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The crisis in UK banking

John Goddard, Phil Molyneux and John O. S. Wilson
Unparalleled turmoil in the banking system over the past two years has impacted
severely on the UK's economic prospects. What was once a profitable, fast-
growing, dynamic and highly innovative banking sector has been publicly
humiliated, while its lending capacity has stalled. This article highlights the
evolution of the credit crisis in the UK, as the fallout from American subprime
lending and the housing market bubble spread rapidly across the Atlantic.
Lessons from the crisis and policy recommendations are considered, focusing on
rebuilding bank liquidity and capital, strengthening bank supervision and
regulation, and improving risk evaluation and risk management practices
throughout the banking and financial system.
Banks play a crucial role in every economy. investments in bank deposits or securities in John Goddard is
Banks operate the payments system, are the deficit countries. Deficit countries borrow in Professor of
major source of credit for large swathes of order to finance the gap between their Financial Economics
economic activity, and (usually) act as a safe expenditure on consumption and their at Bangor
haven for depositors’ funds. The banking earnings from selling goods and services, by University.
system reallocates resources from those in accepting deposits or selling securities to the
surplus (depositors) to those in deficit governments and residents of surplus countries. Phil Molyneux is
(borrowers), by transforming relatively small Professor of Banking
liquid deposits into larger illiquid loans. If this Cheap credit and housing bubbles and Director of the
intermediation takes place in an efficient For several years, savings channelled via the Institute of
manner, the needs of depositors and borrowers banking and financial system from fast-growing European Finance at
can be met at low cost, yielding substantial emerging economies to governments and Bangor University.
private and social benefits for economic growth consumers in developed countries have
and development. permitted western governments to operate with John O.S. Wilson is
To observe that the banking system is low interest rates and a relaxed monetary policy, Professor of Banking
currently in a state of extreme crisis, which without stoking the flames of inflation. This and Finance at the
threatens its capacity to perform this critical cascade of cheap credit has enabled University of St
intermediation role for many years to come, governments to avoid the harmful Andrews.
seems an understatement. This article reviews consequences for living standards of exchange
the underlying causes of the credit crisis, and rate devaluation, which would otherwise have
provides a chronological description of events been required to correct the current account
primarily from a UK perspective. Lessons are imbalance.
drawn from the experiences of the past 24 Western bankers have demonstrated
months for regulatory policy, and for the future considerable skill and ingenuity in persuading
architecture of the banking and financial system. borrowers to take up the abundant supplies of
cheap credit, and repackaging the resulting
Underlying causes of the crisis assets into mortgage-backed and other types of
Most economists agree that macroeconomic structured securities through the ‘originate
imbalance, in the form of large surpluses and and distribute’ model. Light-touch regulation
deficits in the current accounts of the balance of raised few questions concerning the implications
payments of many countries, was a fundamental for systemic risk and financial stability during
cause of the credit crisis (Brunnermeier, 2009). the boom years. In the US, low interest rates
High savings ratios and current account and the erosion of lending standards helped
surpluses in many South and East Asian and fuel a housing market bubble. The creation
Arabian Gulf region (Kuwait, Qatar, Saudi and trade in securitized assets backed by
Arabia, UAE) countries are counterbalanced subprime mortgages ensured that when this
by current account deficits and borrowing in bubble finally burst in 2007, the repercussions
the major consuming economies. Surplus of mortgage delinquencies spread far and wide
countries export their surplus funds, making throughout the global financial system.

© 2009 THE AUTHORS DOI: 10.1080/09540960903205881

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278
Financial innovation
Securitization involves the creation of assets
formed by slicing streams of anticipated income
from mortgages and other loans, corporate
bonds and credit cards into low- and high-risk
tranches:
•The senior tranche has the first claim on the
income from the underlying assets, offering
the lowest return for the lowest risk.
•The mezzanine tranche has the next claim,
offering a somewhat higher return for higher
risk.
•The most junior equity tranche is paid only
after the claims of the senior and mezzanine
tranches have been settled, offering the
highest return for the highest risk.
