Impact of the Credit Crunch in the UK

Impact of the Credit Crunch in the UK Factors Influencing the Financial Institutions in the UK With Particular Reference to Credit Crunch A Comparative Study between Barclays and Northern Rock Bank I- Abstract Banks acts as intermediaries between surplus units depositing funds and investors or individuals seeking capital for investments. Thus, banks role is important in maintaining the flow of fund between these different parties. Banks like any other profit maximising firms are influenced by various factors that represent risks or opportunities. Therefore, banks business decisions are founded on aspects such as confidence in the market, the level of risks, the state of the economy, and their competitive strength. Regulation is essential for assuring compliance and integrity in the financial system, but rigid rules stifles the dynamicity of the banking industry and the financial sector as whole. Moreover, Central Bank role as a lender of last resort can rise the issue moral hazard by helping imprudent banks, however because banks are financial intermediaries, the impact of bank failure can have a detrimental effect on the financial system (systemic risk), and also on clients and customers, therefore bank supervision is vital due to their sensitive important role and their extensive impact. Furthermore, the development of events in the US financial market particularly the high default rate of subprime mortgage market led to a decrease in demand for tradable securities. This has affected confidence in the US and the global financial market, and consequently some financial institutions and banks such as northern rock in the UK faced difficulties in obtaining the necessary funds to maintain the business operation and remain solvent due to lack of short term liquidity. However, other banks faced similar difficulties but are using various methods to improve their balance sheets to overcome the current credit crisis. Moreover, governments and regulatory bodies are all taking the necessary measure to stimulate the market and tackle the core sources of the current credit crisis. II- Introduction Sustained economic development is often linked to efficient management of fund that is used to finance investments, which are projected to further create more wealth and opportunities for states, corporate and individual investors. Banks acts as intermediaries between surplus units depositing funds and investors seeking capital for investments. Thus, banks role is fundamental in maintaining the flow of fund between these different parties. Furthermore, the stability of financial and banking system is vital for the sustainability of economic growth and the preserve of investors confidence. Banks like any other profit maximising firms are influenced by various factors, these includes internal and external factors, which represent risks or advantages. Therefore, banks decisions are based on elements such as confidence in the market, the measurement and management of risks, the state of the economy, and their competitive power and market share. This study will look onto various factors influencing the financial institutions in the UK, with particular reference to Credit Crunch. This literature will comprise the banks management of risks, the role of authorities regulating and supervising the financial system, and explore the regulation of the banking industry and the financial system as a whole, in addition of the effect of regulation on banks performances. The analysis will include a comparative study between Barclays and Northern Rock Bank, taking into accounts the differences in their structure, size, as well as their reaction to changes in global financial markets. Furthermore, the Research will examine the fast moving global effect of the credit crunch; discuss the two banks business model, and explore their activities and behaviours. The study will also investigate the two banks high exposure to credit risks arising from risky investments, highlight the consequences of the heavy reliance on money market, and the use of securitisation for liquidity sources. IV- Methodology The research objective is to investigate the various factors that influence financial institutions in the UK, notably the banking industry. This research was based mainly on secondary research, the gathered data and information was sufficient for this research topic. However, sensitive data regarding the value of risk were not disclosed in both banks publication, such data is useful for the researcher to scrutinise banks estimation of risk and how realistic are the projections. Nevertheless, information about estimation of risks may be obtained directly from banks for further analysis of this specified area of banks management of risk. Research material relevant to the topic was collected from various academic sources; this is to explore issues and arguments regarding the regulation and supervision of the banking system. The two banks internet site was used to gather the background information along with the financial statements of the last six years, which were used in the research analysis to perform the comparison between Barclays and Northern Rock bank business strategies and financial performance. Publications from the Bank of England website were collected to study the central bank regulation and the management of the UK banking system, in addition to the historical data regarding interest, LOBOR, and inflation rate changes. Furthermore, articles from the Financial Services Authority (FSA) were gathered to study the role of the organisation and its contribution in supervising and stabilising the UK financial system. Recent publications from the Bank of International Settlement (BIS) were collected to study the role, the objectives and the effect of Basel directives on banks. Besides research the progress of current Basel II implementation along with the development of new requirements arising from the present credit crunch. Recent newspaper articles and various other media sources were gathered to collect the latest information regarding the development of the present credit crunch and its effect on banking industry, these includes sources such as BBC business, yahoo finance and the Financial Times website, and follow recent actions of regulators and banks management of the current crisis. Moreover, data from the two banks financial statements was collected to perform the Gap Analysis using Microsoft excel package to conduct a series of calculations. Other methods could have been used to assess bank risks such as value at risk (VaR) using regression analysis by utilising a computer package such as Microsoft Excel. The regression result will determine the degree of risk that the researched banks possess in their portfolio. However, the banks seldom disclose such sensitive information in published financial statements. This is to avoid adverse reaction by investors and credit rating agencies, which could therefore affect the banks stock prices, their reputation and confidence in the capital market. V- Literature review (Part I): The nature of banking The term bank can be applied to a wide range of financial institutions, from large banks to smallest mutually owned building society in the UK. The provision of deposit and loan distinguishes Banks from other financial institutions. Deposits products supply money on demand or following time notice. Deposits are liabilities for banks, thus must be well managed if banks want to make profit. Similarly, banks manage assets created through lending. Therefore, Banks main activity is being an intermediary between depositors and borrowers. Other non banks financial institutions, such as building societies and stockbrokers, also act as intermediaries; however it is the provision of loans and taking of deposits that distinguishes banks, though many banks provide various other financial services. 