How Financial Crises Affect the Banking System

Abstract

Banks experienced severe consequences of the global financial crisis that occurred during 2007 and 2008. Some banks became bankrupt while others were enshrined in the distresses that arose from sensitivities, which were stored in the form of balance sheets. Others encountered only minimal challenges. In the discussion of this paper, it is assumed that the risks that banks encountered due to the financial crisis are functions of volatilities and the said sensitivities. The discretion for volatility does not fall within the realm of banks’ control because it is externally determined. Therefore, the paper views the challenges that banks encountered from the financial crisis as mainly determined by their sensitiveness. The paper proposes a research to determine how banks responded to the effects of global financial crisis by drawing data from the EU banks to show how they shifted their investment options to develop credit risk resilience.

Introduction

Overview

Credit crunch refers to the defining moment of the current economic business cycles in many countries. The crunch was first witnessed during the 2007 financial fluctuations in the US. It later developed into what can best be described as a liquidity crisis of global economies during the late summer of 2007. In autumn, the EU experienced credit crunch repercussions through the financial crisis that resulted in the collapsing of businesses together with the erosion of consumer confidence during winter (Finn 2008, Para. 1).

Problem statement and study variables

Currently, it sounds relieving for businesses especially because signs of the first phases of the crisis are almost over. Nevertheless, the crisis experienced in 2007 to 2008 in the developed world nations’ financial systems has irreversible damages irreversible. The main problem of this research is what are the effects of global financial crisis? The dependent variable for the research is the implications of the crunch while the independent variable is the cause of the credit crunch.

Problems significance

The credit crunch weakened immensely the global economy. The problem was initially treated as an isolated case that was only considered affecting few companies although it later turned out to be a major problem that required national interventions across the globe

Research hypothesis

This paper hypothesises that the global economic crunch, which began in 2007 and affected fully the major economies of the world hard in 2008, had the effects of threatening the financial systems to near collapse. The crisis is also hypothesised to have been preventable should the appropriate steps have been taken.

Assumptions and limitations of research

Every research has its own drawbacks related to the assumptions made. In this paper, it is assumed that various challenges of the economic crunch experienced in 2007 to 2008 could be applied in different geographic regions. Hence, the strategies proposed for handling such challenges would also apply in different geographic regions to produce similar effects.

Project justifications

During the global financial crisis era (2007 to 2008), financial organisations’ profitability reduced although loss-bearing abilities remained strong. Hence, through evaluation of its effects on the financial markets strategies can be recommended for mitigating such effects in the future.

This paper analyses how the financial crisis can affect banking systems in the EU with reference to the global financial crunch.

Literature Review

Risks encountered by banking systems

Banking systems encounter several risks when a crisis threatens the financial markets. Such risks include operational risks, credit risks, and systematic risks. Operational risks involve all forms of risks that organisations encounter in their attempt to operate in particular fields. “Operational risk is the risk that is not inherent in financial, systematic or market-wide risks, embracing all risks that remain after determining financing and systematic risk, and includes risks resulting from breakdowns in internal procedures, people, and systems” (Andreas 2010, p.124). Credit risk is the perceived risk by investors accruing from the failure of borrowers to make payments as agreed. More robustly, credit risks are “the risks of loss of principal or a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation” (Cornett & Saunders 2006, p.36). On the worst scale, some structures of a financial organisation may collapse in totality due to the financial crisis. For instance, as depicted by the graph below, the global financial crisis of the year 2007 to 2008 affected severely the securitisation markets in the U.S.

Effects of the financial crisis on the markets securitisation
Fig 1: Effects of the financial crisis on the markets securitisation. Source (Cornett, McNutt, Strahan & Tehranian 2011, p.307)

Financial organisations always put up mechanisms to mitigate a wide-scale collapse due to the deteriorating financial markets. Such mechanisms constitute the ways of preventing systematic risks from occurring. Indeed, according to Dale and Andreas (2008), systematic risks involve “financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries” (p.24). A financial organisation comprises sub-elements that make groups of elements, which in turn are combined to constitute the whole organisation. The failure of the sub-elements consequently may be a key contributor of the failure of the whole organisation.