The originate and distribute model refers to
the practice whereby banks trade their
securitized assets through off-balance sheet
investment vehicles or conduits, known as
‘structured investment vehicles’ (SIV). The SIV
collects the cash flows from the underlying
assets, and passes them to the holders of the
tranches. The latter can insure themselves
against default by purchasing credit derivatives,
such as credit default swaps (CDS), which offer
contingent payments in the event of default on
the underlying assets, in return for a regular
fixed fee.
Risky practices
In principle, trade in securitized assets and
credit derivatives should improve the efficiency
and stability of the financial system, by
facilitating the transfer of risk to those investors
most willing or able to bear it, spreading risk
more widely throughout the system, and
transferring risk to non-bank purchasers of
securitized assets. In practice, however, the
securitization movement has contributed to
the present crisis through several channels
(Brunnermeier, 2009; Milne, 2009).
First, securitization has created a lack of
transparency, as it has become increasingly
difficult to assess where the credit risk associated
with delinquent subprime mortgages (and other
assets) was being borne. In fact, much of the
credit risk never left the banking system, since
banks themselves were among the most prolific
traders and holders of securitized assets and
credit derivatives.
Second, securitization has created problems
of adverse selection and moral hazard, through
disincentives for the originating lender to screen
borrowers thoroughly before lending, and
monitor their performance subsequently.
PUBLIC MONEY & MANAGEMENT SEPTEMBER 2009
Originating lenders failed to complete these
fundamental tasks because they anticipated
that the loans would be repackaged and passed
on to other investors.
Third, questions about moral hazard have
also arisen over the role of credit ratings agencies
in pricing structured products. Higher agency
fees for securitized assets may have encouraged
the production of more favourable ratings than
for corporate bonds. With the benefit of
hindsight, the statistical models used by the
agencies, and by professional investors, are
seen to have attached insufficient weight to
long-tail probabilities of catastrophic events.
Fourth, the popularity of securitization
through SIVs has been driven in part by
regulatory arbitrage. Moving a pool of loans
into a SIV that was not subject to Basel 1 and 2
capital regulation enabled banks to avoid
incurring expensive capital charges under Basel
1, or to reduce their risk-based capital charges
under Basel 2. The Basel rules stipulate
minimum capital requirements according to
the riskiness of the business undertaken by
banks. Basel 1 rules on capital requirements
came into place in 1988, and these were recently
updated to take account of a broader array of
bank business and risks in 2006 under Basel
2—they have been implemented in the EU but
are yet to be in the US. As an indication of how
the rules work for instance, unsecured loans
have to be backed by a minimum of 8%
regulatory capital whereas mortgage loans only
have a 4% capital charge as they are viewed—
traditionally at least—as being less risky. If
loans are re-packaged and moved off-balance
sheet into specially constructed and
collateralized SIVs then, because the SIVs are
classed as ‘bankruptcy remote’ by the regulators,
no capital charge is made.
Fifth, following the collapse of Enron and
other financial scandals and crises during the
1990s and early 2000s, the introduction of
mark-to-market accounting rules (adopting
accounting standards that assign a value to a
position held in a financial instrument based
on the current fair market price for the
instrument or similar instruments), requiring
balance sheet valuations of bank assets to reflect
current market values, may have contributed
inadvertently to the squeeze on banks’ balance
sheets and the contraction of lending during
the present crisis. Banks reported significantly
reduced valuations of securitized assets when
the markets for the latter dried up as the crisis
escalated, even in cases where the underlying
assets were secure and at zero risk of default.
Deteriorating bank balance sheets increased
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investor perceptions of credit risk, thereby
contributing to the drying up of wholesale
funding and interbank lending.
