On 2 May 2012, Sir Mervyn King, Governor of the Bank of England, gave the BBC Today Prgramme’s public lecture. In it, he reflected on the causes and aftermath of the banking crisis of 2007/8.
He said that the main cause of the banking crisis was the risky behaviour of the banks themselves – behaviour that they had been allowed to get away with becuase regulation was too light. The cause was not one of inappropriate fiscal and monetary policy.
According to Dr King, there had been no classical macroeconomic boom and bust. True there had been a bust, but there was no preceding boom. Economic growth had not been unsustainable in the sense of being persistently above the potential rate. In other words, the output gap had been close to zero. As Mervyn King puts it
Let me start by pointing out what did not go wrong. In the five years before the onset of the crisis, across the industrialised world growth was steady and both unemployment and inflation were low and stable. Whether in this country, the United States or Europe, there was no unsustainable boom like that seen in the 1980s; this was a bust without a boom.
In terms of monetary policy, inflation had been on track and interest rates were not too low. And as for fiscal policy, government borrowing had been within the Golden Rule, whereby, over the cycle, the goverment borrowed only to invest and kept a current budget balance. Indeed, the period of the late 1990s and early to mid 2000s had become known as the Great Moderation.
So what went wrong? Again in the words of Dr King:
In a nutshell, our banking and financial system overextended itself. That left it fragile and vulnerable to a sudden loss of confidence.
The most obvious symptom was that banks were lending too much. Strikingly, most of that increase in lending wasn’t to families or businesses, but to other parts of the financial system. To finance this, banks were borrowing large amounts themselves. And this was their Achilles’ heel. By the end of 2006, some banks had borrowed as much as £50 for every pound provided by their own shareholders. So even a small piece of bad news about the value of its assets would wipe out much of a bank’s capital, and leave depositors scurrying for the door. What made the situation worse was that the fortunes of banks had become closely tied together through transactions in complex and obscure financial instruments. So it was difficult to know which banks were safe and which weren’t. The result was an increasingly fragile banking system.
But doesn’t his imply that regulation of the banking system had failed? And if so why? And have things now been fixed – so that banks will no longer run the risk of failure? Dr King addresses this issue and others in his speech and also in his interview the next day for the Today Programme, also linked to below.
Podcasts
The Today Programme Lecture BBC Radio 4, Sir Mervyn King (2/5/12) (Transcript of speech)
Also on YouTube at Governor’s Today Programme lecture, 2 May 2012
Sir Mervyn King: The full interview BBC Today Programme, Sir Mervyn King talks to Evan Davis (3/5/12)
Sir Mervyn King analysis ‘verging on delusional’ BBC Today Programme, Dylan Grice and Ngaire Woods (3/5/12)
Articles
Sir Mervyn King rejects criticism for crisis BBC News (3/5/12)
The boom and bust of Mervyn King BBC News, Robert Peston (3/5/12)
Sir Mervyn King admits BoE failed over financial crisis The Telegraph, Philip Aldrick (3/5/12)
Sir Mervyn King admits: we did too little to warn of economic crisis Guardian, Larry Elliott (2/5/12)
King Says BOE Will Risk Unpopularity to Prevent Crises Bloomberg, Jennifer Ryan and Scott Hamilton (3/5/12)
Data
Economic Outlook Annex Tables OECD (See Annex Tables 1, 10, 14, 18, 27, 28, 32, 33, 61 and 62)
Statistical Interactive Database Bank of England (See for example, A Money and Lending: counterparts to changes in M4, alternative presentation > Seasonally adjusted > Public sector contribution > PSNCR)
Questions
- Why was the period of the late 1990s and early to mid 2000s described as the Great Moderation?
- Chart the size of the output gap, the rate of inflation and public-sector deficits as a percentage of GDP in the UK and other major economies from 1995 to 2007. Is this evidence of the Great Moderation?
- To what extent would evidence of house prices, consumer debt, bank lending and the balance of trade deficit suggest that there was indeed a boom from the mid 1990s to 2007?
- What, according to Dr King were the main causes of the credit crunch?
- What, with hindsight, should the Bank of England have done differently?
