard & Poor’s, Moody’s, and Fitch –

are paid almost all of their fees by the issuers of the bonds being evaluated… Simply put,

the suspicion is that CDO issuers may have essentially bought their AAA ratings from

the Big Three” (Strier, 2008:535).

Looking at this problem on the other hand, 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. After all, if reputation of a rating firm is lost, it will not be able to find clients and its

commissions will automatically fall. Rom (2009) considers that CRAs undertake numerous

actions to avoid a conflict of interests.

“They [CRAs] have established appropriate policies and procedures (e.g., ratings were

made by committees; fees were based on a fixed schedule; and analyst compensation was

based on accuracy, not commission) to ensure that their ratings were independent and

objective. Moreover, they noted, individual issuers tend to be small, generating less than

1 percent of the CRAs’ revenues, so that losing an issuer to a competitor CRA would

have little impact on the bottom line” (Rom, 2009:644).

Rom (2009) also confirms that complexity of the process of repackaging of MBSs did not allow

for perfect assessment of their true intrinsic value. Thus, 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. In this case, even for the Securities

and Exchange Commission (SEC) it was impossible to check the correctness and accuracy of the

provided ratings.

“Moreover, the SEC review determined that none of the major CRAs had specific

written procedures for rating RMBSs and CDOs. As a result, the SEC was unable to

determine whether the CRA ratings were consistent with their own internal policies, and

there is substantial evidence that ratings were at times ad hoc. Finally, the CRAs did not

17

have specific policies or procedures to learn about and correct flaws in their rating

models” (Rom, 2009:647).

The potential users of ratings, such as mutual funds and brokers, take the rating CRAs’

information with a view of carrying out their internal analyses and decision making on capital

investment (SEC, 2003).

“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, 2003).

Since the mutual funds and other entities had special staff that was employed to conduct analysis

of mortgage backed securities and CDOs, rating agencies cannot be blamed for causing the

crisis. None of the well respected investment firms should get involved in the projects without

proper assessment of risks. Using ratings only as a guide for investment decisions does not seem

to be professional. Although the large credit rating agencies, in fact, failed to provide correct

ratings, the institutional investors have enough resources and competence to make their own

assessment of risks.

Undoubtedly, it is important for users to receive authentic credit ratings. Past studies of rating

agencies suggest that there were no problems with fraudulent ratings although the CRAs were

paid by the issuers. Champsaur (2005) argued that CRAs performed their work effectively,

providing fair and adequate credit ratings prior to 2005. 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, in the sense that they generally provide a correct

assessment of an issuer’s or debt instrument’s credit risk. In addition, in cases such as the

Enron collapse, CRAs argued they should not be held responsible for failing to detect

fraud, since verifying the accuracy of financial and other information through a due

diligence process was not part of their work” (Champsaur, 2005).

Rom (2009) argues that among the participants that contributed to development of the US sub-

prime mortgage crisis, there were investors who unconditionally accepted CRAs’ credit ratings

18

without any checking. Investment decisions were made in the absence of any original research.

So, there is a chain of errors made firstly by the CRAs and then by investors that led to

aggravation in the market.

“Given the securities’ complexity, 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. But even if the investors had sought to conduct due diligence, it would

have been difficult for them to do so. During the sub-prime boom, the CRAs were not

specifically obligated to disclose their detailed ratings methodologies or complete

information about the underlying assets, and they did not do so. They did not always

even follow their own methods. At times making “out of model” adjustments” (Rom,

2009:646).

SEC (2008) has found a lot of errors (which generated troubles and mess) that CRAs had done in

the course of their activity. There was no public disclosure of the rating process and

methodologies that were applied. The ratings seemed to be unexplained and appearing out of thin

air without proper grounding.

“Buy-side representatives generally felt there should be more public disclosure from

rating agencies about the reasons of their rating decisions. They would like more

information about the assumptions underlying the rating (e.g., company and industry

expectations, time horizons for achieving certain financial goals, specific events or

financial triggers that would prompt a rating action), as well as more specific disclosure

about the information and documents reviewed by the rating agency” (SEC, 2003).

Conflicts of interest between issuers and CRAs are wildly discussed in the literature. 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.

Also, there is a conclusion that issuer-agency conflict should be successfully operated by CRAs.

“While the issuer-fee-model naturally creates the potential for conflict of interest and

ratings inflation, most were of the view that this conflict is manageable and, for the most

part, has been effectively addressed by the credit ratings agencies” (SEC, 2003).

19

The problem – conflicts of interest – is also considered in the empirical research of Strier (2008).