1) Management of risks in banking The fact is that bankers are in the business of managing risk. Pure and simple, that is the business of banking. (Walter Winston, former CEO of Citibank; the Economist, 10 April 1993). Banks, like all profit maximising firms, have to deal with macroeconomic risks, such as recession, inflation level, as well as other micro economic risks including political pressure, commercial breakdown of core customers or suppliers, natural disaster, in addition to the emergence of new competitive threats. From a finance theory viewpoint, Bank risk management is primarily composed of four main balance sheet risks, which includes liquidity risk, interest rate risk, credit risk, and capital risk (Hempel et al, 1989). Credit risk has been recognised as the principal risk in its effect on bank performance (Sinkey, 1992, p. 279) and bank failure (Spadaford, 1988). The primary reason why the correct management of credit risk is essential is because banks have restricted ability to absorb loan losses. Generally, the ability of a bank to absorb a loan loss is originated firstly from generated income of other profitable loans, and secondly by bank own capital. 2) Factors influencing financial institutions Banks and other profit maximising firms are influenced by various factors; financial institutions in particular are susceptible to a range of changes that may affect their projected growth. Some of these changes are internal changes, this occurs subsequent to restructuring program that a bank adopt following an expansion strategy such as in mergers and acquisitions or as a defensive strategy to remain competitive and maintain market share and fight competitive predators from acquiring the bank. Moreover, there are other external factors that can influence financial institutions, these includes a countys government monetary policy, the economic condition, the financial stability and the level of confidence in the market, the inflation rate, in addition to other risks such as credit and market risks. There are a range of risks that a bank may encounter, these includes the followings: a) Credit risk and counterparty risk: counterparty risk refers to the risks that after the creation of two parties contract, one party will renege the terms of the contract, while credit risk is the risk that a loan or an asset becomes lost due to default. b) Liquidity or funding risk: these are similar terms that refer to the risk of shortage of liquidity for maintaining operational commitments, that is the ability for the bank to cover its liabilities at due date. A shortage of sufficient liquid assets is often the trigger of financial distress, as it is increasingly difficult for the bank to obtain funds from the wholesale markets. Thus funding risk is the inability for the bank to maintain its daily operations. c) Market or price risk: this type of risk refers to the risk linked to over the counter instruments or traded stocks in a non liquid market, such as equities and bonds. Thus if a bank hold these items in its portfolio, then it is vulnerable to market or price risk, this is the risk that the price of these items is unstable, which is caused by systematic (movement of prices in all traded market instruments, for instance due to changes in economic policy) or specific market risks (the movement of a particular instrument is opposite to the rest of similar instruments, for example, this may be caused by unfavourable information about the issuer of that instrument). d) Interest rate risk: this is similar to price risk, because interest rate is price of money, it represent the opportunity cost of keeping money. This occurs because of interest rate mismatches between assets and liabilities, which differ in volume and maturity arising from the banks performing asset transformation. e) Capital or gearing risk: because banks are highly leveraged firms, they have to set aside some capital to cover the losses. The size of capital is proportional to the level of risk taken by the banks. Basel risk asset ratio principle requires banks to hold up to 8%. Besides, settlement or payments risk. This is when one party in the contract deliver assets or makes payment in advance, which creates exposure to potential loss. Furthermore, operational risk refers to risks from human capital, legal risks such as law suits, fraud, and physical capital. While sovereign and political risk refers to the risk that a government default on its debt obligation to a bank. Moreover, financial regulators has identified three main risks linked to banks, these includes market risks such as risks from exchange rates, interest rates, operational risk, commodity and equity prices. 3) The Asset-Liability Management (ALM) technique Because the fundamental and the primary activity of a bank is intermediation between surplus units that makes deposits and those that seek capital, which acquire fund from the bank, thus this payment system gives the bank the role of intermediation , where the intermediation is key activity, risk management is founded principally on a sound asset liability management (ALM). Furthermore, the ALM is a technique practiced by banks to effectively manage their risks, which was largely utilised by banks in the post war period up to the 1980s. The ALM method was the main tool used to manage banks books, it is essential that the bank maintain its assets and liabilities under control to minimise risks and remain solvent. Besides, banks are keeping their managers updated with newer techniques and skills to maintain their efficiency and competitiveness for the future, for instance, ALMA is an association that comprise around 40 financial institutions, which are international and local banking groups and building societies, mostly UK and Irish. However it is growing its membership and links around Europe. Its objective is to offer an informal and inclusive forum regarding the balance sheet management issues (Byrne, J. 2004). Due to the development of banking activities, innovative instrument became increasingly used by banks to manage their assets such as off balance sheet instruments, where banks moved from interest earning income products to non-interest income sources, thus this required that banks risk management should adopt newer techniques other then just the ALM to includes the risks originating from the off balance sheet instruments. Moreover, one of the new methods included in managing market and then credit risks is the Value at Risk (VaR), which involves giving an estimate of losses arising from the volatility of banks assets. 4) Credit Culture A recent research conducted by the Australian institute of bankers on the issue of Improving Asset Quality (Brice, 1992), which focused on the significance of credit culture. The great emphasis on credit culture was due to its influence on bank performance and in some occurrences bank failure ( Spadaford (1988) and Brice (1992)). Spadaford (1988) stated in his study of 162 bank failures in the United States that the analysis showed that 98% of bank failure occurred due to asset quality problems, among these problems are poor management of loan policy, inadequate systems to ensure compliance with internal rules and procedures, and the lack of supervision on senior and key management members in the organisation. McKinley (1991) has defined four main cultures that influence bank performance. predominantly the immediate performance-driven, which emphasis on earnings targets, followed by Market share/production-driven that focuses on being the biggest with greater production volume, along with Values-driven that balances between credit quality and generated income. In addition to the Unfocused (current priority-driven) bank, such bank lacks vision and appropriate strategy often set short term targets which consequently lead to unsuccessful