Corporate Governance And The Banking Crisis In Us And Uk 2007 To 2010

By Author: Henry Ford
Total Articles: 189
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The 2007-2010 financial crises can be described as the worst crisis the world has faced since the Great Depression. It has had severe impact in the world economy and ripples of the crisis have been felt even by the developing nations that were not directly linked to the epicenter of the crisis. One of the main factors that have contributed to the spread of the crisis all over the world has been the interconnectedness of the global economy as a result of globalization. The rate at which the recent economic crisis spread to the rest of the world is not the same rate at which the Great Depression spread because the world economy is more interconnected today than it was in the 1930s.
The recent economic crisis started in the United States and spread to other parts of the world. It build up slowly starting in 2001 and peaked up in 2008 when financial institutions started to crumble and the economy started to slow down. Although it was highly anticipated that an economic crisis would finally ensue as a result of housing bubble in 2001, it was delayed and most people thought that the crisis would not happen in any way. ...
... When the crisis finally struck in 2006, it spread very fast and within two years, it had eroded consumer wealth and claimed a number of financial institutions.
The recent economic crisis was trigged by a subprime mortgage crisis in the United States. Since 1980s, United States had repealed a number of regulations in the financial sector and had allowed it to operate with minimal regulations. In addition, from Clinton administration to Bush administration, Americans had been encouraged to continue spending as a way of stimulating economic growth. The real estate sector was one of the areas that were doing very well and investment institutions rushed to put their money in the sector not knowing the dangers that were hidden. Since 2001, the Federal Reserve kept the interest rate low in a bid to avoid a financial crisis but this encouraged Americans to borrow and invest in the real estate sector. Housing prices kept on rising as the demand for houses increased. Due to lax in regulations, new loans schemes emerged and it became easier for individuals without capability to repay loans, otherwise referred to as subprime lenders, to access loans. Apparently, the supply of housing units surpassed demand and housing prices began to fall. The interest rates began to rise and it became difficult to service the loan with rising interest rates and falling house prices. Eventually, the rate of loan default increased and institutions rushed to repossess homes to recover their loans leading to increased foreclosure. During the boom in the real estate sector in the U.S., international investors with excess capital had found a promising sector to put their money into. They bought collateralized mortgages and when the calamity of the subprime crisis befell on the housing sector, they were also not immune. This led to spread of the crisis from the United States real estate sector to the rest of the world.
There were many factors that led to the economic crisis. The crisis in the subprime sector was contributed by different factors but chief among them was lack of proper regulations of the financial market. The government allowed rise of shadow banking system, which was not well regulated and that used bait method to attract borrowers to borrow loans with hidden interest rates. The government did not come in time to regulate the mortgage sector even after alarm was raised over shadow banking. In addition, there was flawed assessment of the credit worth of borrowers and people who had no capacity to repay the loan were eventually given loans and later defaulted.
The most important cause of financial crisis that is the focus of this study was corporate governance. In both U.S and UK, corporate governance laws were overlooked and financial institutions underestimated the risk they were putting their investment into. Even when it was clear that there would be an eventual crisis in the mortgage sector in the U.S, financial institutions continued to invest in the sector. The risk assessment aspect was overlooked by most financial institutions. In addition, executives of financial institutions continued to receive fat pay and bonuses even when their institutions were dipped into the crisis. Although there were existing rules on corporate governance, they were overlooked and not strictly enforced as should have been the case. The idea of “too big to fail” was finally proved wrong as big financial institutions fall one after the other.
It is in the light of deficiency in corporate governance and regulatory environment that both U.S and UK implemented a number of factors that were aimed at correcting the situation. The U.S Congress passed the tightest regulations of the financial sector in July 2010 that are meant to streamline operations of the sector. Realizing the rot in corporate governance, UK commissioned Sir David Walter to give recommendations on what should be done to streamline corporate governance in the financial sector. Sir David Report gave 39 recommendations that were to be followed to ensure that the financial sector observed the laid down laws on corporate governance. The report did not give new laws to be followed but it gave recommendations on what had to be done to ensure that the existing laws were followed. It appears that the two countries have decided to tackle the problem right from its roots by formulating and implementing regulations of the financial sector, as will be discussed in this study.