- What UK body was responsible for regulating banks in the run up to the credit crunch? Why might its regulation be described as ‘light touch’?
- In what sense was there a moral hazard in central banks being willing to bail out banks?
- What banking reforms have taken place or will take place in the near future? Will they address the problems identified by Dr King and prevent another banking crisis ever occurring again?
With the financial crisis came accusations towards the banking sector that they had taken on too many bad risks. Banks were lending money on more and more risky ventures and this in part led to the credit crunch. Since then, bank lending has fallen and banks have been less and less willing to take on risky investments.
Small businesses tend to fall (rightly or wrongly) into the category of high risk and it is this sector in particular that is finding itself struggling to make much needed investments. All businesses require loans for investments and improvements and if the banking sector is unable or unwilling to lend then these improvements cannot take place.
Quantitative easing has been a key response across the world to the credit crisis to encourage banks to begin lending to each other and to customers. A new government backed scheme worth £20bn aims to increase bank lending to small and medium sized enterprises (SMEs). By guaranteeing £20bn of the participating banks’ own borrowing, lenders will be able to borrow more cheaply than normal. As the banks (so far including Barclays, Santander, RBS and Lloyds Banking Group) can borrow at a cheaper rate, they will therefore be able to pass this on to the businesses they lend to. Under this National Loan Guarantee Scheme (NLGS), businesses will be able to borrow at interests rates that are 1 percentage point lower than those outside the scheme. £5bn will initially be made available with subsequent installments each of £5bn to come later.
With the Budget looming, the Chancellor is keen to show that the government is delivering on its promise to give smaller businesses access to finance at lower interest rates. If this initiative does indeed stimulate higher lending, it may be a much needed boost for the economy’s faltering economic growth. Criticisms have been leveled at the scheme, saying that although it is a step in the right direction, it can by no means be assumed that it will be sufficient to solve all the problems. In particular, the NLGS is unlikely to provide much help for those small businesses that can’t get finance in the first place, irrespective of the cost of the borrowing. Furthermore some banks, notably HSBC, have chosen not to participate in the scheme, due to it not being commercially viable. The overall effect of this scheme will take some time be seen, but if it is effective, it could give the economy and the small business sector a much needed boost.
Banks to join credit-easing scheme Associated Press (20/3/12)
Credit easing: small businesses to get £20bn of guaranteed cheap loans Telegraph, Harry Wilson (20/3/12)
Bank lending scheme targets small businesses BBC News (20/3/12)
Move over Merlin, credit easing has arrived Independent, Ben Chu (20/3/12)
Credit easing injects £20bn into small firms Sky News (20/3/12)
UK launches small firm loan scheme, critics want more Reuters, Fiona Shaikh (20/3/12)
Osborne’s big plan: £20bn for small businesses Independent, Andrew Grice and Ben Chu (20/3/12)
George Osborne launches new scheme to boost lending to businesses Guardian, Larry Elliott (20/3/12)
Questions
- What is credit easing? Has the government’s previous credit easing had the intended effect?
- Why are small and medium sized enterprises normally seen as risky investments?
- Briefly explain the thinking behind this National Loan Guarantee Scheme.
- What are the criticisms currently levelled at this scheme? To what extent are they justified?
- Why has HSBC said that the scheme is not commercially viable for the bank?
- Explain why this scheme could provide a stimulus to the UK economy.
A negative outlook for the UK economy – at least that’s what Moody’s believes. The credit rating agency has put the UK economy’s sovereign credit rating, together with 2 other European nations (France and Austria) on the ‘negative outlook’ list.
The UK currently has a triple A rating and we have been able to maintain this despite the credit crunch and subsequent recession. However, with weak economic data and the continuing crisis in the eurozone, Moody’s took the decision to give the UK a ‘negative outlook’, which means the UK, as well as France and Austria have about a 30% chance of losing their triple A rating in the next 18 months.