He allocates three types of problems with accurate ratings. The first type is concerned with

providing consulting services to the issuers whose securities are rated by the same agencies. This

creates a conflict of interest. The second conflict is that CRAs may be inclined to provide higher

ratings to their customers in order to keep them. And the third one is based on the observation

that rating agencies tend to be unwilling to downgrade the securities they have rated.

There is a great necessity of credit rating market changes to minimise its negative influence on

the mortgage crisis. There are many approaches that can be suggested to create a healthy credit

rating market.

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. The appearance of competition on the market will impact

on CRAs’ activity by limiting their privilege state. The influence of competition could be both

positive and negative.

Champsaur is convinced that credit rating market will receive an opportunity to reduce and

control (to a lesser degree) the conflicts of interest.

“Issuers would be provided with more choice in terms of selecting NRSROs to rate their

debt securities, which could lower their costs for this service. The greater competition on

the market for credit ratings and analysis could provide for more credible and reliable

ratings. Greater competition also could stimulate innovation in the technology and

methods of analysis of issuing credit ratings, which could further lower barriers to entry”

(Champsaur, 2005).

The opposite opinion belongs to Partnoy (2008). He argues, that measures on competition

increase are not effective; there are no considerable advantages to pay attention to.

“Nor is it clear that opening the market to competition would generate any new

information value. Even absent consolidation, there is an argument that opening the

market to competition could make regulatory licenses more important, by creating

incentives for rate shopping among issuers. Overall, opening the market to new NRSROs

seems a weak, and perhaps counterproductive, choice, even if it would be superior to the

current approach” (Partnoy, 2008).

20

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. Alternatively, 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. By taking

this measure, the government can eliminate the problem of misleading ratings and restore the

confidence and trust of investors.

This proposition of a government-owned or government-sponsored rating agency was offered by

Diomande et al (2009).

“We propose that all private business issuing securities that are to be traded publicly in

U.S. financial markets would be required to obtain a rating by the public agency before

they could be conducted legally. They (agencies) would remain accountable to Congress,

including through providing annual public reports on their operations. The staff of the

public agency would be compensated as high-level civil servants. They would receive no

benefits as such from providing either favorable or unfavorable ratings” (Diomande et al,

2009).

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. It will allow investors to be

assured of the quality of the ratings and financial markets will therefore become more

transparent.

2.6. Transmission of the Subprime Mortgage Crisis to the EU

The sub-prime mortgage crisis started in the U. S. when mortgage-backed securities lost much of

their value. For the last five years, the U.S. financial market has been overflowed by sub-prime

mortgages underlying RMBSs and CDOs and their risk was underestimated. Since the securities

were rated safe (AAA rating) and had property pledged as collateral, they seemed to be

preferable investment for institutional clients such as pension funds. The problems began when

“foreclosure and default rates went up and housing prices went down” (Aalbers, 2008).

21

Securitised assets with underlying subprime mortgages had different level of risk. The least risky

were preferred by institutions such as pension funds. They had the rating of Treasury Bills but it

can be argued that the risk was significantly higher. Other tranches of CDOs contained even

more risk and were sold to risk seeking clients such as hedge funds. Although this division in

exposure to risk was present, 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,

2008).

US residential mortgage backed securities went out to the international credit markets. 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), mortgage

backed securities enjoyed high demand. As a result, the crash of mortgage market covered

participants in different countries and the crisis spread beyond the borders of the US. The main

mortgage lenders in the US and UK, such as Fannie Mae, Freddie Mac and Bradford and

Bingley, suffered greatly and became incapable of surviving without support of the governments

(Woods, 2009).

Coleman (2008) argues that the geography of sub-prime mortgage crises covered banking

systems “from Norway to China and the Middle East”. The German banks have also suffered

because of holding a numerous part of resources in mortgage-backed securities. The main task

for German banking system was to rescue IKB Deutsche Industriebank that incurred losses

despite cash injections. The other German banks such as HSH Nordbank, Commerzbank and

Deutsche Bank have also suffered substantial losses.

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 problem of keeping bank’s activity going

became the primary issue for the fifth-largest mortgage lender of the UK – the Northern Rock.

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. The lender

used asset backed securities with underlying subprime mortgages as one of the important sources

of funding. When the rates of default started to increase, the lending institution found the

securities it held rapidly losing their value. Liquidity problems took over the bank. Since other

banks were also hit by the subprime mortgage crisis, it was difficult to cope with the problem by

borrowing from other financial institutions. Most of them were reluctant to lend. It was saved by

the government that temporarily nationalised the bank (Hall, 2008). The case of Northern Rock

22

was the first major example of how the subprime mortgage crisis impacted the UK economy and

banking sector.