Finally, the diversification of credit risk
through securitization and the originate and
distribute model did not eliminate liquidity
risk, a fundamental characteristic of the business
model of banks. Liquidity risk arises from
maturity mismatch between the short time-
horizons of banks’ liabilities, and the long time-
horizons of their assets. Bank depositors need
to feel confident that they can access their
funds on demand; but funds tied up in illiquid
assets such as mortgages and other loans cannot
be recovered quickly from borrowers. SIVs
funded a significant portion of their investments
by selling short-term (90 day) or medium-term
(one year) asset-backed commercial paper on
the money markets. SIVs were therefore subject
to liquidity risk due to maturity mismatch. At
any time, investors might cease buying the
paper (rolling over the debt) used to fund the
long-term investments. This liquidity risk often
reverted directly back to the parent bank, which
might have granted either a contractual credit
line (guaranteed access to liquid funds) to its
SIV, or a reputational credit line (non-
contractual access motivated by concern that
failure of the SIV would destroy the reputation
of the parent bank).
The growth of repurchase agreement
(‘repo’) financing (where borrowers use
securities as collateral to obtain short-term loan
at fixed rates of interest) added to potential
liquidity risk. Investments banks rapidly
expanded their money market repo activities
further increasing the exposure of the financial
system to a liquidity crisis.
Crisis timeline
January–September 2007: first intimations of
catastrophe
The first indications of an impending credit
crisis were observed during the first half of
2007, with an increase in the rate of US subprime
mortgage delinquencies, reductions in the
prices of mortgage-backed securities, and
increases in the cost of insuring these securities
against default. Ratings downgrades of tranches
Table 1. Trend in UK base rate, January 2007 to March 2009.
12 January 2007 5.25% 7 February 2008
10 May 2007 5.5% 10 April 2008
5 July 2007 5.75% 8 October 2008
6 December 2007 5.5% 6 November 2008
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of securities were announced by several credit
ratings agencies in June and July 2007, and
liquidity in the market for short-term asset-
backed commercial paper started to dry up
(Greenlaw et al., 2008; OECD, 2008). The
liquidity crisis escalated on 9 August 2007,
when the LIBOR increased significantly, and
the interbank markets effectively became
frozen. The European Central Bank and the
US Federal Reserve responded immediately
by injecting 95 billion euro and $24 billion of
credit respectively into the interbank markets.
(LIBOR—the London Interbank Offered
Rate—is a daily reference rate based on the
interest rates at which banks borrow unsecured
funds from other banks in the London wholesale
money market. It set by a panel of banks and
published by the British Bankers’ Association
between 11.00 a.m. and 11.45 a.m. each day.)
The first UK casualty of the crisis was
Northern Rock, which revealed on 13
September 2007 that it had received emergency
financial support from the Bank of England,
having been unable to refinance itself in the
interbank markets. Over the next few days £1
billion was withdrawn from Northern Rock’s
high street branches, in what was the first bank
run in the UK for over a century. To stem the
panic, on 17 September 2007 the UK
government announced a full guarantee of
depositors’ savings. Underlying causes of the
Northern Rock failure included over-aggressive
growth in mortgage lending, and over-
dependence on short-term wholesale funding
(Llewellyn, 2007; Treasury, 2008).
October 2007–January 2008: write-downs and
downgrades
The UK banking system navigated the rest of
2007 without enduring any further catastrophic
events, but amid mounting concerns over the
extent of write-downs of non-performing loans
and securitized assets. On 1 October 2007, the
UK authorities strengthened the deposit
guarantee scheme, by eliminating a provision
whereby deposits between £2,000 and £35,000
were only 90% guaranteed, which had
contributed to the loss of depositor confidence
in Northern Rock.
5.25% 4 December 2008 2.0%
5.0% 8 January 2009 1.5%
4.5% 5 February 2009 1.0%
3.0% 5 March 2009 0.5%
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Concerns about the possibility of a major
slowdown in the UK economy led the Bank of
England to implement a base rate cut, on 6
December 2007, to 5.5%. This was the first of a
series of cuts which saw the base rate reduced
to a historically unprecedented 0.5% by March
2009 (see table 1). On 12 December 2007, the
Bank of England participated in a co-ordinated
international effort to increase liquidity in the
interbank markets, by increasing the size of its
next two auctions of short-term funds, in
December 2007 and January 2008, from £2.85
billion to £11.35 billion each.