ventures. VI- Literature review (Part II): Banks regulation The base of regulating financial institutions is founded on three broad frameworks. Primarily, the consumer protection argument, this is based on the notion that investors and depositors cannot be demanded to perform risk assessment of financial institutions they deal with, nor monitor standard of service or performance of these institutions. The consumer protection underlying principle is based on three types of regulation; firstly, compensation schemes created to repay all or part of losses caused by the insolvency of financial institutions; secondly, rules and regulations such as capital adequacy requirements designed to prevent insolvency; and lastly promote fairness in business or market practices by setting rules and standards. The latter regulation reveals market imperfections arising from principle agent problems, asymmetric information, and the issue of determining the true value of financial products or services, which are established well after the transaction or contract was formed (Dale, R and Wolfe, S. 1998). Furthermore, there are other concerns associated with consumer protection rationale. The provision of compensation to depositors and investors for losses sustained from the insolvency of financial institutions will further encourage these institutions to pursue risky investment decisions, thus there will be minimal or no incentive for prudence. This indicates that risky firms will be able to attract trade with identical terms and ease as prudent institutions, thus affecting financial market standards and discipline, and rising potential insolvency incidences. Therefore, the resulting losses must be covered by the deposit insurance scheme, investor protection fund, or in some cases by the tax payer. Thus, prudential controls on financial institutions are essential to minimise losses and to balance the regulatory incentives with the excessive risk-taking. The third aim of financial regulation is to promote integrity of markets, encompassing various issues such as market manipulation, fraud, transparency, and fairness; market integrity emphasis on organising the market as whole beyond just the relationship between financial firms and their consumers. Supervisors implementing the financial regulation consider systematic risk as the factor that causes great concerns. That is the risk that failure of one or more distressed financial institution could spread and cause a contagion effect, which could cause the collapse of other prudent institutions. It is their vulnerability to the contagion effect that single out financial institutions from other non financial firms. 1) Targets of regulation The major objectives of Financial regulation is to set guidelines for the activities of Banks, insurance companies, investment firms, exchanges, and fund management companies. The diverse principles for financial regulation mentioned above vary in their relation to these various institutions of the financial services sector. Banks are distinguished by what is referred to as short- term and unsecured value certain liabilities (deposits) and illiquid value-uncertain assets (loans). Banks conforms to deposits insurance and other type of consumer protection, partly because banks balance sheet consists of a variety of complex instruments and depositors are not capable to measure the riskiness of their deposits. However, depositor protection creates moral hazard problem. Furthermore, banks regulation focuses more on systemic risk. That is the possibility of a bank run that can spread to a number of banks and trigger a wider instability in the financial system. According to this notion, bank runs are the result of action by depositors retrieving their funds in response to amounting fear and uncertainty of the bank future arising from bank asset losses that could render it insolvent. Due to potential risk of losing all or some of their assets, depositors tend to make a run when initial signs indicate some troubles. Moreover, recent research found that the occurrence of a bank run can not be entirety explained by the decline of banks underlying assets (LaWare, J.1991.p34), (Diamond and Dybvig, 1983).The emphasis is on a banks maturity transformation notably the transfer of illiquid assets (bank loans) into liquid claims (bank deposits), taking into account that the banks loan portfolio substantially decline in value in an event of liquidation than on going concern. What triggers a rational bank run is that the uncertainty and the higher probability that the loan portfolio liquid value is less than the value of liquid deposits. This notion demonstrates how bank runs can possibly arise and affect even healthy banks. Thus distressed bank have to liberate its assets at liquidation value, therefore leading to possible insolvency. 2) Techniques of regulation While procedures of conduct of business regulation do not differ among various types of institutions, but in terms of prudential regulation there are fundamental differences that reveal the distinctive risk features of banks, insurance firms, and investment companies. Because bank failure has a greater effect on the whole market, and can create systemic crisis, governments and central banks have set bank regulation for creating extra protection in provision of extra fund by setting the lender of last resorts facilities, and deposit protection, however, these facilities creates moral hazard. Moreover, the deposit protection fund may exceeds the available protection from deposits insurance schemes, demonstrating policymakers greater emphasis for protecting the banking institutions rather then just depositors, as well showing the regulatory objectives of sustaining the banking system, while preventive regulation focuses more on tackling excessive risk taking by setting capital adequacy requirements for assets. Institutional regulation varies between states; in the UK for instance there was a single mega regulator, all regulation is institutional, each group/ institution have a diversified activity which all work under a single agency that overlook the supervision. Alternatively, in a system of multiple regulatory agencies specialised by duty, a fixed institutional regulation is unattainable due to the fact that these agencies are divers in functions, which calls for the appointment of a lead regulator for diversified groups (Taylor, M. 1995). 3) Regulation of the financial system By tradition banks are providers of loans among other services to firms and individual investors, temporary banks falls in deficits when their expenditure exceeds receipts; however banks generally adjust their liquidity position by using capital or wholesale market. Problems occur when banks capital is misused in funding high risk investments; this is often the consequences of bad governance by senior management in controlling the banks assets or it is the outcome of a contagion effect resulting from systemic risk. Moreover, the central bank controls and monitor commercial banks activities and set rules to regulate the banking system. This is to create stability and to promote confidence in financial market, which are vital elements in maintaining steady economic growth. 4) Bank failure Regulation of banks must be explored in context of bank failure. As any substantial problem produces the need for the introduction of changes in the regulatory framework, because the regulators attempt to correct any loophole in the system. Major bank failures in the history of banking occurred in the US in the year 1929. At that period there were 25,000 operating banks, however by 1934 the number had reduced to 14,000. These incidences consequently led to the implementation of more restrictive bank rules, such as single state operations, which until recently remained the feature of the US banking system. The subsequent major bank failure was the fringe banking crisis in the UK in the year 1973. 