James (2008) suggests another opinion about the contribution of sub-prime crisis to the British

banking problems of liquidity. He argues that other lending companies of the UK were not as

much impacted by the crisis as Northern Rock was. The effects felt by other lending institutions

were present but not as strong. The reason why Northern Rock lost stable position on the credit

market lies in its internal policies and poor management.

“…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. The

Financial Services Authority systematically failed in its regulatory duty to ensure that

Northern Rock would not pose a systemic risk” (James, 2008).

Hall (2008) argues that Northern Rock officials disagree with the conclusion that their business

policy was inefficient. They argue that the model of risk testing they have used was effective and

reliable. The origin of all problems they faced consists in unpredictable events. They became a

victim of a crash that no one expected.

James (2008) also argues that there was a lack of transparency in the UK financial institutions.

Public confidence and trust in the banking system of the UK was shattered. This can be proved

by the run on Northern Rock that happened in 2007. The government, however, managed to stop

it by nationalising the lending institution and making deposit guarantees (BBC News, 2007).

Several cases concerning refusal of the customers to access their accounts took place. At the

same time Brian Giles, Northern Rock spokesmen, declared, that there was not any attempt to

limit anyone to access his (her) account: the branches were working in a usual way, access to the

accounts through web-site was limited but not closed because of a great number of customers.

Moreover, there was no need to do so (BBC News, 2007a, 2007b).

Hall (2008) makes a conclusion on how fragile the banking system of the UK is in the light of all

the events. He argues that in order to increase earnings, financial institutions operated

irresponsibly. Recently, before the signs of crisis appeared, Northern Rock had increased its

mortgage market’s share considerably. By increasing the portion of sub-prime mortgages in its

23

portfolio, Northern Rock took excessive risk and put to risk the deposits held by the UK

households.

Bruno (2009) observes that financial condition of Northern Rock was critical and that is why it

had to seek financial help. There were no institutions that could offer financial help because

credit crunch made banks more cautious and risk averse. 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. The only party that could rescue Northern Rock was the Bank of

England. Northern Rock was given transfers of emergency loans. The only way to save Northern

Rock from liquidity problem was to nationalise it. After this step, depositors were expected to

become more confident and stop the run on the bank. So, the government made a decision of

Northern Rock nationalisation for uncertain term.

Gotham (2009) carries out an analysis of the measures that can return stability in the British

banking system. Among the numerous suggested approaches, it is necessary to allocate the

following. The Bank of England has already conducted loose monetary policy and reduced the

base rate to almost zero. Lower interest rates make it easier for banks to raise cash from the

lender of the last resort. The other important measure taken by the government was the insurance

of all deposits. This will help the customers to have more confidence in the banking system and

keep their deposits with financial institutions.

Robins (2009) argues that the local governments in the UK were also unprotected from negative

impacts of the crisis. The revenue from tax collections decreased as businesses were closing and

the rate of unemployment was going up. Since the UK had already accumulated budget deficit

prior to the crisis, this deterioration of business activity will lead the country into deeper national

debt and larger budget deficits will be created. The rescue measures that are currently attempted

may have positive results. However, it is valid to argue that in the longer run, these expenses will

have to be paid in the following years. The tax burden for companies and individuals may be

expected to rise when the economy stabilises.

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. S., Europe and Japan. Additional cash

was injected into the financial system in order to help avoid bankruptcies of financial

institutions. It is valid to note that coordination and consolidation between countries is very

important during the global financial crisis. Members of G7 already performed substantive

24

provisions of reforms at the Financial Stability Forum. 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, 2008).

Further research will be conductd to access the impact of the subprime mortgage crisis on the

five major banks in the UK.

3. METHODOLOGY

3.1. Overview

The purpose of this chapter is to introduce the methodological approach employed for the

conducted research in the context of this paper. It represents an argument, through which the

most suitable approach to the research question is selected. This chapter also presents the data

collection methods, the data sources employed and the formulation of the research process

adopted.

3.2. Research Design

25

The main focus of the research is on the orgainsational performance of the major UK banks in

the period of the credit crunch. Organisational performance can be measured by a quantitative

assessment of managerial decisions and planning. The result is seen in the changes of financial

indicators of banks such as profitability. 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.

3.3.Research Approach Selection

The way the research project is designed often determines its final outcome. 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. There are two major

approaches that can be used: inductive and deductive. The choice of the approach would

determine the whole structure of the research project. 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, 2007, p.599).