Bank crisis in the US
Bank crisis in the United States started in 2007 and peaked in 2008. It happened at the same time as the subprime mortgage crisis, which has been described as the main cause of 2008 global economic crisis. Subprime mortgage crisis was a real estate crisis that was triggered by a sudden rise in mortgage deliquesces consequently leading to increased foreclosures in the country. This had adverse consequences on banks and financial markets in the United States and other parts of the world as well.
The 2008 bank crisis in the United States did not start at once but it had piled over long period of time. The problem can be traced to 2001 when there was a massive stock market and capital spending bubble. It became evident that the country was facing a recession and Federal Reserve had to cut interest rates down to 1% which remained until 2004 when they were raised slowly. This means that because the interest rates were low, the financial services industry saw opportunity in a lot of money that they could make and they all went into real estate but they were unaware that the low interest rates just masked large risks. However, Americans were expecting a downturn after such a bubble burst but it was not yet coming. It was soon realized that the money that was being lost in the stock market could be fast offset by increasing home prices and therefore they continued spending freely. Consequently, as Americans continued with free spending, United States was still getting into bad debts with the rest of the world. Foreigners continued to use their dollar IOUS from these accumulated debts to lay foundation for their bubbles as well.
In 2006, it became evident that the market could not hold any longer. Those who could least afford to purchase their own homes, hereby referred to as subprime borrowers continued defaulting on their loans, with prices having overgrown their range of affordability. However, it was not until 2007 when HSBC issued a stern warning, just a harbinger of things that were to come when it write down tens of billions of dollars in losses. HSBC had made a large loss from its ill-timed acquisition of subprime lender Household International in 2002. Policy makers did not first see reason to raise the alarm and they sat down watching for the system to correct itself. However it became evident that things were not moving in the right direction when two Bear Stearns hedge funds blew up in 2007. It became evident that the potential risk had been underestimated and fear gripped the market. In August 2007, BNP Paribas, a French bank, froze withdrawals in three investment funds and panic gripped the market. If this bank, that had zero exposure to U.S mortgage market could have found it difficult, the financial institutions in the United States were hiding untold stories. The year 2007 therefore marked the beginning of the credit crisis that was later to spread to other parts of the world. Fear spread not only in the stock market but also among the financial institutions. There was mutual distrust among large banks because no bank knew how far the other bank had been affected by the financial crisis. Interbank lending became difficult which means that most banks could not easily access credit. Credit became dry in the market and the economy started a downward spiral.
At the same time, housing prices in the United States continued to fall. There were massive losses in the mortgage-relative derivative assets that were held by large global banks. These instruments had come to be referred to as derivative because they were largely derived from value in underlying assets including mortgages. The first cases of mortgaged-related losses were concentrated on these instruments and investment vehicles like RMBSs (Residential Mortgage Backed Securities), CDOs (Collateralized Investment Vehicles) and CDOs. Among the leading investment institutions, Merrill Lynch became the first institution that reported large losses of $5.5billion in 2007. Three weeks after this loss, Merrill Lynch came again and announced that losses had reached $8 billion. That year alone, aggregate losses from all global institution grew to $500 billion. While things cooled a bit in 2008, the fall of hedge funds Peloton and Carlyle Capital brought in another wave of panic. The sudden collapse of Bear Stearns, which was the fifth largest investment bank in United States brought market confidence to all time low. In June 2008, Lehman Brothers accounted that it had made a loss of $3 billion and the crisis came to a full view once again as panic spread in the market.
At this time, the market did not recede that fast. It remained under constant stress. The market remained in panic as IndyMac, which was an aggressive mortgage lender was taken over by FDIC. Next on the line was GSEs. Fear and panic gripped the market and questions were now raised about Fannie Mae and Freddie Mac, which were the largest mortgage lender in the market. To restore market confidence, the government had to take over the two institutions to stabilize the stock market. Financial shares came under severe assault. Those that were considered weakest had come under selling pressure that eventually led to collapse of Lehman Brothers. The company was not able to access government support and it could neither close on a merger and it filed for bankruptcy on September 15, 2008. On the same weekend, Merrill Lynch eventually sought cover and was taken over by Bank of America. Eventually it was evident that there was no institution that was too big to fail and assault on financial sector continued as AIG, the world largest insurance company, succumbed to the crisis. With the fall of AIG, more fear gripped the marked and the entire banking system was almost collapsing. It was important for the government to take prompt measures and rescue financial institution that were on verge of collapsing because this would have a huge impact on the financial sector.