5) Reasons for regulating banks The principle reason is the systemic risk, because the financial system is susceptible to level of confidence, therefore external regulation is essential in maintaining the stability and reduces further volatility. The second reason represents the social cost that a failure of bank causes, which have a greater impact then a failure an ordinary firm. The insolvency of a firm affects the shareholders, while the failure of a bank will have a greater number of affected customers (depositors), which could also be spread across larger geographical locations. As well as the effect it will have on providing savings for potential investors which will have a detrimental impact on the economic growth. The third reason is the possible lack of knowledge by the public, it is suggested that they lack the necessary background information to distinguish between safe and risky investments partly due to asymmetric information because depositors do not have access to the same information available for banks. Thus comprehensive risk assessments necessitate additional information to that included in financial reports. Hence for this particular reason regulators had introduced depositor protection. Although the above arguments support regulation, however there should be some caution on the use of excessive control over banks. It is primarily the issue of sustained cost in terms of resources on banks and the regulators. Because the central bank has to set teams of experts to perform the prudential control, likewise banks have to employ skilled resources capable to produce the necessary required returns to the regulator. Such costs can be large, thus it is a matter of cost benefit analysis to establish whether the gain of applying prudential control exceeds the incurred costs. Other possible dangers of excessive regulation are the fall of competition, increase in costs and the diminishing pace of financial innovation and development. Furthermore, heavy regulation on a particular centre may lead to the migration of the activities to locations that have lenient regulation, which has been the principle factor in the development of offshore banking centres that led to the need for a global regulation system for international banks, which is known as a level playing field. 6) The supervision of the financial system in the UK The above arguments about prudential regulation are based on banks but it can also be applied on various other financial institutions. Furthermore, the current UK financial regulation system utilise the same measures in authorising and supervising financial institutions without a distinction between insurance firms, building societies, or banks. The FSA is the principle regulator of the financial system in the UK. The FSA was established in 1997, succeeding the Securities and Investments Board (SIB), which was supervising the investment industry. However, the FSA has progressively thought to become the main controller responsible for regulating insurance and investment industry, building societies, and banks. In addition to regulating financial exchanges such as Euronext.liffe and the Stock exchange besides clearing houses, along with other functions such as the responsibility of regulating the access of companies to Official List in cooperation with the UK Listing Authority. The initial development occurred in 1998, when the Bank of England transferred its responsibility of regulation and supervision of banking to the FSA, which was succeeded with the passing of the Financial Services and Markets Act (FSMA) 2000 that provided the FSA with full power as the main regulator. The FSMA requires the FSA to attain the following objectives: Promote public awareness of financial system Maintain confidence in the UK financial market Secure consumer protection Reduce financial crime. 7) The FSA approach to supervision The FSA approach to supervision is risk based; the primary phase is to assess the risks associated with four objectives above. The FSA attain this through gathering information from various sources including customers and supervision of firms. The secondary phase is risk weighing and estimating impact, by giving each risk the probability of occurring, thus giving it a score or value. Thus firms with high magnitude impact require greater supervision. This is to reduce systemic risk and consumer losses. However, firms that possess highly sophisticated and effective risk assessment systems require less supervision by the FSA. Finally, after the risks are identified, assessed and weighted, the FSA select the appropriate measures to respond using various tools, which can be summed as follows: Those aimed to influence the behaviour of consumers, operators, and the industry Those aimed to influence the behaviour particular firms. The first category encompasses consumer education, the discloser of information, and compensation method, while the second category includes the provision of authorisations to firms and discipline, in addition to reimbursement of losses. 8) Capital adequacy (Basel Capital Accord, 1988). Liquidity is essential for any firm to maintain its daily operation, whereas solvency refers to the ability of a bank to meet its commitments in terms of liabilities at due time. However, there is a distinction between liquidity and solvency. There is a general understanding that if a bank is thought to remain solvent then it should be able to borrow fund from open market to meet its short term liquidity requirements. Likewise, the presence of liquidity problems that cannot be resolved through the wholesale market suggests that other lenders believe that the risk of insolvency of that particular bank is great. Furthermore, if a bank struggle to find short term funds in the markets, it will face difficulties in paying its claims. Therefore the Bank of England and the FSA requires banks to efficiently managing their liquidity as a principal policy element of reducing the risk of insolvency. The Basel committee on Banking Supervision has introduced Basel Capital Accord II; it included new amendments to the assessment of capital adequacy of banks. This new approach was ought to be implemented in year 2006, which contains three pillars: Minimum capital requirements Supervisory review of capital adequacy Public disclosure. Basel II accord focuses on credit risk and market risk. In pillar 1, the treatment of market risk was not altered but changes were made on the treatment of credit risk notably operational risk. The bank for international settlement and the Basel committee on banking supervision have founded the financial stability institute (FSI) to assist central banks across the world to improve their financial systems. The new Basel II requirements set challenges on banks to develop and increase efficiency on their capital management. In this section, there is a discussion of the effect of Basel II on Banks in Europe and North America, and how the new directives are going to improve the cohesion of trade between the International Banks. Furthermore, this study will examine the banks resource capability to meet Basel II requirements, and discuss the impact and the implementation of the proposed guidelines. The Basel II framework is a tool that international financial institutions have created to be used by banks around the world as a common standard. The principle of Basel II is that banks are required to hold in reserve certain level of capital as a protection to maintain bank operation when making losses. It promotes transparency of banks activities and encourages efficient management of capital. It is estimated to total 8% of bank assets. The Basel II framework has set standards for banks in managing their capital and requires the discloser of information to detect any risks. The guidelines promote efficien