Operation of banking systems

In the EU, when surplus spending units (SSUs) deposit their funds into the banks, they anticipate securing a fixed rate of return on savings. They also expect to be immunised from various risks of investments. Eken, Selimler, and Kale (2012) confirm how “DSUs borrow from the banking industry to fix the cost of their borrowings to protect themselves from the effects of risks” (p.18). Such effort is crucial in helping the DSUs together with SSUs to deal with financial uncertainties. This suggests that both SSUs and DSUs push banks to assume unwanted risks in the EU banking system. In this end, Eken, Selimler, and Kale maintain, “Banks deal with management of risks from their activities allowing them to charge their customers with risk premium” (2012, p.18). Consequently, one of the major concerns for banks is to manage their risks in the effort to gain returns of investments whilst also protecting the equities of shareholders. This goal is realised when there is financial prosperity within a nation.

Effects of banking systems’ risks during the financial crisis

Financial crisis exposes banks to major threats in their efforts to mitigate risks and/or increase their profitability and market value. Financial crisis affects different banks differently depending on their risk resilience capacities. Financial risks are made up of two main components: sensitivity and the volatility (Eken 2005). For banks, which are risk prone, they have high levels of sensitivity and low levels of volatility. This means that banks, which are hazard prone, are influenced much relative to those that are threat hesitant during times of the fiscal catastrophe.

During times of the financial crisis, volatility levels go up. Consequently, “the risks taking preferences of investors and banks are widely believed to shrink to minimum levels during times of the financial crisis” (Eken, Selimler & Kale 2012, p.21). Investors who are essentially risk prone also make strategic decisions to deploy risks adverse strategies in the effort to keep exposures to non-financial together with financial risks at the lowest levels. According to De Haas and Van Horen, financial crisis makes banks raise their efforts to conduct thorough scrutiny of borrowers to ensure that they eliminate the risk of loans defaults (p.5). Ivashina and Scharfstein (2010) support this assertion by emphasising that banks reduce their lending activities during the global financial crisis (p.320).

During the financial crisis, banks increase their provisions for non-performing assets. According to Ivashina and Scharfstein (2010), during the financial crisis that was experienced during 2007 to 2008, some banks also recorded increased net interest margin (NIM). The authors suggest that this increase “implied that banks tend to continue their business in line with their experience and preferences” (Ivashina & Scharfstein 2010, p.321). Therefore, they endeavoured to keep up with their efforts of protecting borrowing and lending rates differences in their quest to remain profitable. Such an approach is largely not sensitive to the responses for the financial crisis.

Global financial crisis produced severe impacts on the liquidity risks for the European banks. According to Eken, Selimler, and Kale (2012), “before the crisis, European banks’ average liquid assets /total assets ratio was 30 percent, which latter went down to 24 percent after the crisis” (p.23). Indeed, this effect was harmonious among all banks in the EU. For the XS and S banks, low ratios were maintained in comparison with the larger banks. The small banks’ operation is more dependent on the stored liquidity (Barajas et al. 2010). This implies that banks commit more of their investments to liquid assets in comparison with the large banks whose operation is highly dependent on the purchased liquidity. In the case of the EU banks, small banks’ liquidity ratios were maintained low in comparison with large banks in pre-financial crisis and post-financial crisis era.