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. Saunders et al. (2007) and

Easterby-Smith et al., (2002) make an emphasis on the fact that the inductive approach is the

most appropriate for small samples rather than large. This is because it is mostly associated with

a case study strategy that involves exploration of the context, in which a phenomenon develops

rather than the content itself. Inductive approach is useful in those areas of studies that are not

well investigated or there is no available theory to explain certain events. If the theories are

scarce and an original hypothesis cannot be made, a research can develop inductively. In other

words, observation of statistical or empirical data will eventually lead to conclusions and the

creation of a hypothesis or a theory.

Deductive approach is completely different in its nature. 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,

2007, p.596).

Deductive approach is primarily associated with the philosophy of positivism that attempts to

explain all phenomena by science or scientific methods. The structure of the study that is

26

approached deductively would be very different from an inductive approach. Firstly, a

theoretical hypothesis or statement has to be set. Secondly, the research will evolve around

different testing to prove or disprove the hypothesis. The testing can be normally conducted

using statistical and econometrical tools and instruments. Finally, if the tests demonstrate that

statistical observations prove the hypothesis, it is being accepted. Otherwise, the hypothesis is

rejected and a new theory can be built instead to replace it (Robson, 2002; Collis and Hussey,

2003).

Saunders et al (2007) point out that deductive approach often lacks an alternative for explaining

a phenomenon. Scientific methods do not allow this. They imply that all values are absolute. So,

there cannot be one and another. 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. Particularly, 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. This assumption will be

tested by applying financial data obtained from annual reports of the banks. So, the basic

approach to this particular research is deductive. However, the study is not being guided by

positivist philosophy that has room only for one scientific explanation but rather by interpretivist

approach. The assumption will be tested but the findings may suggest a different explanation of

the current problems in the banking sector. Therefore, the elements of inductive approach will

also be present in this paper.

3.4. 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. In fact,

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. 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. However, a deeper investigation can be made by utilising inductive approach as

well. Sauders et al (2007, p.119) argue that “not only is it perfectly possible to combine

deduction and induction within the same piece of research, but also in our experience it is often

advantageous to do so”.

27

So, this research project attempts to answer the main question set in the introduction to the study

by using a combination of the described approaches. 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. On the other hand, it will not be a too much of a qualitative investigation and

inquiry into the context as in the pure inductive studies. Nonetheless, deduction can be singled

out as a predominant approach but whenever it is necessary, induction is used to draw the

context and disclose the qualitative side of the investigated phenomenon.

3.5. 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. Among the strategies that were

rejected, there were surveys, archival research, experiment, action research and grounded theory.

All these strategies could have been perfect for exploring other phenomena but, for several

reasons, none of these was adequate for the purposes of this particular study.

Experiment is one of the most commonly used strategies in science. It allows detecting causal

relationships between the events or variables observed in a study (Hakim, 2000). In an

experiment, a chosen dependent variable is tested for changes by applying the effects of certain

independent variables. For example, a simulation could be attempted to project profitability of

major UK banks in the conditions without liquidity constraints. 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 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. The limited observations of financial data did not allow

making valid projections either. For these reasons, other strategies had to be reviewed.

Survey strategy offered a variety of data collection methods. 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 data collection techniques that

could be used in surveys are interviews, questionnaires and others (Saunders et al, 2007). 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. Moreover, in a successful survey quite large samples

with many observations would have to be retrieved in order to perform an analysis. Taking into

28

account the fact that about a half of the questionnaires sent may not return with responses, using

this strategy would have caused risk of obtaining too small samples that would not be useful in

conducting further analysis. 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). Since organisational performance can

be assessed from these reports, there is no great need to conduct an additional survey to enhance

the data with primary sources.

Archival research is one of the strategies proposed by Bryman (1989). It relies on the collection

of previous historical documents that allow tracing the tendencies and trends over a given period.

This is a quite specific research strategy that does not fit every study. 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. Although, secondary data

is predominant in the study, it cannot be treated as archival. So, this strategy was not appropriate.

Action research can be a good strategy for investigating managerial issues and the impact of

financial crisis on an organisation such as a bank. Action research represents an “involvement

with members of an organization over a matter which is of genuine concern to them” (Huxham,

1996, p.75 cited in Saunders et al, 2007, p.141). It can be argued that this research strategy has a

limitation since only one organisation is being investigated. A researcher should become a part

of an institution to explore its internal processes (Coghlan and Brannick, 2005). However,

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. Similarly, 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. A single

bank would not be representative of the whole sectors. For this reason, this strategy was also

rejected.

Grounded theory is another strategy that was viewed as an alternative option. It is quite flexible

because it allows a combination of deductive and inductive approach in a research project

(Goulding, 2002). The strategy is a theory or hypothesis builder. 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. Grounded theory is still more of an

29

inductive study, although it allows combination with deduction. This dissertation is more of a

deductive study. Thus, a quite different strategy had to be applied.