Impact of the Credit Crunch in the UK Impact of the Credit Crunch in the UK Factors Influencing the Financial Institutions in the UK With Particular Reference to Credit Crunch A Comparative Study between Barclays and Northern Rock Bank I- Abstract Banks acts as intermediaries between surplus units depositing funds and investors or individuals seeking capital for investments. Thus, banks role is important in maintaining the flow of fund between these different parties. Banks like any other profit maximising firms are influenced by various factors that represent risks or opportunities. Therefore, banks business decisions are founded on aspects such as confidence in the market, the level of risks, the state of the economy, and their competitive strength. Regulation is essential for assuring compliance and integrity in the financial system, but rigid rules stifles the dynamicity of the banking industry and the financial sector as whole. Moreover, Central Bank role as a lender of last resort can rise the issue moral hazard by helping imprudent banks, however because banks are financial intermediaries, the impact of bank failure can have a detrimental effect on the financial system (systemic risk), and also on clients and customers, therefore bank supervision is vital due to their sensitive important role and their extensive impact. Furthermore, the development of events in the US financial market particularly the high default rate of subprime mortgage market led to a decrease in demand for tradable securities. This has affected confidence in the US and the global financial market, and consequently some financial institutions and banks such as northern rock in the UK faced difficulties in obtaining the necessary funds to maintain the business operation and remain solvent due to lack of short term liquidity. However, other banks faced similar difficulties but are using various methods to improve their balance sheets to overcome the current credit crisis. Moreover, governments and regulatory bodies are all taking the necessary measure to stimulate the market and tackle the core sources of the current credit crisis. II- Introduction Sustained economic development is often linked to efficient management of fund that is used to finance investments, which are projected to further create more wealth and opportunities for states, corporate and individual investors. Banks acts as intermediaries between surplus units depositing funds and investors seeking capital for investments. Thus, banks role is fundamental in maintaining the flow of fund between these different parties. Furthermore, the stability of financial and banking system is vital for the sustainability of economic growth and the preserve of investors confidence. Banks like any other profit maximising firms are influenced by various factors, these includes internal and external factors, which represent risks or advantages. Therefore, banks decisions are based on elements such as confidence in the market, the measurement and management of risks, the state of the economy, and their competitive power and market share. This study will look onto various factors influencing the financial institutions in the UK, with particular reference to Credit Crunch. This literature will comprise the banks management of risks, the role of authorities regulating and supervising the financial system, and explore the regulation of the banking industry and the financial system as a whole, in addition of the effect of regulation on banks performances. The analysis will include a comparative study between Barclays and Northern Rock Bank, taking into accounts the differences in their structure, size, as well as their reaction to changes in global financial markets. Furthermore, the Research will examine the fast moving global effect of the credit crunch; discuss the two banks business model, and explore their activities and behaviours. The study will also investigate the two banks high exposure to credit risks arising from risky investments, highlight the consequences of the heavy reliance on money market, and the use of securitisation for liquidity sources. IV- Methodology The research objective is to investigate the various factors that influence financial institutions in the UK, notably the banking industry. This research was based mainly on secondary research, the gathered data and information was sufficient for this research topic. However, sensitive data regarding the value of risk were not disclosed in both banks publication, such data is useful for the researcher to scrutinise banks estimation of risk and how realistic are the projections. Nevertheless, information about estimation of risks may be obtained directly from banks for further analysis of this specified area of banks management of risk. Research material relevant to the topic was collected from various academic sources; this is to explore issues and arguments regarding the regulation and supervision of the banking system. The two banks internet site was used to gather the background information along with the financial statements of the last six years, which were used in the research analysis to perform the comparison between Barclays and Northern Rock bank business strategies and financial performance. Publications from the Bank of England website were collected to study the central bank regulation and the management of the UK banking system, in addition to the historical data regarding interest, LOBOR, and inflation rate changes. Furthermore, articles from the Financial Services Authority (FSA) were gathered to study the role of the organisation and its contribution in supervising and stabilising the UK financial system. Recent publications from the Bank of International Settlement (BIS) were collected to study the role, the objectives and the effect of Basel directives on banks. Besides research the progress of current Basel II implementation along with the development of new requirements arising from the present credit crunch. Recent newspaper articles and various other media sources were gathered to collect the latest information regarding the development of the present credit crunch and its effect on banking industry, these includes sources such as BBC business, yahoo finance and the Financial Times website, and follow recent actions of regulators and banks management of the current crisis. Moreover, data from the two banks financial statements was collected to perform the Gap Analysis using Microsoft excel package to conduct a series of calculations. Other methods could have been used to assess bank risks such as value at risk (VaR) using regression analysis by utilising a computer package such as Microsoft Excel. The regression result will determine the degree of risk that the researched banks possess in their portfolio. However, the banks seldom disclose such sensitive information in published financial statements. This is to avoid adverse reaction by investors and credit rating agencies, which could therefore affect the banks stock prices, their reputation and confidence in the capital market. V- Literature review (Part I): The nature of banking The term bank can be applied to a wide range of financial institutions, from large banks to smallest mutually owned building society in the UK. The provision of deposit and loan distinguishes Banks from other financial institutions. Deposits products supply money on demand or following time notice. Deposits are liabilities for banks, thus must be well managed if banks want to make profit. Similarly, banks manage assets created through lending. Therefore, Banks main activity is being an intermediary between depositors and borrowers. Other non banks financial institutions, such as building societies and stockbrokers, also act as intermediaries; however it is the provision of loans and taking of deposits that distinguishes banks, though many banks provide various other financial services. 