On 21 January 2008 several global stock
market indexes, including the UK’s FTSE 100,
plummeted, amid continuing concerns over
the scale of losses emanating from US subprime
lending, and the potential for a global recession.
The downgrade of Ambac, one of the US
‘monoline’ insurers of municipal bonds, by the
ratings agency Fitch, appears to have helped
trigger the stock market decline. The Federal
Reserve implemented an emergency 0.75% cut
in the federal funds rate on 22 January, and the
UK Monetary Policy Committee followed with
a further 0.25% cut in the base rate on 7
February 2008.
February–August 2008: Nationalization and the
Special Liquidity Scheme
On 17 February 2008, the UK government
finally exhausted its attempts to find a private
sector buyer for Northern Rock and announced
the remedy of full-scale nationalization. On 21
February 2008 the Banking (Special Provisions)
Act introduced new provisions for faster
intervention and resolution of bank failures, in
recognition that authorities’ powers to intervene
had been inadequate as the crisis at Northern
Rock first broke and escalated. The new powers
allowed for intervention at a stage before
corporate bankruptcy procedures would be
triggered. Permissible types of intervention
would include transfer of assets and liabilities
to a third party bank, transfer of assets to a
‘bridge bank’, temporary nationalization or
liquidation.
On 16 March 2008 the US investment bank
Bear Stearns was acquired by J.P. Morgan
Chase for $236 million, in a deal that was part-
financed by the provision by the Federal Reserve
of $30 billion in loan guarantees. Bear Stearns,
the smallest of the big five US investment
banks, carried a large portfolio of mortgage-
backed securities. Meanwhile the outlook for
the UK economy, and especially the
performance of the housing and mortgage
markets, continued to deteriorate. On 21 April
PUBLIC MONEY & MANAGEMENT SEPTEMBER 2009
the Bank of England announced a Special
Liquidity Scheme, to allow banks to swap
temporarily high-quality, illiquid mortgage-
backed and other securities for Treasury bills
(T-bills). Swaps would be available on demand,
throughout the following six months. The swaps
were initially for a period of one year, but were
renewable for periods of up to three years. An
estimated £50 billion in liquid assets would be
made available through the scheme. The banks
would receive liquid assets of lower value than
the illiquid securities being exchanged. The
swaps were available only for assets existing at
the end of 2007.
While the monetary authorities continued
with their efforts to inject liquidity into the
banking system, the potential for write-offs of
non-performing assets to erode the
capitalization of the UK’s largest banks was a
growing concern. On 22 April 2008, the Royal
Bank of Scotland (RBS) announced plans to
raise £12 billion in capital via a rights issue.
This followed an announcement of a £5.9 billion
write-down on its investment portfolio, at the
time the largest such announcement by any
UK bank. Over the next few months, several
other UK banks announced plans to raise new
capital. On 18 July, Barclays announced that
only 18% of the shares in a £4.5 billion rights
issue had been taken up, with the rest acquired
by an investment group including the Qatar
Investment Authority. Similarly, in July 2008,
HBOS attempted to raise £4 billion through a
rights issue, but only 8% was taken up, the
remainder reverting to the underwriters. The
inability of UK banks to convince their current
shareholders to invest in rights issues provided
a clear signal that further serious difficulties lay
ahead. Growing concerns about the stalling of
the housing market prompted a UK
government announcement on 2 September
of a temporary (one-year) rise in stamp duty
exemption from £125,000 to £175,000.
September 2008: Meltdown!
The international crisis deteriorated sharply
with the news on 7 September 2008 that the
two US government-sponsored enterprises,
Fannie Mae and Freddie Mac (responsible for
the securitization of around 50% of US
mortgages) had been placed in
‘conservatorship’ (effective government
ownership). Following crisis meetings held over
the weekend of 12–14 September, Lehman
Brothers, the fourth largest US investment
bank, filed for bankruptcy. The Lehman
Brothers collapse triggered a spectacular
sequence of events that brought the global
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financial system to the brink of catastrophe:
•14 September: Merrill Lynch was acquired by
Bank of America for $50 billion.