3.6. 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., 2003). 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., 2003). 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. The

data available and the choice of the data collection method is interrelated with the research

strategy.

The final choice of strategy was made after considering the type of data required and the

research objectives. Since the research was meant to include a sample of several banks, the most

rational source of data would be the annual reports of banks. They are publicly available and

audited. This data can be treated as reliable and valid. It can also be gathered in quite short time

because time consuming surveys are not required. Annual reports contain both financial

information for the banks and organisational issues such as forecasts, risk management and

others. The data for the period after the subrpime mortgage crisis is already available in the

annual reports. Therefore, financial statements’ analysis was selected as the primary strategy of

conducting the research. It allows observing different cases of different banks, comparing

findings, making generalised conclusions and accessing quantitative information that could not

have been retrieved by surveys.

The dissertation contains all three types of studies provided by Saunders et al. (2007). There is

an exploratory part in the literature review. It is essential for better understanding of the

investigated phenomenon. Elements of descriptive study are present to draw the context of the

phenomenon. Finally, explanatory study was used to disclose the causes and causal relationships

between different variables. The next section will present the methods and data collection

techniques that were used in the research project.

3.7. Data Collection Techniques and Methods

30

There are multiple techniques available to collect the necessary data for a research project. These

can be structured interviews, questionnaires, retrieving statistical data from secondary sources

and others (Saunders et al, 2007). This research project is concerned with both quantitative and

qualitative aspects of major banks’ performance in the pre-crisis and post-crisis period. Since the

sample consists of only five largest banks, each case can be individually assessed using annual

reports published by the financial institutions. 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.

3.8. The Research Procedure

The procedure will be as follows. As a first step, profitability of the large banks will be

evaluated. Calculations will be made using accounting ratios such as profit margins and returns

on equity and total assets. These findings will be compared among the banks to select the ones

that performed worst from the total sample.

The second step involves the assessment of managerial issues, expectations of managers in the

pre-crisis period and the main sources of funding. 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.

Impairment losses on loans are connected to the amount of write downs that had to be done by

banks. 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. 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. 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.

4. FINDINGS AND ANALYSIS

31

4.1. UK Banking Sector Analysis

Weakened by the current economic conditions UK banking sector does not however represent an

even picture, it has its leaders and laggards. Among the unarguable leaders striving amidst the

economic crisis are such banking institutions as Barclays and HSBC, whereas the outlook for

Northern Rock and RBS is painted in much darker colours.

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, which has

implications on the ways these banks are managed as well as on their performance.

Following the subprime crisis the level of regulation in the banking sector is perpetually

increasing with new risk management policies introduced. This might have a negative effect on

the development of the banking sector, which is required to fight the economic downturn.

The rise of unemployment, 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. Another important concern of the British banking

sector lies with the shattered public trust in banks and the ensuing low deposit volumes.

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. Lower levels of investing and spending also have a negative effect on

the performance of the UK banking sector. 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.

However, there are some positive trends, too. It has been noted that the investment banking was

doing particularly well amidst recession, which drove up the profits of Barclays and HSBC for

the first half of 2009. 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.

Further analysis of the UK banking sector (PESTEL and SWOT) is presented in the appendix.

32

4.2. Financial Performance of the Major UK Banks

The US subprime mortgage crisis greatly impacted the UK banking sector. Financial

performance of major banks substantially deteriorated in the period since 2007. Financial annual

result is the most observable indicator of a bank’s organisational performance. The management

sets the goals to maintain high profitability and provide the best return on investments. However,

these goals are not always reached. Financial performance of the chosen banks can be assessed

by analysing profitability ratios and indicators in the period from 2006 to 2008. 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.

4.2.1. Northern Rock

Northern Rock was one of the first banks to be impacted by the subprime mortgage crisis.

Changes in its financial performance are shown below.

Figure 1: Northern Rock Profitability

33

Source: Annual Reports of Northern Rock (2008)

In 2006, prior to the subprime mortgage crisis, 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. Banks cannot be viewed as regular manufacturing corporations. They do

not have sales but their main activity is to make loans and receive deposits. The overall amount

of interest payments received on the loans made to individual and corporate clients constitutes

the gross income of the bank. It can be equivalent to the revenue from sales received by

manufacturing companies. The cost of sales in a corporation is determined by the prices of

materials sourced and labour costs to produce a product. In banks, the situation is quite different.

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). Liquidity is determined by the amount of

deposits and current accounts made by individuals and corporations. So, 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). Gross profit margin

is, then, the percentage of the gross profit in the interest received.