Both Labour and the Coalition government have claimed this decision supports their view of the economy. Labour says this decision shows that the economy needs a stimulus and the Coalition should change its stance on cutting the budget deficit. However, the Coalition says that it shows the importance the Credit ratings agencies attach to budget deficits. Indeed, Moody’s statement showed no signs that it feels the UK should ease up on its austerity measures. The statement suggested the reverse – that a downgrade would only occur if the outlook worsened or if the government eased up on its cuts. The Coalition’s focus on cutting the deficit could even be something that has prevented the UK being put on the ‘negative watch’ list, as opposed to the ‘negative outlook’ list. The former is definitely worse than the latter, as it implies a 50% chance of a downgrade, rather than the current 30%.
The triple A rating doesn’t guarantee market confidence, but it does help keep the cost of borrowing for the government low. Indeed, the UK government’s cost of borrowing is at an historic low. A key problem therefore for the government is that there is a certain trade-off that it faces. Moody’s says that 2 things would make the UK lose its rating – a worsening economic outlook or if the government eases on its austerity plans. However, many would argue that it is the austerity plans that are creating the bad economic outlook. If the cuts stop, the economy may respond positively, but the deficit would worsen, potentially leading to a downgrade. On the other hand, if the austerity plans continue and the economy fails to improve, a downgrade could also occur. The next few days will be crucial in determining how the markets react to this news. The following articles consider this issue.
The meaning of ‘negative’ for Mr Osborne and the UK BBC News, Stephanomics, Stephanie Flanders (14/2/12)
Relaxed markets remain one step ahead of Moody’s move The Telegraph, Philip Aldrick (14/2/12)
George Osborne tries to be positive on negative outlook for economy Guardian, Patrick Wintour (14/2/12)
Moody’s wants it may cut AAA-rating for UK and France Reuters, Rodrigo Campos and Walter Brandimarte (14/2/12)
Moody’s rating decision backs the Coalition’s path of fiscal consolidation The Telegraph, Damian Reece (14/2/12)
Moody’s rating agency places UK on negative outlook BBC News (14/2/12)
Britain defends austerity measures New York Times, Julia Werdigier 14/2/12)
Questions
- What does a triple A rating mean for the UK economy?
- Which factors will be considered when a ratings agency decides to change a country’s credit rating? What similarities exist between the UK, France and Austria?
- Which political view point do you think Moody’s decision backs? Do you agree with the Telegraph article that ‘Moody’s rating decision backs the Coalition’s path of fiscal consolidation’?
- If a country does see its credit rating downgraded, what might this mean for government borrowing costs? Explain why this might cause further problems for a country?
- How do you think markets will react to this news? Explain your answer.
- What action should the government take: continue to cut the deficit or focus on the economic outlook?
- Why has the eurozone crisis affected the UK’s credit rating?
Throughout the credit crunch and since then, one of the major problems in the global economy has been a lack of lending by banks. A key cause of the credit crunch and many of the debt problems countries and people face today is because of people living off borrowed money. In the past, credit was so easy to obtain – people could receive a mortgage for more than 100% of the value of their property. However, when more and more people began to struggle to make their monthly mortgage repayments, the banking crisis began and since then mortgage lenders have become increasingly wary about who they lend to and how much.
The Bank of England has said that in the coming months it will become even harder to obtain mortgages, as banks become increasingly wary about who becomes their customer and potential home buyers put off even applying for a mortgage. Although mortgage approvals are at a 2-year high, they still remain significantly below their pre-crisis level. Indeed, the Bank of England said:
“Lenders expected the proportion of total loan applications being approved to fall over the coming quarter with some lenders commenting that they had revised down expectations for households’ disposable incomes and hence the affordability of taking out new secured loans.”
As part of this new rationing of mortgages, lenders are requiring applicants to put down larger and larger deposits and so for first time buyers, getting on to the property ladder is becoming more and more of a dream. The property market has been suffering from this mortgage rationing as house sales are down below their pre-crisis level. The housing market is crucial to any economy, as so many other sectors and hence jobs depend on it. If mortgages remain scarce and the required deposit so high, the UK housing market is likely to remain stagnant and this will certainly prove damaging for the prospects of the UK economy in 2012.