Financial organisations offer liquidity to creditors and/or depositors by putting in place programs for giving money on demand. A liquidity risk arises from “deposits outflows and more from exposure to make lending and interbank financial arrangements” (Barajas et al 2010, p.13). Such arrangements include the commitments involving loans, which have been undrawn together with requirements to make purchases for securitised assets. Banks lend money by developing credit lines from which people borrow besides making other credit commitments. When borrowers take advantage of the available credit commitments, banks are exposed to higher financial risks. In fact, “when the overall supply of liquidity falls, borrowers draw funds from the existing credit lines en masse” (Eken, Selimler & Kale 2012, p.24). During the 2007 to 2008 financial crisis, the non-financial sector organisations had no access to short-term loans following the drying up of the commercial markets for the commercial paper. People who utilised the commercial paper resorted to prearranged credit lines from the bank to help them finance their paper whenever necessary. Since banks had the responsibility to finance the credit, funds available for lending were minimised. This took place in a financial market environment with increasing credit risks as shown in the fig below. The TED spread, as indicators for general credit risks in the markets, shows spikes in the 2008.

Fig 2: TED spread diagram for the U.S. financial markets in 2008. Source (Eken, Selimler & Kale 2012, p.26)

TED spread diagram for the U.S. financial markets
Fig 2: TED spread diagram for the U.S. financial markets in 2008. Source (Eken, Selimler & Kale 2012, p.26)

Financial crisis also affects the banking systems through the increase in demand for liquidity by nonfinancial organisations. For instance, upon considering the case of the 2007 to 2008 credit crunch, “many businesses drew funds from existing credit lines simply because they feared continued disturbances in the credit markets” (Eken, Selimler & Kale 2012, p.24). For instance, the American electric power company withdrew 2 billion US dollars for the credit lines of JP Morgan together with the Barclays bank. This strategy was taken to ensure that the utility’s cash position was improved in the fear of credit markets’ disturbances (Ivashina and Scharfstein 2010).

Balance sheets for banks are financed in different ways. The most important ways are equity capital and/or deposits. Other alternatives include extensive selling of deposits that have no insurance cover, buying of contracts, and unsecured gadgets. During crises as evidenced by the 2007 to 2008 global financial crisis, these interventions were limited. For instance, repos are used in financing highly risky assets among them being the “private-label mortgage-backed securities” (Eken, Selimler & Kale 2012, p.25). According to Gorton and Mentrick (2011), by the middle of 2007, all these securities were possible to fund through short-term loans acquired from the repos (p.427). Following the global financial crisis, this changed so that only about 55 percent of all such securities were possible to fund from repos by the end of 2008. Consequently, according to Eken, Selimler, and Kale, “banks that used repos to finance purchases of mortgage-backed securities faced an unpleasant choice” (2012, p.29). The banks suffered huge losses since the only available option was to sell securities in the falling financial market. The impacts of the liquidity risks on the US banks are shown in the figure 1 below.

Impacts of liquidity risks on the banking system in the US.
Fig 3: Impacts of liquidity risks on the banking system in the US. Source: Cornett, McNutt, Strahanand Tehranian (2011, p.299)

Upon considering the implications of the liquidity risks in times of any financial crises on banking systems, banks had a major role to play in helping to mitigate such risks. Banks, which had more threats of liquidity, elevated the capital for liquid possessions. They also struggled to lower lending levels. However, according to Gorton and Mentrick (2011), “in of the assets, banks holding securities with low liquidity such as mortgage-backed securities expanded their cash buffers during the crisis by decreasing new lending” (p.428). Efforts were also put to ensure that banks became leveraged as shown in the bar chart below

 Growth of the leverage ratio in five major US banks
Fig 4: Growth of the leverage ratio in five major US banks from 2003 to 2007. Source: Ivashina & Scharfstein (2010, p.320)

Financial crisis affects banking systems in terms of decision on the amount of funds to hold in different forms of credit. According to Eken, Selimler, and Kale, “the global financial crisis did not affect the preferences of banks in terms of allocating their resources between credit and other assets” (2012, p.34). Even though this did not happen, the size of banks had immense influences on resource allocation preferences. The advances of banks provided for in the balance sheets depended on the size of a bank. Smaller banks have greater advances. Hence, small banks are able to have diversified portfolios concerning assets. On the other hand, large banks focus their investments on the bonds targeting differing corporation or states. The strategic decision to invest bonds by large banks places them at an advantage compared to the small banks in times of the financial crisis. Compared to holding private loans, bonds are less risky. Consequently, large banks are able to invest large amounts of funds in ways that have greater multiplying effects while shielding the banks from risks. State banks have the capacity to offer more loans compared with the private banks. Such a move is a measure to enhance better provisioning of large banks. However, easy credit condition encourages growth increase of credit risks through encouraging borrowing as evidenced by the graph below.