•16 September: the Federal authorities
acquired an 80% stake in the largest US
insurer, American International Group
(AIG), at a cost of $85 billion.
•25 September: Washington Mutual, the largest
US savings and loans institution with assets
valued at $300 billion, making it the largest
US bank failure to date, was sold to J.P.
Morgan.
•29 September: Wachovia (the fourth largest
US bank) was acquired by Citigroup.
•Late September: within a few days, several
major European bank rescues took place.
These included: the part-nationalization of
the Dutch/Belgian banking group Fortis; a
bailout of the Belgian/Luxembourg/French
bank Dexia; and a bailout of the German
Hypo Real Estate in the form of a 35 billion
euro secured credit facility supplied by other
banks and the German government.
In the UK, on 17 September 2008 Lloyds TSB
announced that it was to acquire HBOS for £12
billion, creating a merged entity with a market
share of around one-third of the UK savings
and mortgage markets. The UK competition
authorities deemed that the aim of preventing
the collapse of HBOS overrode antitrust
concerns that would otherwise stem from the
merger of two large high-street retail banks.
On 29 September 2008, after several months of
uncertainty, the UK government announced
that it was acquiring the mortgage-lending
arm of Bradford & Bingley, and selling the
still-viable depositor base and branch network
to the Spanish Santander banking group.
October 2008: Recapitalization, liquidity injection
and lending guarantees
The US authorities’ immediate response to
these events was the announcement of the
Troubled Assets Relief Programme (TARP),
under which $700 billion was earmarked for
the purchase of mortgage-backed securities,
non-securitized loans, or even entire banks.
The TARP ‘Bailout Bill’ was passed into law on
3 October. Principal features of the UK
government’s immediate response to the crisis,
announced on 8 October 2008, were:
•The allocation of £50 billion for
recapitalization of ailing banks. The
mechanism would be government purchase
of (non-voting) preference shares.
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•An extension of the Special Liquidity Scheme,
making available on demand T-bills to the
value of at least £200 billion, to be swapped
for illiquid high-quality securitized assets.
•Treasury guarantees would be provided on
commercial terms for up to £250 billion of
wholesale funding.
Two days previously, on 6 October 2008, the
UK government had lifted the ceiling on the
deposit guarantee scheme from £35,000 to
£50,000. Although this fell short of the
guarantees on deposits that had recently been
announced by the Irish and German
governments, the impression of an implicit
100% guarantee was conveyed by the
announcement on 8 October that the deposits
of all UK residents in Icesave, the internet
banking branch of the failed Icelandic bank
Landsbanki, would be guaranteed by the
Treasury.
On 13 October 2008, capital injections were
announced for RBS (£20 billion), and Lloyds
TSB and HBOS (£17 billion combined),
increasing the government stakes in their
ownership to around 60% and 40%,
respectively. In a similar move, on 14 October
2008, the US authorities unveiled a $250 billion
plan to take ownership stakes in a number of
banks. In return for government capital
injections, the UK banks were required to
make commitments to lend at competitive rates
to homeowners and small businesses;
reschedule mortgage payments for
homeowners facing difficulties; and exercise
restraint over executive compensation.
Meanwhile Barclays announced that it planned
to raise £6.5 billion by private means, avoiding
the need for partial nationalization.
November–December 2008: Fiscal stimulus and
further bailouts
On 3 November 2008, the UK government set-
up a new ‘arm’s-length’ company, UK Financial
Investments Limited (UKFI), to manage the
banks in public ownership, Northern Rock and
Bradford & Bingley. A large fiscal stimulus was
announced on 24 November 2008, including a
temporary reduction in the rate of value added
tax (VAT) from 17.5% to 15%, until the end of
2009.
Further bad news emerged from the US in
late November, when Citigroup became the
largest US bank so far to secure a bailout.