There were many factors that contributed to the 2008 financial crisis. The growth of the housing bubble between 1997 and 2006 had led to 124% increase in housing prices and sudden decline in prices led to lose value and increase default of loans. There was also easy access of credit that baited people to take loans they could not repay back leading to default of loans. Low interest rates from 2001 encouraged people to borrow and fault assessment of creditworthy of borrowers further increased default of loans. Subprime lending therefore became the biggest factor that contributed to the credit crisis. Increased lending to borrowers with weakened credit histories and greater risk of defaulting loans led to massive loan default. The predatory lending gave rise to unscrupulous lenders who used bait-and-sight method to entice lenders to take loans inform of home financing but the cost of repaying these loans became higher later and the rate of default increased. Another major factor that led to financial crisis in the United States was deregulation. The regulatory framework did not guarantee tightened control of the financial sector and therefore financial instructions came up with financial innovations like shadow banking system, derivatives, and off-balance sheet financing. There were weak laws while the existing laws were also not well enforced thereby leading to the financial crisis. A number of regulations on financial sector that had been implemented after Great Depression were phased off through different acts like Depository Institution Deregulation and Monetary Control Act 1980, Gramm-Leach-Billey Act 1999 that repealed Glass-Steagall Act of 1933, 2004 relaxing of net capital rule by SEC, and others that weakened regulation of financial sector.
Closely tied to regulatory factor was corporate governance factor. There was evidence failure and weaknesses in corporate governance arrangements that eventually lead to collapse of the financial sector. The effectiveness of corporate governance could have been realized during the financial crisis but when they were put to test, corporate governance routines showed that they were not in a position to serve their purpose and safeguard against taking of excessive risk. There was evident greed among the executives that had been trusted to take up leadership of the financial regulations. Apart from taking home fat salaries and bonuses, executives were less concerned with the risk they were taking in name of getting more profits for their companies. Even when companies started making huge losses, executives continued to be awarded huge salaries and bonuses.

Bank crisis in the UK
The case of bank crisis in the UK is a perfect illustration of the fact that the belief that bankers can create wealth and bring about economic productive cycle is mere illusion. Before 2001 when the bank crisis started in the UK and U.S, UK banks had no previous exposure to wholesale lending markets. This was a new experience to UK banks, which could be described as nothing more than a euphemism for collective international banks. The new borrowers in the block were Northern Rock and Halifax among others. Their entry into the market was something to be celebrated but their exit was not celebrated.
UK financial crisis was an overspill of what was happening in the U.S. The interconnectedness of the two economies meant that what was happening in one economy affected the other. The events taking place in the U.S were fast catching up with the UK and the timeliness of the crisis in the two countries was almost the same. First, it was spread of fear and panic in the U.S market but there was little concern in the UK. No one in UK thought that the crisis that was affecting U.S subprime sector could in any way affected the UK. On September 13, 2007, BBC revealed that Northern Rock had asked to be granted emergency financial support from the Bank of England as a last resort as the crisis made inroads into the UK. Northern Rock was among the new lenders that had relied heavily on the markets instead of the saver’s deposit to fund the mortgage lending. This means that once the confidence of the market was affected, Northern Rock was shaken from its core. In the same month, it had been revealed that the rate at which banks lend each other had risen to its highest since December 1998. The Bank of England set its base rate at 5.75%. The rise in the interbank lending rate was contributed by the fact that no bank understood how the other had fallen deep into the mucky of economic crisis. There was general mistrust among the UK banks.
In the wake of realization of the problems that were facing Northern Rock, fear gripped the UK market. In September 14, 2007, depositors lined up to withdraw their saving in Northern Rock. In one day alone, depositors withdrew more than £1 billion from Northern Rock, what can be considered the biggest run in the history of banking industry in UK. Northern Rock dipped into more trouble as more and more depositors lined up to withdraw their saving until the UK government intervened and assured depositors of the security of their savings. The problem of Northern Rock continued until it was partially nationalized by the government on February 17, 2008.

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