US trade deficits
Fig 5: US trade deficits. Source (Brigo, Pallavicini & Torresetti 2010, p.47)

Financial crisis affects the banking systems in terms of development of new methods of mitigating risks. One of such ways is to increase or derive new credit governance. In the development of risk models, governance in particular has a noble role to play. It describes the approaches deployed by an organisation’s executive arm to direct, monitor, and/or control the organisation. To do this, executives make use of “a combination of risk-model information and hierarchical control structures” (Brigo, Pallavicini & Torresetti 2010, p.45). In the formulation of risk models, governance provides the avenues through which critical information that gets into the hands of the executive team is made accurate, complete, and timely. This permits crucial decision-making, hence providing amicable grounds on which control strategies are developed, with instructions and directions being formulated and then executed effectively and systematically. Without this information, models for risk identification, their analysis, and ways of responding to them in an attempt to realise business objectives become almost unachievable. In fact, “Responding to any perceived risk demands an organisation to be cognisant of the gravity of the perceived risks together with cognition of mechanisms that may control them, accept, avoid, or make their transfer to another party” (Brigo, Pallavicini & Torresetti 2010, p.45). In all these processes, the decisions and directions of organisations’ governance are essential. As Bluhm, Overbeck, and Wagner (2002) reckon, “organisations routinely handle a wide range of risks (e.g. technological risks, commercial/financial risks, information security risks etc.), external legal, and regulatory compliance risks are the key issues in governance and compliance” (p.87). Compliance entails conforming to the established requirements. In the derivation of risk models, non-regulatory compliance is critical since the analysis of costs of non-conformance and costs of conformances provides the basis for making decisions to embrace the proposed risk model. According to Brigo, Pallavicini, and Torresetti (2010), akin to the development of risk models is the need to “assess the state of compliance, assess the risks, and potential costs of non-compliance against the projected expenses to achieve compliance in the effort to prioritise, fund, and initiate any corrective actions deemed necessary” (p.56). Non-regulatory compliance aids in setting decisions for risk taking and risk avoidance while deriving risk models.

The global financial crisis was indeed a total systematic failure amid the existence of risk management systems adopted by various banks. In case of the US, the best governance awards went to organisations that ended up failing later. One would wish to know what went wrong. Governance failed to achieve its roles. Financial systems constitute numerous institutions structured in the form of layers. These institutions include audit, board and even risk committees among others. A keen scrutiny of Investment Horizons (2010) reveals that these institutions need to have appropriate governance, which indeed failed miserably (Para. 9). Governance in the multilateral bodies including the state banks, self-regulatory bodies, private sector including the private banks, regulators, and even global bodies failed. The failure of governance of these bodies was attributed to the fact that they indeed enhanced them instead of helping in curtailing risks. For instance, in the case of US, disposable income in comparison to household debt became out of control as shown in fig below

Disposable income versus household debt
Fig 6: Disposable income versus household debt from 1994 to 2010 in the US. Source (Eken, Selimler & Kale 2012, p.27)

From the point of view of a multilateral organisation and government, a major response to this failure “…has been a chorus of calls for systemic regulation, particularly around issues of solvency” (Lukomnik & Watson 2006, p.12). The question that remains is whether this strategy is a sufficient remedy. Although regulation is necessary for incorporation as part of the governance mechanism of control, its proposal is also incomplete. Any regulator scrutinising any system needs to consider, in the first place, whether the organisation needs constraining for being inherently untrustworthy or because it is unable to handle itself. However, systems are dynamic. Hence, regulatory responses also need to be dynamic. Lack of this dynamism pushes the governance of financial institutions into making the wrong monetary policies (Krugman 2009, p.45). For instance, consider the 2-by-20 incentive method. In such a situation, when people operate funds, they get 2 percent as fee and 20 percent as profits. In case of loses, however, they get absolutely nothing.