Government funds were used to provide a $40
billion capital injection, and future losses on
$300 billion of the bank’s assets were to be
guaranteed. On 28 November 2008, the US
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Federal Reserve and Treasury announced an
$800 billion fiscal stimulus package, comprising
$600 billion for the purchase of mortgage-
backed assets, including securities issued by
Fannie Mae and Freddie Mac, and a $200
billion lending facility to support lending to
consumers. In December, $17.4 billion of TARP
funds were assigned to assist General Motors
(GM), Ford and Chrysler. GM’s financing arm,
GMAC, was subsequently the recipient of a $6
billion bailout. In late December a further $20
billion (in addition to $25 billion allocated in
October) was assigned to Bank of America, to
cover losses arising from its earlier acquisition
of the investment bank Merrill Lynch.
January–March 2009: Renewed efforts to restore
confidence
Official statistics published in January 2009
showed the UK economy to be in recession for
the first time since the early 1990s. On 14
January, the UK government announced that
it would guarantee up to £20 billion of loans to
small- and medium-sized firms. On 19 January
a comprehensive plan was announced to restore
confidence to the UK financial markets.
Building on the measures implemented in
October 2008, the principal features included:
•Extension of the drawdown window for new
debt under the Credit Guarantee Scheme
(CGS), intended to reduce the risks on inter-
bank lending.
•A new facility for asset backed securities to be
used as collateral for banks seeking to raise
additional funds to support mortgage
lending.
•Extension of the maturity date for the Bank of
England’s Discount Window Facility,
providing liquidity by allowing banks to swap
illiquid assets for T-bills. This provision
replaced the Special Liquidity Scheme.
•A new Bank of England facility for purchasing
high-quality assets. The Treasury will
authorize initial purchases of up to £50
billion, financed by the issue of T-bills.
•Subject to Treasury assessment on a case-by-
case basis, certain bank assets to be eligible
for inclusion in a new capital and asset
protection scheme.
On 21 February 2009 the Banking Act 2009
established a permanent Special Resolution
Regime (SRR), providing the authorities with
tools to deal with banks facing financial
difficulties. Details of recourse to the capital
and asset protection scheme by RBS and the
Lloyds Banking Group (formerly Lloyds TSB
PUBLIC MONEY & MANAGEMENT SEPTEMBER 2009
and HBOS) were unveiled shortly afterwards.
Having posted recorded losses of £24 billion,
RBS would participate in respect of £325 billion
of assets, in exchange for a fee of £6.5 billion.
RBS will bear first losses of up to £19.5 billion,
and make new lending commitments totalling
£25 billion for 2009. The Treasury also agreed
to purchase £13 billion of capital, and granted
an option for a further £6 billion. Exercise of
this option would leave 95% of RBS in public
ownership. Lloyds announced subsequently
that it had agreed to participate in respect of
£260 billion of assets, increasing its public
ownership stake from 43% to 65%.
The UK base rate reached 0.5% on 5 March
2009. With its interest rate ammunition virtually
exhausted, the Bank of England announced
the implementation of quantitative easing, a
new form of monetary stimulus. £75 billion was
assigned for the direct purchase of assets
(predominantly gilts) from the banking system,
with the banks’ accounts at the central bank to
be credited directly with newly created money.
On 18 March the Financial Services Authority
(FSA) published the Turner review of bank
regulation. Recommendations included:
extension of coverage of bank regulation based
on economic substance rather than legal form;
improved capital provisioning; enhanced
liquidity regulation and supervision; improved
supervision of credit rating agencies; codes
covering remuneration to limit incentives for
excessive risk-taking; centralized clearance of
trades in CDS to reduce counterparty risk; and
improved regulation of cross-border banking.
On 30 March the Treasury announced its
acquisition of around £1.5 billion of non-
performing mortgages and commercial
property loans from Dunfermline Building
Society. The rest of the Dunfermline’s loans
portfolio, and its deposits and branch network,
were taken over by Nationwide Building
Society.