There is a steep declining trend observed in the gross profit margin of Northern Rock. In 2007, it

fell to 11 per cent. In 2008, the indicator reduced to less than 1 per cent. When liquidity of

Northern Rock was shattered in 2007 as the effect of devaluation of the mortgage backed

securities held by the institution, the panic occurred in the UK. It was driven by the fear that

Northern Rock would go bankrupt and customers would risk losing some of their deposits. A run

on the bank accompanied the panic and the UK government took bold measures to nationalise

the lending institution. All deposits were guaranteed and the run on the bank stopped. In spite of

these measures of the government, the amount of deposits made with the Northern Rock

substantially decreased. The overall amount of interest paid on the deposits fell from £6.1 billion

in 2007 to £5.6 billion in 2008 (Annual Reports of Northern Rock, 2008).

The reduction of the number of deposits in Northern Rock led to a decrease in reserves held in

the Bank of England. As a result, the bank could not make as many loans as in the previous

periods. Liquidity problems started and they were reflected in the pre-tax and after-tax losses

suffered in 2007 and 2008. Profitability of Northern Rock fell to almost -3 per cent (calculated as

after-tax net profit margin). In 2008, net profit margin fell further and reached the level of -23

per cent (Annual Reports of Northern Rock, 2008).

34

Such a downfall cannot be only attributed to the decrease in deposits and the consequent

reduction of loans made to the customers. Large expenses were suffered by the lender as

impairment losses on loans. In 2006, they constituted only £81.2 million. In 2007, the

impairment losses on loans increased to £239.7 million. In 2008, the losses more than tripled and

reached £894.4 million (Annual Reports of Northern Rock, 2008). The overall trend can be

visualised in the following chart.

Figure 2: Northern Rock Impairment Losses on Loans (in £’m)

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. The amount of loans made to customers reduced from £99 billion to £73 billion in

2008 (Annual Reports of Northern Rock, 2008). 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. These write-offs were the

reason why Northern Rock suffered such great losses in 2007 and 2008.

The following two figures demonstrate the changes in returns on total assets and equity of

Northern Rock after the subprime mortgage crisis.

Figure 3: Northern Rock Return on Equity

35

Source: Annual Reports of Northern Rock (2008)

In 2006, the lending institution had a moderate return on equity that was equal to 13.8 per cent.

Adjusting the book value of loans to their fair value led to the overall decrease in assets and

reduction of equity. In 2008, total equity of Northern Rock was equal to only £633.6 million

compared against the value of total equity in 2006 that was £3,211 million. 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. Similar situation is observed with the returns on total assets (Figure 4).

Figure 4: Northern Rock Return on Assets

36

Source: Annual Reports of Northern Rock (2008)

Total assets of Northern Rock were reduced by nearly £5 billion in 2008. The rapidly increased

book losses made returns on assets negative. Negative returns were already observed in 2007. In

2008, a further decrease in returns was suffered.

As an effect of the subprime mortgage crisis, Northern Rock experienced substantial losses, large

amounts of asset write-offs and became nearly insolvent. After the write-off had been made, total

equity of the institution shrank to less than 1 per cent of the total assets. In such circumstances

nationalisation saved the company from possible bankruptcy in the future and restored the

confidence of its customers.

4.3. Banks’ Share Price Performance

The price of a company’s shares is an indicator of how the market reacts to the news,

announcements of financial and organisational performance and future projections for the

company. The analysed banks are public companies and their shares are traded on stock

exchanges. The analysis of the share price dynamics will demonstrate whether the market has

37

had an optimistic or pessimistic attitude towards the financial institutions. The share price of

three banks whose performance was analysed is presented in the figure below.

Figure 20: Share Prices of Banks

Source: Yahoo! Finance (2009)

Throughout the year 2008, the shares of the three banks were on the declining trend. The slope of

the trend became steeper in October of the same year. That is when the stock market in the UK

crashed. However, it was not only a national phenomenon. In fact, the stock market crashes

occurred in other countries such as the US and Russia. The share price indexes in those countries

lost much of their value and reached the bottom by the year 2009.

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. Regardless of the better or worse profitability of each

bank, their equity’s market value substantially decreased during the second half of 2008. 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. In the

early 2009, when annual financial reports were published and the results were announced, the

market reacted with even higher volume of sales that caused further devaluation of the shares.

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

38

entered the market to get rid of the shares of the banks that started suffering losses and financial

problems.

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. The share

prices of both banks plummeted under the pressure of increased amount of sellers.

Since March 2009, the stock market started correcting upwards. Even the shares of the banks that

suffered unprecedented losses (RBS) began to increase in value. 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.

