Financial Crisis in the UK - Research Paper Example

Financial Crisis in the UK The term 'financial crisis' is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value.Provide a clear explanation on the key events in the financial crisis as it has affected the UK beginning from the start of 2007.Why do you think financial crisis keep re-occuring? Introduction Financial crisis is an economic situation where there is widespread systematic loss of monetary wealth. In the modern era, the financial sector has increased in importance in developed economies because of their capacity to generate wealth and multiply capital to supplement the production capabilities of industries that developed prior to the era. Financial services ranged from managing investments, banking and debt management among others. These have allowed some economies like Iceland to develop into countries that are dependent on the strength of their financial sector (BBC, 2009a). The Global Financial Crisis The wake of the global financial crisis saw titans of the financial markets fall on their own weight. As giants such as the Lehman Brothers, Citibank and the American Insurance Group began their free fall and other financial institutions around the world began breaking under the pressure of mounting forfeitures and unpaid debts, governments of the world were quick to respond to prop up this important part of the global economy (CNN, 2009b). The epicenter of the financial crisis is the United States of America, the world’s largest economy, where the past decade a continuing bubble growing with continuous spending fueled by debts that suddenly burst when financial institutions that were supposed to generate money ended up producing even more debt (U.S. Treasury Department, 2009). Analysts point to the United States housing bubble burst as the beginning of the crisis. This happened in 2005-2006. For a decade since the time of President Clinton, the growth of the United States economy had mostly been riding on the strength of the consumerist demand of American society. This era saw the rise of debt-driven consumerism – households spending more than they can actual produce – to buy big investments such as cars, houses and appliances. This culture spread relatively quickly to other Western countries. Between 1997 and 2006, the price of a typical American house increased by 124%. The national median home price ranged from 2.9 to 3.1 times median household income, increasing to 4.0 in 2004 and 4.6 in 2006 (BBC, 2009b). The bubble caused very few homeowners to refinance their homes at lower interest rates, or finance consumer spending by getting second mortgages secured by the price appreciation (BBC, 2009 e, f, g). Liquid cash that consumers used from home equity extraction became two times as high from $627 billion in 2001 to $1,428 billion to 2005. This contributed to economic growth worldwide (BBC, 2009b). To finance these debts, Western nations had to draw from surpluses of emerging economies in Asia and the Middle East. China had become the largest lender to the United States. These conditions catalyzed the continued integration of all major economies in the world, fueling the global economic engine. Financial institutions, in the advent of advanced communications and analytical technologies, became more aggressive in the multiplication of wealth without actual production to back it up. New financial packages sought to make money out the trillions and trillions of debt mounting on the world’s largest economy. However, this unbridled greed of consumerist societies became their own downfall (BBC 2009f). The housing bubble burst when the debts incurred by households reached a tipping point. When mortgages started going on default, more and more houses were put under the assets of lending agencies such as banks, investment companies and insurance groups. The bubble bursting turned entire communities into foreclosed ghost towns. As more and more of the assets of banks became more difficult to liquidate, freezing up capital and debt markets (BBC, 2009a). Together with these, house prices dramatically fell, thereby, erasing large amounts of money from these financial institutions (BBC, 2009f). By September 2008, the general housing prices in the United States decreased by a dramatic 20% from the 2006 peak. Due to easy credit and the hope that house prices will eventually appreciate, more and more homeowners obtained adjustable-rate mortgages. This made refinancing more difficult as house prices continued to decline in several parts of the United States. In 2007, 1.3 million properties had been foreclosed. In 2008, the figure was at 2.3 million. By August 2008, 9.2% of all mortgages outstanding were either delinquent or foreclosed (CNN, 2009a). Another problematic situation that led to the crisis was that the regulatory frameworks of the financial sector were not strong enough to meet the demands of the growing importance of financial innovation, as seen in the greater dependence on the shadow banking system, derivatives and off-balance sheet financing. Key regulatory decisions that made an impact leading to the crisis include: (1) Passing of the Gramm-Leach-Bliley Act in 1999 that reduced the separation between commercial and investment banks; (2) Relaxing of the net capital rule by the Securities and Exchange Commission in 2004 that allowed investment banks to substantially increase the level of debt they can take on; (3) No regulations were set for the financial institutions of the shadow banking system allowing them to incur bigger debts; (4) Allowing of depository banks such as Citigroup to move significant amounts of assets and liabilities off-balance sheet into complex legal entities known as structured investment vehicles; (5) Allowing of self-regulation of the derivatives market through the passing of the Commodity Future Modernization Act of 2000 (BBC, 2009c). To add to the situation, a commodity price bubble was created after the collapse of the housing bubble. The price of oil tripled from $50 to $140 from 2007 to 2008, but plunged as the crisis began to affect more and more economies in 2008. An increase in oil prices tends to divert a larger share of consumer spending into gasoline, which creates downward pressure on economic growth in oil importing countries, as wealth flows to oil-producing states. To summarize the situation, we can look at the Declaration of the Summit