1) Management of risks in banking The fact is that bankers are in the business of managing risk. Pure and simple, that is the business of banking. (Walter Winston, former CEO of Citibank; the Economist, 10 April 1993). Banks, like all profit maximising firms, have to deal with macroeconomic risks, such as recession, inflation level, as well as other micro economic risks including political pressure, commercial breakdown of core customers or suppliers, natural disaster, in addition to the emergence of new competitive threats. From a finance theory viewpoint, Bank risk management is primarily composed of four main balance sheet risks, which includes liquidity risk, interest rate risk, credit risk, and capital risk (Hempel et al, 1989). Credit risk has been recognised as the principal risk in its effect on bank performance (Sinkey, 1992, p. 279) and bank failure (Spadaford, 1988). The primary reason why the correct management of credit risk is essential is because banks have restricted ability to absorb loan losses. Generally, the ability of a bank to absorb a loan loss is originated firstly from generated income of other profitable loans, and secondly by bank own capital. 2) Factors influencing financial institutions Banks and other profit maximising firms are influenced by various factors; financial institutions in particular are susceptible to a range of changes that may affect their projected growth. Some of these changes are internal changes, this occurs subsequent to restructuring program that a bank adopt following an expansion strategy such as in mergers and acquisitions or as a defensive strategy to remain competitive and maintain market share and fight competitive predators from acquiring the bank. Moreover, there are other external factors that can influence financial institutions, these includes a countys government monetary policy, the economic condition, the financial stability and the level of confidence in the market, the inflation rate, in addition to other risks such as credit and market risks. There are a range of risks that a bank may encounter, these includes the followings: a) Credit risk and counterparty risk: counterparty risk refers to the risks that after the creation of two parties contract, one party will renege the terms of the contract, while credit risk is the risk that a loan or an asset becomes lost due to default. b) Liquidity or funding risk: these are similar terms that refer to the risk of shortage of liquidity for maintaining operational commitments, that is the ability for the bank to cover its liabilities at due date. A shortage of sufficient liquid assets is often the trigger of financial distress, as it is increasingly difficult for the bank to obtain funds from the wholesale markets. Thus funding risk is the inability for the bank to maintain its daily operations. c) Market or price risk: this type of risk refers to the risk linked to over the counter instruments or traded stocks in a non liquid market, such as equities and bonds. Thus if a bank hold these items in its portfolio, then it is vulnerable to market or price risk, this is the risk that the price of these items is unstable, which is caused by systematic (movement of prices in all traded market instruments, for instance due to changes in economic policy) or specific market risks (the movement of a particular instrument is opposite to the rest of similar instruments, for example, this may be caused by unfavourable information about the issuer of that instrument). d) Interest rate risk: this is similar to price risk, because interest rate is price of money, it represent the opportunity cost of keeping money. This occurs because of interest rate mismatches between assets and liabilities, which differ in volume and maturity arising from the banks performing asset transformation. e) Capital or gearing risk: because banks are highly leveraged firms, they have to set aside some capital to cover the losses. The size of capital is proportional to the level of risk taken by the banks. Basel risk asset ratio principle requires banks to hold up to 8%. Besides, settlement or payments risk. This is when one party in the contract deliver assets or makes payment in advance, which creates exposure to potential loss. Furthermore, operational risk refers to risks from human capital, legal risks such as law suits, fraud, and physical capital. While sovereign and political risk refers to the risk that a government default on its debt obligation to a bank. Moreover, financial regulators has identified three main risks linked to banks, these includes market risks such as risks from exchange rates, interest rates, operational risk, commodity and equity prices. 3) The Asset-Liability Management (ALM) technique Because the fundamental and the primary activity of a bank is intermediation between surplus units that makes deposits and those that seek capital, which acquire fund from the bank, thus this payment system gives the bank the role of intermediation , where the intermediation is key activity, risk management is founded principally on a sound asset liability management (ALM). Furthermore, the ALM is a technique practiced by banks to effectively manage their risks, which was largely utilised by banks in the post war period up to the 1980s. The ALM method was the main tool used to manage banks books, it is essential that the bank maintain its assets and liabilities under control to minimise risks and remain solvent. Besides, banks are keeping their managers updated with newer techniques and skills to maintain their efficiency and competitiveness for the future, for instance, ALMA is an association that comprise around 40 financial institutions, which are international and local banking groups and building societies, mostly UK and Irish. However it is growing its membership and links around Europe. Its objective is to offer an informal and inclusive forum regarding the balance sheet management issues (Byrne, J. 2004). Due to the development of banking activities, innovative instrument became increasingly used by banks to manage their assets such as off balance sheet instruments, where banks moved from interest earning income products to non-interest income sources, thus this required that banks risk management should adopt newer techniques other then just the ALM to includes the risks originating from the off balance sheet instruments. Moreover, one of the new methods included in managing market and then credit risks is the Value at Risk (VaR), which involves giving an estimate of losses arising from the volatility of banks assets. 4) Credit Culture A recent research conducted by the Australian institute of bankers on the issue of Improving Asset Quality (Brice, 1992), which focused on the significance of credit culture. The great emphasis on credit culture was due to its influence on bank performance and in some occurrences bank failure ( Spadaford (1988) and Brice (1992)). Spadaford (1988) stated in his study of 162 bank failures in the United States that the analysis showed that 98% of bank failure occurred due to asset quality problems, among these problems are poor management of loan policy, inadequate systems to ensure compliance with internal rules and procedures, and the lack of supervision on senior and key management members in the organisation. McKinley (1991) has defined four main cultures that influence bank performance. predominantly the immediate performance-driven, which emphasis on earnings targets, followed by Market share/production-driven that focuses on being the biggest with greater production volume, along with Values-driven that balances between credit quality and generated income. In addition to the Unfocused (current priority-driven) bank, such bank lacks vision and appropriate strategy often set short term targets which consequently lead to unsuccessful