It is valid to notice that not all of the three banks enjoyed a similar appreciation in value of their

stocks. Barclays that was financially the best performing financial institution saw the value of

their shares reach the level of the pre-crash period. Other banks such as Lloyds Banking Group

and Royal Bank of Scotland could not enjoy a substantial appreciation of their shares. The prices

have not yet reached the level of the beginning of the 2009.

4.4. Managerial and Organisational Issues

4.4.1. 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. 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.

This excessive optimism did not allow them to make corrections to their plans. So, no proper

strategy for a possible economic downturn and the fall of house prices was developed.

In the 2006 Annual Report of Northern Rock, Chairman Ridley announced impressive growth

indicators of the financial institution.

“We reached all of our strategic goals and grew both assets and profits to record levels.

We increased lending by 23% taking us to the position of the fifth largest UK mortgage

lender by stock. Our assets increased by almost 24% to pass £100 billion and we recorded

39

underlying profit growth of over 19% - well within our newly upgraded strategic range”

(Annual Reports of Northern Rock, 2008, p.2).

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. Possible problems and changes in the

economic trends were not properly taken into account. Success often blinds the management

team and stimulates overconfident planning for the next period. This happens because managers

naturally desire to beat the records in the next period. However, higher returns on investments

and better performance often have to be connected with higher risks taken. Low risk does not

pay much. For example, 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. By investing financial capital into the risk-free assets, the bank would have

limited its opportunities to earn in high-yield investments.

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, the gross market was larger than originally predicted at about £345 billion. This

year, we expect the market to be above this and in 2008, to be a little higher again,

reflecting house price growth. Support for the housing market remains strong, with

increasing demand for property in the UK from first time buyers, immigrant labour,

university leavers and a falling average household size. This is combined with a restricted

supply of new housing completions. The remortgage market also remains buoyant as

customers seek to refinance at the end of their “teaser” period” (Annual Reports of

Northern Rock, 2008, p.2).

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. 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. 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, this did

not allow reducing the credit, liquidity and market risks of the bank. Unsecured debts continued

rising during the economic boom and in 2006, the portfolio was valued at £4.2 billion (Annual

Reports of Northern Rock, 2008).

The increased demand for securitised investment vehicles prompted Northern Rock’s managers

to offer more of these tools in the market. In order to proceed with securitisation, more

40

individual mortgages had to be bought and repackaged into mortgage backed securities and

CDOs.

“The appetite for securitisation, particularly in the US and Europe, remains huge. We

now have a total securitisation book of £40.2 billion, representing 43% of total funding

stock, and we would expect this to remain at or about that level going forward” (Annual

Reports of Northern Rock, 2008, p.8).

From this statement, it can be noticed that Northern Rock increased the proportion of

securitisation in the total funding. Retail funding, for example, was almost twice as little. The

most emphasis was placed on securitisation and there occurred a concentration of sources of

funding rather than diversification. Concentration, in turn, increases the overall risk for the

financial institution.

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. However, the

monetary policy of the UK government at that time was already directed at reducing inflation by

increasing interest rates. The changes in the Bank of England base rate are as follows:

Figure 21: Bank of England Base Rate

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. Nonetheless, mortgage rates are

dependent on the overall level of short-term interest rates in the country. The UK government

started increasing interest rates in 2006 when Northern Rock announced record profits. The

managers should have foreseen that tightened monetary policy might have an impact on the

situation in the housing and mortgage market. 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

41

sources of funding. However, these warnings from the monetary policy of the government seem

to be neglected. Chief Executive Officer made the following statement:

“UK economic fundamentals are set to remain supportive for the mortgage market - our

core market. Whilst interest rates have nudged up, they remain historically low and long-

term unemployment also continues to trend at low levels, meaning mortgage affordability

remains good” (Annual Reports of Northern Rock, 2008, p.9).

It can be noticed that the management of Northern Rock realised the increase of interest rates but

the possible effects were underestimated. The arguments were made that the level of interest

rates and unemployment remained low compared against historical values. In fact, 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. Consumers and homebuyers plan their expenditure based on the

recent cost of credit rather than what it was twenty years ago. Thus, an increase in the cost of

borrowing even by 1.5% (as it was the case in 2006) could cause a significant shift in monthly

payments on the loans and fewer credits would be taken. However, 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.

5. 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 roots and causes of the crisis lie deep in

the processes that had been developing in the past decade. 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.

The period of prosperity was marked by the rise of global commodity price and house prices in

many countries. The US housing market was among them. A speculative bubble had been

building and lending institutions started taking more risk by including subprime customers to

42

their client base. Recent innovations in financial products that consisted of CDOs and MBSs

became very complex even for institutional investors to assess the credit risk properly. In such

conditions, investors had to rely solely on the ratings assigned by the agencies such as Standard

& Poor’s and Moody’s. However, 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.

