The Bank of England and the Big Band Day - Term Paper Example

1) Overview: The term “Big Bang” is used by market analysts in the UK to describe the reforms that were introduced to free-up the financial institutions of the United Kingdom from excessive governmental regulations. This term was coined to describe the historical day of 27th October on which a series of reforms were introduced by “Thatcher government” which changed the way banking was done in the United Kingdom. Looking at the background, the main reason behind introduction of these reforms was the fact that the United Kingdom’s banking system was lagging behind New York and Switzerland and was fast losing its important as financial hub of the world. These reforms were aimed at making London the financial hub of the world once again and it was thought that it was imperative to deregulate the banking system of the UK. These reforms were a success and an economic boom was experienced in the UK. The lead many into believed that deregulation of financial system was the need of the time, and many countries including Japan and China imitated the United Kingdom’s action. However, a series of events in 1987 showed that freeing up the financial institutions from governmental control in not necessarily good. On October 16 1987, all the markets in London were unexpected closed following The Great Economic Storm. This had a trickledown effect on the financial institutions and most particularly the stock markets all over the world. Major stock markets including Spain, Hong Kong and Australia dropped points. The biggest fall was seen in the United State’s DOW Jones index and it was thought that this was a result of excessive deregulation of the financial sector and markets of the USA and the UK. Another financial crisis occurred in the month of September in 1992. It is widely remembered as “Black Wednesday” owing to the fact that it occurred on a Wednesday. The crisis started when the United Kingdom’s government withdrew Pound Sterling from European Exchange Rate Mechanism. The major reason behind this was their inability to keep Pound Sterling at its lowest possible exchange rate value. The Thatcher government took desperate measures to prevent Pound Sterling from decline, but nothing proved successful. The government tried to buy the currency from the currency market and increased the interest rate, only to see that it raised inflation and the value of Pound Sterling continued to fall. As a last resort, it was decided to withdraw Pound Sterling from ERM, so that United Kingdom could pursue its own monetary and fiscal policy and in turn it could rescue the value of Pound Sterling from falling. By the end of 1990s, deregulation of the banking system and financial sector was becoming famous throughout the world. It became common in the Asian region also, but unfortunately in the year 1997 Asian region suffered credit crunch and economic crisis. The crisis started by the fall in the value of Thai Baht. The government in Thailand tried to solve the problem by pegging its currency with United State’s dollar. Other regions in Asia were also affected having large current account deficits, but IMF came forward to help them. However, the help coming from IMF was not enough as interest rates charged against this help was too high. In the end, Asian countries decided to help themselves by forming an economic assistance pact known as ASEAN. 2) INTRODUCTION The Bank of England is the central bank of United of Kingdom. The central bank is also known to be a regulatory authority of the banks and financial sectors of an economy. The major functions of central banks consist of promoting economic stability and working towards promoting the public interest in the banking system. In the United Kingdom, The Bank of England performs the following tasks: 1) Custodianship 2) Controlling the Commercial banks 3) Economic Monitors The Bank of England is the custodian of the United Kingdom’s financial sector. It has the authority to monitor the activity of various financial institutions and to make sure that these institutions are performing ethically and in accordance to the banking rules and regulations of the country. However, the Big Bang Day reduced the bank’s control over the financial sector of the United Kingdom. It called for the deregulation of the banking sector, giving them chance to devise their own trading rules and thus limiting the governmental control. I think that this was the turning point in the history of banking in the United Kingdom and it opened the doors for crises which occurred immediately in 1987 in the form of Black Friday and later in the form of Black Wednesday in 1992. Similarly, by lessening the control of government over banks, you giving an invitation to the banks to do anything to increase their profits which is bad and can lead to crisis and lack of confidence in the banking system. The other function of “The Bank of England” is controlling the commercial banks. It enables “The Bank of England” to extend loan to commercial banks when they are facing financial crisis. This is an extremely important source of earning revenues and profits for the central banks. It must be noted that the Bank of England has earned the record profit since its foundation in 1694. The bank of England does not have this opportunity before the Big Bang Day, as it was mainly responsible for looking after the commercial banks than earning profits by lending to them. Hence, the role of the bank of England has changed from being a caretaker to being an institution that earns profit from the commercial banks. (Conway, 2009). The Bank of England is also responsible for looking after the economic measure of the United Kingdom and evaluating the performance of United Kingdom in various sectors. This is one role which hasn’t changed for the Bank of England even after the Big Band day. The Bank of England is responsible for looking at the economic policy of England from the day of its inception up till now and this is one role which it is performing even after the promulgation of Economic reform which deregulated the financial sector of the UK from any sort of excessive governmental control. (Bamford, 2003) 4) TASKS: Lehmann brothers Inc. was one of the premiere banking organization in the United States of America. However, it was forced to file for bankruptcy in 2008. Many people give different reasons as to why such a big and established organization was forced to go out of business. One of the strongest reasons that is widely discussed is the fact that Lehmann Brothers were heavily involved in sub-prime lending. This type of lending is one of the most risky investments. It does not ask for collateral or any income proof. Although, It commands highest interest rate from the borrower, the default rate is very high. Since, Lehmann Brothers had all their eggs in one basket, and many of its lending defaulted, it was forced to file bankruptcy. This would have not been possible hence the government controlled the financial sector and levied strict rules on financial institutions on lending and investment they can and they cannot make. This would have saved institutions like Lehmann Brothers and Northern Rock from the financial crisis. (Duncan, 2008) Short-selling is selling of any asset which is not owned by seller at the moment and he tries to obtain the asset at the lowest possible price before the delivery date. Hedging occurs when one party diverts all the risks of unwanted price fluctuation to a third party. This is done by creating a portfolio of risky and stable investment. This maximizes the return and makes sure that there is not too much risk involved in the investment. Suppose I sold 1000 shares of Company X to Andy at a price of $2 each share. I promised to deliver him his shares by the end of the month. He will pay me the current prevailing price at the end of the month. Now, what I will try to do is that I will wait for market price to go lower than $2 and will buy these shares to make a profit on my sale. However, if this does not happen I will make a loss. Many banks bought short-securities prior to crises and this was again due to lack of regulation in the financial sector and hence, had there been more regulations the condition could have been different and we could have escaped the economic crisis. Theory of Comparative Cost states that it is only feasible to perform a certain task if your opportunity cost for that task is lower than what others are experiencing. For example, if in order to produce one market, you have to forego 15 pens, whereas others have to forego only 10 pens for producing one marker, then whatever you are producing does not bear a comparative advantage. In the banking sector, this war to become the most profitable bank and greed let to the collapse of the financial system and only more governmental regulation and more control could have protected it. ( 4) CONCLUSION: From the above discussion, it can be safely concluded that deregulation was the main cause behind the collapse of the financial sector and financial system throughout the world. The world could have handled the situation better and could have prevented it from occurring, had the government had more stakes in the running of the financial system. As we have come to know that one of the major role of the central bank is that of custodianship, it is highly important that governments, once again, should give more authority to central banks over the operation of the commercial banks, so that in future these crises could be prevented. References: Collin Bamford. (2003). Economics. Oxford University Press James Van Horne and Wachowicz. (2004). The Fundamentals of Financial Management. Prentice Gary Duncan. (2008). Lehmann Brothers Collapse sends Shockwave round the World. The Sunday Times: http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article4761892.ecehttp://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article4761892.ece Edmund Conway. (2009). Bank of England makes £1bn profit thanks to crisis measures. Telegraph: .http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5345487/Bank-of-England-makes-1bn-profit-thanks-to-crisis-measures.html Read More