ventures. VI- Literature review (Part II): Banks regulation The base of regulating financial institutions is founded on three broad frameworks. Primarily, the consumer protection argument, this is based on the notion that investors and depositors cannot be demanded to perform risk assessment of financial institutions they deal with, nor monitor standard of service or performance of these institutions. The consumer protection underlying principle is based on three types of regulation; firstly, compensation schemes created to repay all or part of losses caused by the insolvency of financial institutions; secondly, rules and regulations such as capital adequacy requirements designed to prevent insolvency; and lastly promote fairness in business or market practices by setting rules and standards. The latter regulation reveals market imperfections arising from principle agent problems, asymmetric information, and the issue of determining the true value of financial products or services, which are established well after the transaction or contract was formed (Dale, R and Wolfe, S. 1998). Furthermore, there are other concerns associated with consumer protection rationale. The provision of compensation to depositors and investors for losses sustained from the insolvency of financial institutions will further encourage these institutions to pursue risky investment decisions, thus there will be minimal or no incentive for prudence. This indicates that risky firms will be able to attract trade with identical terms and ease as prudent institutions, thus affecting financial market standards and discipline, and rising potential insolvency incidences. Therefore, the resulting losses must be covered by the deposit insurance scheme, investor protection fund, or in some cases by the tax payer. Thus, prudential controls on financial institutions are essential to minimise losses and to balance the regulatory incentives with the excessive risk-taking. The third aim of financial regulation is to promote integrity of markets, encompassing various issues such as market manipulation, fraud, transparency, and fairness; market integrity emphasis on organising the market as whole beyond just the relationship between financial firms and their consumers. Supervisors implementing the financial regulation consider systematic risk as the factor that causes great concerns. That is the risk that failure of one or more distressed financial institution could spread and cause a contagion effect, which could cause the collapse of other prudent institutions. It is their vulnerability to the contagion effect that single out financial institutions from other non financial firms. 1) Targets of regulation The major objectives of Financial regulation is to set guidelines for the activities of Banks, insurance companies, investment firms, exchanges, and fund management companies. The diverse principles for financial regulation mentioned above vary in their relation to these various institutions of the financial services sector. Banks are distinguished by what is referred to as short- term and unsecured value certain liabilities (deposits) and illiquid value-uncertain assets (loans). Banks conforms to deposits insurance and other type of consumer protection, partly because banks balance sheet consists of a variety of complex instruments and depositors are not capable to measure the riskiness of their deposits. However, depositor protection creates moral hazard problem. Furthermore, banks regulation focuses more on systemic risk. That is the possibility of a bank run that can spread to a number of banks and trigger a wider instability in the financial system. According to this notion, bank runs are the result of action by depositors retrieving their funds in response to amounting fear and uncertainty of the bank future arising from bank asset losses that could render it insolvent. Due to potential risk of losing all or some of their assets, depositors tend to make a run when initial signs indicate some troubles. Moreover, recent research found that the occurrence of a bank run can not be entirety explained by the decline of banks underlying assets (LaWare, J.1991.p34), (Diamond and Dybvig, 1983).The emphasis is on a banks maturity transformation notably the transfer of illiquid assets (bank loans) into liquid claims (bank deposits), taking into account that the banks loan portfolio substantially decline in value in an event of liquidation than on going concern. What triggers a rational bank run is that the uncertainty and the higher probability that the loan portfolio liquid value is less than the value of liquid deposits. This notion demonstrates how bank runs can possibly arise and affect even healthy banks. Thus distressed bank have to liberate its assets at liquidation value, therefore leading to possible insolvency. 2) Techniques of regulation While procedures of conduct of business regulation do not differ among various types of institutions, but in terms of prudential regulation there are fundamental differences that reveal the distinctive risk features of banks, insurance firms, and investment companies. Because bank failure has a greater effect on the whole market, and can create systemic crisis, governments and central banks have set bank regulation for creating extra protection in provision of extra fund by setting the lender of last resorts facilities, and deposit protection, however, these facilities creates moral hazard. Moreover, the deposit protection fund may exceeds the available protection from deposits insurance schemes, demonstrating policymakers greater emphasis for protecting the banking institutions rather then just depositors, as well showing the regulatory objectives of sustaining the banking system, while preventive regulation focuses more on tackling excessive risk taking by setting capital adequacy requirements for assets. Institutional regulation varies between states; in the UK for instance there was a single mega regulator, all regulation is institutional, each group/ institution have a diversified activity which all work under a single agency that overlook the supervision. Alternatively, in a system of multiple regulatory agencies specialised by duty, a fixed institutional regulation is unattainable due to the fact that these agencies are divers in functions, which calls for the appointment of a lead regulator for diversified groups (Taylor, M. 1995). 3) Regulation of the financial system By tradition banks are providers of loans among other services to firms and individual investors, temporary banks falls in deficits when their expenditure exceeds receipts; however banks generally adjust their liquidity position by using capital or wholesale market. Problems occur when banks capital is misused in funding high risk investments; this is often the consequences of bad governance by senior management in controlling the banks assets or it is the outcome of a contagion effect resulting from systemic risk. Moreover, the central bank controls and monitor commercial banks activities and set rules to regulate the banking system. This is to create stability and to promote confidence in financial market, which are vital elements in maintaining steady economic growth. 4) Bank failure Regulation of banks must be explored in context of bank failure. As any substantial problem produces the need for the introduction of changes in the regulatory framework, because the regulators attempt to correct any loophole in the system. Major bank failures in the history of banking occurred in the US in the year 1929. At that period there were 25,000 operating banks, however by 1934 the number had reduced to 14,000. These incidences consequently led to the implementation of more restrictive bank rules, such as single state operations, which until recently remained the feature of the US banking system. The subsequent major bank failure was the fringe banking crisis in the UK in the year 1973. 