A number of UK banks were directly involved in the process of securitisation. A part of their

income derived from trading CDOs and other asset backed securities. Those banks that relied

most heavily on funding from these transactions were hit the most by the crisis. Although their

regular operations remained profitable, the losses suffered after adjusting financial assets to their

fair value undermined profitability of nearly all banks in the UK. Financial obligations that could

be expected did not allow many of the banks to lend to each other and to customers. As a result,

the amount of loans made to the clients and other banks decreased. The examples of such

institutions are HSBC and the Royal Bank of Scotland. However, other strong banks such as

Barclays continued to lend more in the international markets and their financial performance was

significantly better.

Correlation coefficients between the interbank credits and profitability of the financial

institutions are demonstrated in the Appendix. Credit crunch made banks reluctant to provide

loans to each other. Therefore, a number of banks that were analysed showed a decrease in the

amount of loans made to other banks in 2008. Lloyds Banking Group and Barclays were the

exceptions. After observing the cases of the five major banks, the amounts of interbank loans

were not found to be highly correlated with profitability of each individual bank. The highest

correlation was shown by HSBC. However, 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, impairment losses suffered by the banks were all highly correlated with

profitability. This proves the hypothesis that the increase amount of write downs and impairment

losses substantially undermined profitability of major banks in the UK.

On the operational level, the majority of the analysed banks showed good results and the

increase of gross profit margin. Northern Rock was the only exception. This suggests that

ordinary banks’ operations such as making loans to corporate and individual clients continued to

43

improve and could have led to higher profitability of the banks. The problem was observed in the

trading activities of the banks and changes in the fair value of financial securities. The

impairment and trading losses were the main reason why major UK banks showed such poor

financial results in 2008.

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. Freezing up of

the money supply or credit crunch was also a factor of lower profitability. However, its

importance was less significant in large and financially stable lending institutions such as

Barclays. The bank increased the provision of credit to other banks in 2008 and other banks’

deposits with Barclays also increased. 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.

Managerial issues such as decision making mechanisms showed to be significant factors in

determination of the banks’ profitability. Not all cases of the banks demonstrated that managerial

decisions and planning lacked resilience. 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. On the other hand, the banks with the worst managerial performance (e.g.

Northern Rock) showed significantly worse financial and organisational results. Hence, the level

of resilience in management substantially determined organisational performance of the analysed

banks.

5.1. Limitations and Future Recommendations

The main limitation of the research is that a small sample of banks was used to perform the

analysis. This did not allow constructing a regression and statistically assessing the significance

of each factor that could impact profitability of the financial institutions. However, large sample

would have limited the qualitative analysis of managerial issues and disclosing the individual

case of each bank. Attempting such an analysis would be time consuming and irrational. 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.

Regressing the variable by factors such as the amount of loans made to banks, the amount of

loans made to customers, the amount of write-offs and interest rates will demonstrate

44

contribution and significance of each factor with t-statistic test. The limitation of the model,

however, will be the inability to observe qualitative factors that can help assess the level of

resilience in managerial decisions.

APPENDICES

Appendix A: Correlation Coefficients

  Pre-Tax Income  Northern Rock HSBC LBG Barclays RBSImpairment Losses -0.959115011 -0.81699 -0.99593 -0.9932 -0.99972Deposits by Banks -0.67177682 -0.3275 -0.99987 -0.97163 -0.21292Loans to Banks 0.472071305 0.86103 -0.45884 -0.87315 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

Social Factors

High unemployment rates

Shattered trust in banks

Negative publicity from the bonus payouts issues in failing banks

Low levels of consumer spending

Technological Factors

Development of online-banking that helps reduce costs

Growing online fraud

Innovations in credit card services appealing to consumers

45

Environmental Factors

Corporate responsibility becomes more and more of an issue, with banking institutions

trying to reduce their CO2 footprint, 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.

Appendix C: SWOT Analysis of the UK Banking Sector

Strengths Weaknesses Profits from the investment

banking sector Available governmental support Global operations ensure the

benefits of economies of scale and diversification of risks

Volatile economic conditions Shattered public trust in UK banking

institutions Due to the economic crisis, 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

Opportunities Threats Growth in the investment banking

sector Rapid growth rates in the

developing countries and international expansion of the UK banking institutions provides growth opportunities

Possible increase of the tax burden , due to the high level of buget deficits

Increasing online fraud Negative publicity with regards to

bonus payments, inefficient management, etc.

46

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