An Overview of the UK Banking System - Report Example

The UK Banking System - An overview The UK banking sector is the third largest in the world after the US and Japan. In addition to having one of thelargest commercial banking industries, the UK is also a major international centre for investment and private banking. The UK banking sector's strong international orientation is reflected in the substantial foreign presence and sizeable assets of foreign banks in London. The number of authorized banks in the UK totalled to about 690 in 2004. Although the number of UK incorporated banks declined over the past decade there was a significant increase in their average size and financial strength. The total number of authorized banks increased largely due to the growing presence of European Economic Area (EEA) banks. Many of these do not have a physical presence in the UK but can accept deposits on a cross-border basis. Assets and liabilities of the UK banking sector reached 4,165bn at the end of 2003, nearly three times the 1993 total. Although their share decreased somewhat during the past decade, foreign banks still held over half of UK banking sector assets in 2003. European banks accounted for nearly a half of this, followed by US and Japanese banks (Delta Quest Network, 2005). Bank of England is responsible for maintaining overall stability of the financial system as a whole. Since its responsibilities for supervising individual banks were transferred to the FSA, the financial stability role of the Bank has been to focus on identifying and limiting systemic financial risk. This involves close monitoring of the financial system infrastructure, particularly payments systems. The Bank also monitors economic and financial market developments, as part of an overview of the system as a whole. Now-a-days, the main focus of most of the banks is on risk management primarily on reputational, regulatory, operational and strategic risk, as well as the more traditional credit and market dimensions of risk. There are a number of factors responsible for this increased focus. The major of them are globalization, the relatively favourable economic environment - such that the UK banking sector has made record profits again this year, it remains highly capitalised and asset quality remains strong; the reputational impact that high profile regulatory issues are seen to have had - on both the retail and wholesale side - and the shift in the regulator's focus towards governance and control issues; and the unprecedented volume of regulatory change (Hale, 2004). Both the UK and world economy are continuously gaining advantage from a sustained period of consistent growth. The banks have benefited from the economic health, producing a strong financial performance over the last few years and in the first half of 2004. They remain well -capitalized and there are no signs of any serious deterioration in asset quality. Yet, the risk of macroeconomic outlook continues to exist. The move to slightly higher interest rates is the first aspect to be considered. To state the obvious, higher interest rates will increase the cost and reduce the affordability of both the stock of consumer lending and new loans. Although the monetary authorities both in the UK and abroad are managing the turn in the interest rate cycle with great care, regulators are required to acknowledge the risk that the shift to a more moderate rate of growth in consumer borrowing may not be universally smooth (Hale, 2004). Secondly, the decline in lending margins. A long period of strong personal sector credit quality, coupled with strong competition for lending business, has helped squeeze margins to historically low levels. The effects of this on the bottom line have been disguised by strong volume growth. There are two downside risks for the banking sector in the UK as felt by the FSA. The first is that, the period of strong volume growth may be coming to an end. The second is that a downturn could expose banks as having under- priced risk through the cycle. The Northern Rock Crisis Northern Rock is Britain's fifth largest mortgage bank, and the Bank of England deemed it necessary for Britain's economic stability to come to its rescue by offering the mortgage bank an open ended line of credit for the duration of the current liquidity crisis, which is set to continue well into 2008. The amount of the funding has not been specified but is estimated at more than 4 billion (Walayat, 2007). It has specialised in mortgage lending based on the availability of cheap credit. The credit crunch that followed the collapse of the US sub-prime mortgage market meant that Northern Rock was unable to raise loans. The Bank of England stepped in to provide loans when depositors scrambled to withdraw their money in the first run on a British bank since over end and Gurney in 1866. Even Wall Street shuddered at the spectacle. The threat of contagion was felt internationally, and the Bank of England was forced to act (Talbot, 2007). Northern Rock was facing difficulty raising money on the wholesale money markets. It was experiencing difficulty funding its day-to-day requirements and had therefore sought a short-term line of credit from the Bank of England (BoE) in order to improve its liquidity. It is quite normal for the BoE to act as a 'lender of last resort' for banks struggling to raise funds (D'Arcy, 2007). Northern Rock has a credit squeeze and is a bit short of cash, so it has therefore agreed a form of temporary overdraft (costing a mere 1% over base rate, or 6.75% a year) from the Bank of England. This created a situation that had not been seen in Britain since the 1860s. On Sept. 14, 2007, as soon as the bank's management announced that it had turned to the Bank of England for temporary assistance, long lines of clients appeared in front of Northern Rock offices trying to withdraw their deposits. The bank's Web site collapsed under the huge wave of clients attempting to transfer money from Northern Rock accounts to other banks. The bank's crisis is linked to the global credit crunch which has been caused by the problems in the American sub-prime mortgage market. Northern Rock has been hit as other banks - the main source of its cash - are unwilling to lend in the current unsteady climate. However, the Bank of England, and the Chancellor, has stepped in to rescue the bank with extra funds, which they say is enough to save Northern Rock. The U.K. government is