5) Reasons for regulating banks The principle reason is the systemic risk, because the financial system is susceptible to level of confidence, therefore external regulation is essential in maintaining the stability and reduces further volatility. The second reason represents the social cost that a failure of bank causes, which have a greater impact then a failure an ordinary firm. The insolvency of a firm affects the shareholders, while the failure of a bank will have a greater number of affected customers (depositors), which could also be spread across larger geographical locations. As well as the effect it will have on providing savings for potential investors which will have a detrimental impact on the economic growth. The third reason is the possible lack of knowledge by the public, it is suggested that they lack the necessary background information to distinguish between safe and risky investments partly due to asymmetric information because depositors do not have access to the same information available for banks. Thus comprehensive risk assessments necessitate additional information to that included in financial reports. Hence for this particular reason regulators had introduced depositor protection. Although the above arguments support regulation, however there should be some caution on the use of excessive control over banks. It is primarily the issue of sustained cost in terms of resources on banks and the regulators. Because the central bank has to set teams of experts to perform the prudential control, likewise banks have to employ skilled resources capable to produce the necessary required returns to the regulator. Such costs can be large, thus it is a matter of cost benefit analysis to establish whether the gain of applying prudential control exceeds the incurred costs. Other possible dangers of excessive regulation are the fall of competition, increase in costs and the diminishing pace of financial innovation and development. Furthermore, heavy regulation on a particular centre may lead to the migration of the activities to locations that have lenient regulation, which has been the principle factor in the development of offshore banking centres that led to the need for a global regulation system for international banks, which is known as a level playing field. 6) The supervision of the financial system in the UK The above arguments about prudential regulation are based on banks but it can also be applied on various other financial institutions. Furthermore, the current UK financial regulation system utilise the same measures in authorising and supervising financial institutions without a distinction between insurance firms, building societies, or banks. The FSA is the principle regulator of the financial system in the UK. The FSA was established in 1997, succeeding the Securities and Investments Board (SIB), which was supervising the investment industry. However, the FSA has progressively thought to become the main controller responsible for regulating insurance and investment industry, building societies, and banks. In addition to regulating financial exchanges such as Euronext.liffe and the Stock exchange besides clearing houses, along with other functions such as the responsibility of regulating the access of companies to Official List in cooperation with the UK Listing Authority. The initial development occurred in 1998, when the Bank of England transferred its responsibility of regulation and supervision of banking to the FSA, which was succeeded with the passing of the Financial Services and Markets Act (FSMA) 2000 that provided the FSA with full power as the main regulator. The FSMA requires the FSA to attain the following objectives: Promote public awareness of financial system Maintain confidence in the UK financial market Secure consumer protection Reduce financial crime. 7) The FSA approach to supervision The FSA approach to supervision is risk based; the primary phase is to assess the risks associated with four objectives above. The FSA attain this through gathering information from various sources including customers and supervision of firms. The secondary phase is risk weighing and estimating impact, by giving each risk the probability of occurring, thus giving it a score or value. Thus firms with high magnitude impact require greater supervision. This is to reduce systemic risk and consumer losses. However, firms that possess highly sophisticated and effective risk assessment systems require less supervision by the FSA. Finally, after the risks are identified, assessed and weighted, the FSA select the appropriate measures to respond using various tools, which can be summed as follows: Those aimed to influence the behaviour of consumers, operators, and the industry Those aimed to influence the behaviour particular firms. The first category encompasses consumer education, the discloser of information, and compensation method, while the second category includes the provision of authorisations to firms and discipline, in addition to reimbursement of losses. 8) Capital adequacy (Basel Capital Accord, 1988). Liquidity is essential for any firm to maintain its daily operation, whereas solvency refers to the ability of a bank to meet its commitments in terms of liabilities at due time. However, there is a distinction between liquidity and solvency. There is a general understanding that if a bank is thought to remain solvent then it should be able to borrow fund from open market to meet its short term liquidity requirements. Likewise, the presence of liquidity problems that cannot be resolved through the wholesale market suggests that other lenders believe that the risk of insolvency of that particular bank is great. Furthermore, if a bank struggle to find short term funds in the markets, it will face difficulties in paying its claims. Therefore the Bank of England and the FSA requires banks to efficiently managing their liquidity as a principal policy element of reducing the risk of insolvency. The Basel committee on Banking Supervision has introduced Basel Capital Accord II; it included new amendments to the assessment of capital adequacy of banks. This new approach was ought to be implemented in year 2006, which contains three pillars: Minimum capital requirements Supervisory review of capital adequacy Public disclosure. Basel II accord focuses on credit risk and market risk. In pillar 1, the treatment of market risk was not altered but changes were made on the treatment of credit risk notably operational risk. The bank for international settlement and the Basel committee on banking supervision have founded the financial stability institute (FSI) to assist central banks across the world to improve their financial systems. The new Basel II requirements set challenges on banks to develop and increase efficiency on their capital management. In this section, there is a discussion of the effect of Basel II on Banks in Europe and North America, and how the new directives are going to improve the cohesion of trade between the International Banks. Furthermore, this study will examine the banks resource capability to meet Basel II requirements, and discuss the impact and the implementation of the proposed guidelines. The Basel II framework is a tool that international financial institutions have created to be used by banks around the world as a common standard. The principle of Basel II is that banks are required to hold in reserve certain level of capital as a protection to maintain bank operation when making losses. It promotes transparency of banks activities and encourages efficient management of capital. It is estimated to total 8% of bank assets. The Basel II framework has set standards for banks in managing their capital and requires the discloser of information to detect any risks. The guidelines promote efficien