on Financial Markets and the World Economy of the leaders of the Group of 20 (BBC, 2009c): “During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation or take into account the systematic ramifications of domestic regulatory actions.” One of the first to fall after the beginning of the crisis in the United States was Northern Rock, a medium-sized British bank. The highly leveraged nature of its business pushed the bank to request security from the Bank of England. This move caused widespread investor panic and a bank-run in mid-September. In the political arena, Liberal Democrat Shadow Chancellor Vince Cable called for the nationalization of the bank but was initially ignored. However, by February 2008, the British government, after having failed to find a private sector buyer for the bank, took the bank into public hands. Taxpayer money injected into Northern Rock reached £40,000,000 and could reach £50,000,000, representing a staggering 5% of GDP of the United Kingdom. Northern Rock’s problems became an early depiction of the type and magnitude of problems that other financial institutions will have to face in the coming months. The first institutions to fall were those involved directly with home construction and mortgage lending such as Northern Rock and Countrywide Financial, because these banks and lending agencies saw their credit markets freeze. The decline in wealth had a direct impact in consumption and business investment, two key economic indicators that used to fuel GDP growth for most economies of the world. Between June 2007 and November 2008, citizens of Western countries, including Americans and the British, saw a quarter of their net worth lost. By early November 2008, all major stock markets in the world dipped to their lowest levels in decades. Total home equity in the United States saw $5 trillion worth of value lost in less than a year. Total retirement assets also dropped by 22%. Savings and investment assets lost $1.2 trillion while pension assets lost $1.3 trillion (CNN, 2009c). To counter this decline in consumption and lending capacity, governments around the world began to pour in more and more money in the financial sector, either to save existing institutions or prop up other industries. From being “lenders of last resort”, central banks across the world became “lenders of only resort”, and increasingly, “buyers of last resort”. The spread of the crisis was staggeringly quick, with European banks falling very quickly. Iceland and other emerging economies around the world, that used to have sound financial systems, quickly collapsed, prompting larger lending agencies such as the International Monetary Fund to intervene. Because of lending and investment markets began to freeze, the productive sectors of the economy also began to suffer. Negative growth was expected in the United States, Eurozone, UK and Canada. UK’s recession would last for a year at least, with annualized decline in GDP at 7.4% (BBC, 2009a). The Crisis in the UK In UK, the crisis is showing in various ways. Most shops now sport a “50% off” sign just to be able to earn enough to continue operations. UK house prices continue to drop dramatically. The Bank of England has continued to reduce the UK base rate in the hopes to unfreeze investment markets. Soon enough, job losses began to mount, initially in the construction and real estate sectors, eventually to manufacturing and all other sectors. The car industry collapse in the United States also had shockwaves in the UK (BBC, 2009d). Some of the strongest corporations in the United Kingdom had began slashing more and more jobs, making mortgage payments even more difficult to settle. Diageo, the maker of Guinness, Johnnie Walker and Smirnoff cut 900 jobs. Lloyds banking group cut 2,100 jobs across its UK operations. Gambling group Gala Coral cut some 280 jobs after closures it had to deal with. Steelmaker Corus cut 2,045 jobs. Lloyds also cut 270 jobs in its insurance and offshore operations. French insurer Axa cut 560 jobs in its UK operations. British council cut 500 jobs in the face of the weak pound and government pressure to cut costs. 1,660 jobs were again slashed by Lloyds Banking Group for the closure of all 164 Cheltenham and Gloucester branches and 530 more from AGM. Hewlett-Packard closed down its Scottish factory cutting 710 jobs. Northern Foods closed its Hull factory costing 349 jobs. Defense research and technology company QinetiQ cuts 400 jobs and Lloyds again cuts 211 jobs. Fashion retailer Bay Trading cut 1,200 jobs with the closure of 125 branches. Lloyds, after part-nationalization, cut another 625 jobs. Bay Trading cut a further 15,000 jobs globally, slashing 10,700 in the UK. Industrial supplier Cookson cut 600 jobs. Kesa Electricals slashed 120 jobs. Newspaper distributor John Menzies cut 400 jobs. Sheffield-based building products group SIG cut 170 jobs. BAE systems, Europe’s largest defense company cut 500 jobs and closed three factories in the United Kingdom. Footwear retailer Stylo slashed 2,5000 jobs. GKN, the British car and aircraft parts maker, cut 564 jobs after the closure of three factories. Swiss bank UBS cut 2,000 jobs in its UK operations. Cadbury removed 600 employees. All these major job losses continue to show the extent of the crisis in the United Kingdom (BBC, 2009d). Conclusion For most of the 20th century, the financial sector has been an asset to any economy, whether developing or developed. However, in the beginning of the 21st century, the world was gripped with a crisis that threatened to undo all the gains in the past decades, with a magnitude that almost surpassed the first global crisis some 80 years ago. References BBC (2009a). July 14, 2009. “Europe bank chief warns on debt.” Retrieved July 14, 2009 from http://news.bbc.co.uk/2/hi/in_depth/business/2007/creditcrunch/default.stm. BBC (2009b). July 14, 2009. “Eurozone retail sales post fall.” Retrieved July 14, 2009 from http://news.bbc.co.uk/2/hi/in_depth/business/2007/creditcrunch/default.stm. BBC (2009c). July 14, 2009. “Eurozone unemployment up again.” Retrieved July 14, 2009 from http://news.bbc.co.uk/2/hi/in_depth/business/2007/creditcrunch/default.stm. BBC (2009d). July 14, 2009. “French youth unemployment rises.” Retrieved July 14, 2009 from http://news.bbc.co.uk/2/hi/in_depth/business/2007/creditcrunch/default.stm. BBC (2009e). 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