Articles
Mortgage approvals hit new two-year high The Telegraph, Angela Monaghan (4/1/12)
Mortgage approvals up but overall lending weak Reuters (4/11/12)
Mortgage rationing becomes worse, Bank of England says BBC News (5/1/12)
Mortgage demand fell in Q4 2011, say lenders Mortgage Strategy, Tessa Norman (5/11/12)
Mortgage lending still stagnant, Bank figures show BBC News (4/11/12)
BoE: Lending to be tighter in Q1 2012 Mortgage Introducer, Yuan Phoon (5/11/12)
Data
Lending to Individuals Bank of England
Questions
- Why are mortgages being rationed?
- Why is the housing market so important for the UK economy?
- Which other sectors of the economy employ people whose jobs are dependent on a buoyant housing market?
- Why has the Bank of England said that in the coming months it will become harder to get a mortgage?
- Why would increased mortgage lending be a much needed stimulus for the UK economy?
- Using an aggregate demand and aggregate supply diagram, show how rationing of mortgages and other loans will affect the UK economy.
We have covered the issue of bank bonuses in previous blogs. See for example: Banking on bonuses? Not for much longer (November 2009); “We want our money back and we’re going to get it” (President Obama) (January 2010); and Payback time (Updated April 2010). But the issue has not been resolved. Despite public outrage around the world over the behaviour of banks that caused the credit crunch and about banks having to be bailed out with ‘taxpayers money’ and, as a result, people facing tax rises and cuts in public-sector services and jobs, bankers’ pay and bonuses are soaring once more. The individuals who caused the global economic crisis seem immune to the effects of their actions. But are things about to change?
The Committee of European Banking Supervisors (CEBS) has confirmed tough new guidelines on bank bonuses applying to all banks operating in the EU. The CEBS’s prime purpose in recommending restricting bonuses is to reduce the incentive for excessive and dangerous risk taking. As it states in paragraph 1 of the Guidelines on Remuneration Policies and Practices:
Whilst institutions’ remuneration policies were not the direct cause of this crisis, their drawbacks, nonetheless, contributed to its gravity and scale. It was generally recognized that excessive remuneration in the financial sector fuelled a risk appetite that was disproportionate to the loss-absorption capacity of institutions and of the financial sector as a whole.
The guidelines include deferring 40–60% of bonuses for three to five years; paying a maximum of 50% of bonuses in cash (the remainder having to be in shares); setting a maximum bonus level as a percentage of an individual’s basic pay; appointing remuneration committees that are truly independent; publishing the pay and bonuses of all senior managers and ‘risk takers’. Although they are only recommendations, it is expected that bank regulators across the EU will implement them in full.
So will they be effective in curbing the pay and bonuses of top bank staff? Will they curb excessive risk taking? Or will banks simply find ways around the regulations? The following articles discuss these issues
Articles
Bankers’ bonuses to face strict limits in Europe BBC News, Hugh Pym (10/12/10)
Bankers’ bonuses to face strict limits in Europe BBC News (10/12/10)
Europe set to link banking bonuses to basic salaries The Telegraph, Louise Armitstead (10/12/10)
Some bankers may escape EU cash bonus limit moneycontrol.com (India) (11/12/10)
Banks to sidestep bonus crackdown by raising salaries Guardian, Jill Treanor (10/12/10)
Bonuses: When bank jobs pay Guardian (11/12/10)
Bank bonuses (portal page) Financial Times
Committee of European Banking Supervisors (CEBS)
CEBS home page
CEBS has today published its Guidelines on Remuneration Policies and Practices (CP42) CEBS news release (10/12/10)
Guidelines on Remuneration Policies and Practices (10/12/10)
Questions
- What are main objectives of the CEBS guidelines?
- Assess the arguments used by the banking industry in criticising the guidelines.
- In what ways can the banks get around these new regulations (assuming the guidelines are accepted by EU banking regulators)?
- What conditions would have to met for a remuneration committee to be truly independent?
- How likely is it that countries outside the EU will adopt similar regulations? How could they be persuaded to do so?
On 2 May 2012, Sir Mervyn King, Governor of the Bank of England, gave the BBC Today Prgramme’s public lecture. In it, he reflected on the causes and aftermath of the banking crisis of 2007/8.