Policy lessons
The sheer scale of the litany of government
bank bailouts, recapitalization plans, liquidity
injections and credit guarantee schemes,
implemented since mid-2007 raises profound
concerns about the business model for banking
in the developed world. Clearly the system has
been underwritten by a huge but previously
implicit public subsidy: large banks, irrespective
of their performance, have exploited their status
as ‘too big to fail’, in order to expand their
balance sheets recklessly. Clearly, gaps and
weaknesses in the system for bank regulation
and supervision must be addressed. All large
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financial institutions should be subject to
regulatory oversight, regardless of legal status.
SIVs should not be permitted to escape capital
and liquidity regulation and disclosure
requirements that apply to parent banks. The
co-ordination of mechanisms for international
bank regulation and supervision should be
improved, with greater clarity concerning the
responsibilities of the home and host countries.
Opportunities for regulatory arbitrage across
national boundaries should be addressed, and
regulatory gaps arising from offshore banking
centres closed.
During the crisis, meetings of the G7 and
G20 have been used as a forum for international
discussion of various forms of policy
intervention. There are differences of emphasis
and approach between governments, and co-
ordinated policy action is difficult to achieve.
The most immediate policy concern has been
the avoidance of a deflationary spiral that would
encourage consumers to defer spending in the
expectation of falling prices, and increase
borrowers’ incentives to default as the real
value of their collateral sinks below the nominal
value of their outstanding debts. Tackling the
more fundamental macroeconomic imbalance
between creditor and debtor countries appears
to be a longer-term endeavour.
The credit crisis has exposed weaknesses in
the current regime for the regulation of bank
capital ratios (ratio of shareholder equity to
total assets, crucial because equity is the buffer
that absorbs losses in the event of write-offs of
non-performing assets). Under the risk-
weighted capital regulation regime of Basel 2,
the use of backward-looking models for risk
assessment creates a destabilizing tendency for
capital provisioning to amplify the economic
cycle. Under boom conditions, observed rates
of borrower default decline. Accordingly, bank
assets in all risk classes are assessed as having
become less risky and as requiring lower
provisioning. Therefore existing capital buffers
can support increased bank lending, which
tends to amplify the upturn in the cycle. It is
now widely accepted that banks should be
required to accumulate capital during booms,
so that reserves are available to draw upon
during times of economic stress. Capital
provisioning would thereby exert a stabilizing
effect.
Past regulation may have over-emphasised
capital at the expense of liquidity. In the run-
up to the crisis, many banks appear to have
been operating with dangerously low liquidity
(ratio of liquid assets to total assets). As has
become clear, a liquidity crisis can easily trigger
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a full-blown capitalization crisis. In future,
benchmarks for capital adequacy are likely to
be raised, and liquidity standards will focus on
the maintenance of larger portfolios of highly
liquid assets, and reduced reliance on wholesale
funding. The introduction of a simple leverage
ratio (ratio of capital to assets), alongside risk-
based capital regulation, may make a further
contribution to improved risk management
(G30, 2009).
Effective regulation has been constrained
by a lack of transparency throughout the system.
While the crisis has forced banks to provide
detailed information on their exposures,
disclosure of risk management and valuation
practices remains limited. Likewise, the
restoration of confidence in over-the-counter
(OTC) markets for securitized assets and credit
derivatives will require increased transparency,
reduced complexity, and improved oversight.
For credit derivatives, counterparty risk has
been a serious concern, with CDS holders fearful
that counterparties may default on their
obligations in the event that the underlying
asset defaults. The Federal Reserve bailout of
AIG, two days after the Lehman collapse, may
have been motivated partly by concerns that
AIG would otherwise have defaulted on CDS
written on Lehman, a development that could
have triggered a total collapse of the banking
system.
Credit ratings agencies have been widely
criticised for their contribution to the credit
crisis, with questions raised concerning the
quality and clarity of ratings data. Misaligned
incentives and conflicts of interest led to poor
lending standards being applied by many
originators, and unreliable ratings being
assigned to securitized assets by the agencies.