Methodology

Determination of research design

The main purpose of this research paper is to study the impacts of the financial crisis on the banking systems in the context of the EU. This will be conducted with the main aim of developing theoretical models for deployment by the banking systems to address issues of credit risks when the financial crisis in the near future becomes evident.

Research design

Secondary data is utilised in the study. The data is anticipated to be drawn from various banks selected randomly within the EU. However, since the goal is to determine the impacts of the financial crisis on the main banking systems, the research will deploy data from banks having asset values worth more than 1 billion US dollars.

Data collection

The number of banks for use in the research will be selected such that they represent more than 85 percent of the total asset value of all banks within the EU. Selecting the sample size this way helps in conducting a research that is representative of the general implications of the financial crisis on banks. Once the data is generated, trend analysis will be conducted to draw information on how the banks responded to the global financial crisis between 2007 and 2008 and/or how these responses acted to enable banks recover from the economic turmoil in later years between 2009 and 2010. Every research methodology has its own merits and demerits. For the current research, data is obtained from secondary sources.

Summary, conclusions, and recommendations

Recommendations

The process of solving liquidity risks involves addressing the problems that cause the challenges. For instance, if the challenge is attributed to the liquidity spirals, it is necessary to raise the liquidity of the banks during times of the financial crisis. Cornett, McNutt Strahan, and Tehranian (2011) suggest, “banks must be recapitalised by raising new capital, diluting old equity, possibly reducing face value of old debt” (p.311) during financial crises. One of the ways of accomplishing this role is by quick declarations of bankruptcy of the banks, which causes the spirals or the banks exhibiting liquidity spirals. It is also important to expand funding markets together with ensuring that guarantees for the banks are ascertained and broadened. Another strategy is to offer collateralised funding in a reasonable way such that the deleveraging produced does not encourage increasing the appetite of the banks for credit (Ivashina & Scharfstein 2010, p.332). It is also important for risk management to be appreciated as entailing systematic risks accruing from liquidity spirals. The regulation needs to address the challenges affecting the banking system during times of the financial crisis collectively but not in isolation.

Summary

Although the above recommendation is important in helping to mitigate risks associated with the financial crisis, it is equally important to note that collapsing of banks’ credit markets during times of the financial crisis is difficult to avoid. The question that many researchers on banking systems focus on addressing is whether such effects can be minimised. Cornett, McNutt Strahan, and Tehranian (2011) deploy statistical models to address this challenge. The model provides a simulation of the overall “credit production that would have occurred if all banks had entered the crisis with low liquidity risk exposure” (p.297). As revealed in the discussions of the paper, banks, which heavily depend on the commitments made on off-balance sheet, reduce substantively their credit levels when they encounter financial crisis. Hence the model proposed by Cornett, McNutt Strahan, and Tehranian (2011) may provide an ample starting point for the computation of the manner in which banks would have altered credit productions should such banks have gotten into the financial crisis while having low levels of commitments.

Conclusion

The global economic crisis that occurred in 2007 to 2008 was one the worst period in financial markets since the 1930 recession. Banking systems experienced challenges of credit risks that almost resulted in the collapsing of large financial institutions. The paper has proposed a research to determine how banks within the EU responded to these challenges. It has also showed the mechanisms that were later deployed to ensure that they would remain credit risk resilient in the future. To achieve this focus, trend analysis of the investment options that were adopted by different banks was proposed to form the basis of analysis to determine whether the experiences of the global financial crisis made banks resort to less risky investment options.

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