facing growing criticism for its decision to temporarily nationalize Northern Rock. Taking the total volume of loans and guarantees provided by the Bank of England in combination with the value of mortgages on the troubled bank's books, the state's involvement in Northern Rock reached 100 billion (Kol, 2008). The crisis began when the management of Northern Rock and the government were approached by U.K. bank Lloyds TSB with a proposal to purchase Northern Rock for 2 per share if the government provided a credit of 10 billion to cover the risks associated with the takeover of the threatened bank. Northern Rock's problems have been caused by the crisis in the credit markets over the past few weeks, which has seen banks become increasingly wary about lending to each other. The credit crunch began because a number of mortgage lenders in the US had been lending too much and too freely to consumers with poor credit ratings. As interest rates increased in the US; many of these borrowers were unable to keep up payments on their loans. Unfortunately, this was not just a problem for the banks that lent them the money. Many lenders packaged up their books of so-called "sub-prime" mortgage debt and sold it to other institutions around the world in the form of high-yielding bonds. When the borrowers stopped paying their mortgages, the bonds were no longer worth as much as the institutions who had bought them thought. This caused a crisis of confidence in debt markets around the world - amplified by the fact that it was not clear exactly how exposed various companies were to the sub-prime crisis (The Independent, 2007). After these series of incidents, Northern Rock shares slide further, with the stock opening 31% lower after tumbling by a similar amount in the immediate wake of the crisis. Meanwhile, savers continue to queue at Northern Rock branches across the UK. Darling intervenes, pledging that the government will guarantee all deposits lodged with Northern Rock (Association, 2008). Despite reassurances that the money of its customers' is safe, worrying pictures of customers the length and breadth of the country queuing up at Northern Rock branches dominated the news. Northern Rock put on extra staff to deal with the surge of customers arriving at branches and some stayed open later to deal with them, with transfers of up to 140,000 taking place. The reasons for the crisis Systematic failure of duty is believed to be the main reasons for the crisis of Northern Rock bank. Northern Rock has fared badly because without a large savings base to use as collateral on loans, it must seek support for loans on the debt markets. Northern Rock stands accused of "reckless" lending after it emerged. The business practices of Northern Bank were also responsible for the crisis to occur. The Northern Rock crisis looked initially like a liquidity crisis. Northern Rock's problem is no longer just a matter of liquidity and timing. Even if the Rock could liquidate all its mortgages tomorrow, it could not raise enough money to repay its depositors and the Bank of England in full, because the market prices of mortgage assets are today much lower than 100p in the pound. The upshot is that the Government will almost certainly have to nationalise Northern Rock after putting it into administration (Kaletsky, 2007). If banks could convince investors that their audited year-end results offer an honest picture of their potential losses and new capital needs, then most banks could easily raise this extra capital on global markets and normal financial conditions would quickly be restored. The reason the Rock got into trouble in the first place is that it relied on borrowing from other lenders rather than raking in cash from savers to fund its mortgage business. Though direct exposure of Northern Rock Bank in subprime mortgage is very less and its mortgages are said to be high class, however, when US subprime crisis started to spread through the market, banks suddenly got very scared of lending to one another. Now, when Northern Rock was borrowing money in the short term, it was used to being able to roll over the loans- so when the three month term ended, another would begin. But as banks stopped being willing to lend, the three-month lending rates shot up, and suddenly it became near impossible and very expensive to roll over those loans. Once rolling up come to an end borrowers were not able to return the money, which they had taken from the bank and slowly the bank was not able to return money to its depositors. The liquidity situation of the bank spread like wild fire in UK and mobs started gathering to withdraw their money from the bank. So this Northern Rock Bank crisis can be told to be an indirect fall out of subprime crisis (Kant, 2007). Bibliography 1. Association, P. (2008, March 26). Timeline: The Northern Rock Crosos. Retrieved April 10, 2008, from Guardian.co.uk: http://www.guardian.co.uk/business/2008/mar/26/northernrockgusrc=rss&feed=uknews 2. D'Arcy, C. (2007). Northern Rock: A Busted Bank. London: The Motley Limited. 3. Delta Quest Network. (2005, March 23). Banking System of UK. Retrieved April 10, 2008, from DeltaQuest: http://www.myoffshoreaccounts.com/english/offshore_uk-banking-uk-bank-account 4. Hale, K. (2004, November 9). Challenges of the UK banking sector. Retrieved April 10, 2008, from FSA: http://www.fsa.gov.uk/Pages/Library/Communication/Speeches/2004/SP211.shtml 5. Kaletsky, A. (2007, December 17). This crisis is no longer a simple problem of liquidity. Retrieved April 10, 2008, from Times Online: http://www.timesonline.co.uk/tol/comment/columnists/anatole_kaletsky/article3060223.ece 6. Kant, R. (2007, October 4). Northern Rock Bank goes down: Reasons and lessons . Retrieved April 10, 2008, from Merinews: http://www.merinews.com/catFull.jsparticleID=126772&catID=8&category=Business&rtFlg=rtFlg 7. Kol, M. (2008). Northern Rock rocking the U.K. Czech Business Weekly. 8. Talbot, A. (2007, December 22). Northern Rock crisis deepens. Retrieved April 10, 2008, from ukwatch.net: http://www.ukwatch.net/article/northern_rock_crisis_deepens 9. The Independent. (2007, Spetember 14). Concerned at the crisis of Northern rock. Retrieved April 10, 2008, from The Independent: http://www.independent.co.uk/money/invest-save/concerned-by-the-crisis-at-northern-rock-dont-panic-464303.html 10. Walayat, N. (2007, September 14). UK Banking Sector Crash - Run on Northern Rock Bank. The Financial Times , pp. 3-4. Read More