Initiatives devised to address these issues
include revisions to the agencies’ code of
conduct (International Organization of
Securities Commissions, 2008). More radically,
a case has been made for the creation of a state
agency to provide credit ratings. In any event,
banks and professional investors should develop
their own models for reliable risk assessment
and stress testing, based on a realistic evaluation
of long-tail default probabilities, and avoiding
the fallacy that the absence of a crisis last year
implies a reduced or negligible probability of a
crisis this year or next (Milne, 2009).
Summing up
A recent estimate suggests that the additional
financial resources already committed by
governments around the world in direct
response to the credit crisis amounts to $7
PUBLIC MONEY & MANAGEMENT SEPTEMBER 2009
284

trillion (Huertas, 2009). Short-term fire-fighting References

to try to prevent the crisis from evolving into a
devastating and long-lasting deflationary spiral
has been high on the policy agenda as the crisis
has developed. However, there is also extensive
debate surrounding the longer-term
implications of the crisis for the future
architecture of the banking and financial system.
In bank regulation, support has been expressed
for a ‘return to basics’ involving:
•Greater emphasis on simple leverage and
liquidity ratios.
•More realistic risk assessment as the basis for
risk-based capital regulation.
•Greater transparency and the curtailment of
opaque business models (including SIVs).
•Effective early-warning systems and effective
procedures for early intervention in cases of
financial distress.
Whatever changes take place, there is no doubt
that the momentous events of the past 24
months will resonate for many years to come,
and that banks must anticipate significant
restrictions on their future lending and
securitization activities and risk-taking
capabilities. ■ (London).
Brunnermeier, M. K. (2009), Deciphering the
liquidity and credit crunch 2007–08. Journal of
Economic Perspectives, 23, pp. 77–100.
G30 (2009), Financial Reform: A Framework for
Financial Stability (Group of 30, Washington,
D.C.).
Greenlaw, D., Hatzius, J., Kashyap, A. K. and Shin,
H. S. (2008), Leveraged losses: lessons from the
mortgage market meltdown. Paper presented to
the US Monetary Policy Forum (March).
Huertas, T. (2009), The rationale for and limits of
bank supervision. Speech to the London Financial
Regulation Seminar (19 January).
International Organization of Securities
Commissions (2008), Code of Conduct Fundamentals
for Credit Rating Agencies (Madrid).
Llewellyn, D. T. (2007), The Northern Rock crisis:
a multi-dimensional problem waiting to happen.
Journal of Financial Regulation and Compliance, 16,
pp. 35–58.
Milne, A. (2009), The Fall of the House of Credit
(Cambridge University Press, Cambridge).
OECD (2008), The Sub Prime Crisis: Size, De-
Leveraging and Some Policy Options (Paris).
Treasury (2008), Pre-Budget Report: Facing Global
Challenges: Supporting People Through Difficult Times

Call for papers: Citizens and

technology—trends and developments
Guest editor: Christopher Exeter (PMM, Vol. 31, No. 2, March 2011)

The use of information technology in delivering public services has had a chequered history.
This is met, if not surpassed, by public expectations. However, the public's attitude
fibrillates. The future of information and technology in delivering public services is as much,
if not more, to do with philosophy and sociology, as it is with the technology. Borders will
increasingly become a purely a construct of government: the internet has already opened
up a world of new experiences whether to purchase different, cheaper goods from overseas
to planning journeys which would once have required lengthy organization. At a macro-
level, this is being driven by fundamental changes in public behaviour: primarily the
empowering nature of the internet, the demand for more personalized services and the
increasing lack of deference within society.
A themed edition of PMM will explore some of these issues in greater depth. The edition
will try to look ahead and consider some of the longer terms trends in society and how the
public sector needs to change in anticipation. It will also include a case study on healthcare.
Topics for articles include privacy; trends in society; embedding innovation in organizations;
consumer innovation; productivity; and the sociology and behaviour of using technology.

Abstracts of 1,000 words should be sent to Christopher Exeter

(pmmtrends@live.co.uk) where further information can also be obtained.

© 2009 THE AUTHORS

PUBLIC MONEY & MANAGEMENT SEPTEMBER 2009 JOURNAL COMPILATION © 2009 CIPFA