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The economic context of banking reform

This guide was last updated in November 2012.

The global financial crisis became a universal reality with the collapse of Lehman Brothers on 15 September 2008. The warning signs were first apparent in late summer 2007 as credit began to dry up and the London Interbank Offered Rate (Libor), which reflects the cost of inter-bank borrowing,  began increasing indicating the lack of perceived creditworthiness between financial institutions.

The implications for the banking industry have been huge. Since the collapse of Lehman Brothers over 400 US banks have been wound up by the Federal Deposit Insurance Corporation, and many countries, including the UK and the US, are changing the way that banks are regulated.

This guide outlines some of the causes of the crash and some of the regulatory action that has been taken in its aftermath.

What caused the crash?

Many factors contributed to the crash. These included:

  • globalisation – the opening up of new markets to multi-national corporates including banks
  • the abolition of the Glass Steagall Act in 1999 making it possible for US investments banks to undertake proprietary trading by leveraging off the balance sheets of retail or commercial banks which they were now permitted to merge with. This type of activity between investment and retail banking arms was a factor leading to the Great Depression of the 1930s and was the very reason the Glass Steagall Act was introduced in the early 1930s. Other global banks followed suit shortly afterwards by undertaking numerous mergers.
  • the general availability of large sums of cheap credit globally.
  • less stringent capital adequacy requirements allowing banks to leverage excessively.
  • sub-prime debt issuance with little or no basis for the investment grade ratings they were awarded.
  • banks having grown too large (via mergers and acquisition of non-core business units) for their domestic governments to allow them to fail due to the ramifications for the wider economy (including deposit holders of such banks). This resulted in an implicit guarantee being given by such governments in respect of the liabilities of these banks – too big to fail.

What have been the ramifications of the crash?

  • Evaporation of available short term credit and liquidity within financial institutions.
  • Global recession.
  • Collapse of hundreds of financial institutions globally including:
    • Lehman Brothers and AIG, and the acquisition of Merrill Lynch by Bank of America in the US,
    • Government ownership of Allied Irish Bank in Ireland and the placement of its assets into the National Asset Management Agency (NAMA),
    • All three Icelandic banks - Kaupthing, Landsbanki and Glitnir,
    • Government ownership of RBS and Lloyds Banking Group in the UK.
  • Changes of Government and sovereign debt crises in numerous countries including Iceland, Greece, Spain, Portugal Ireland and Italy (due in part to the implicit guarantees by such Governments referred to above).

How have governments and regulators responded?

  • Extensive regulation enacted globally including significant international co-ordination between regulators.
  • Restructuring of financial regulation in the UK with powers being transferred from the Financial Services Authority to the Bank of England and the creation of the Financial Conduct Authority (FCA) and the Prudential Regulatory Authority (PRA).
  • Increased liquidity and capital adequacy requirements under Basel III as well as domestic regulations (see PLAC below).
  • Banking Act 2009 which provided a good/bad bank resolution model and the recognition of critically important payment systems within the UK.
  • The Vickers Report and the Bank Reform Bill, which is being introduced into the UK to implement the recommendations of the Vickers Report. These include:
  • the implementation of a ring-fence around the core activities and services of UK banks,
  • increased primary loss absorbency capital (PLAC) proposals for UK banks, and
  • resolution and recovery measures for banks including preferential creditor treatment for deposit holders qualifying under the Financial Services Compensation Scheme.
  • The Liikanen Report by the European Commission to reform the structure of the EU banking sector including the introduction of ring-fencing measures and recovery and resolution measures for EU banks.
  • A move away from financial self-regulation by industry bodies in the UK:
  • Libor under the British Bankers Association
  • Payment Systems under the Payments Council.
  • First Litigation successfully brought in Australia against Ratings Agencies in respect of pre-crisis derivative products and EU proposals to ban Ratings Agencies acting where conflicts of interest exist. 

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