Banks play a very important role in a nation's economy. A stable financial system can help a nation's economy grow steadily unlike in an unstable financial system. The recent financial crisis has brought out the existing flaw in the banking system which probably no one had forecasted few years before. In the past, the economy would slowdown first which would than result in financial crisis but this time it is other way round. The epicentre of current financial crisis has been U.S where the banks and other financial institutions have collapsed. This has resulted in the slowdown of the global economy because U.S as an economy is very big and many nations are dependent on it and U.S banks are amongst the largest banks in the world. And in order to understand the impact of the crisis on the U.K and Indian economy and banks, it is important to compare performance of banks.
The dissertation aims to look at the developments in banking sector in both, a developed and developing economy, so that the positive points from both the economies can be brought forward and negative points can be addressed and rectified. The study also aims to highlight some of the key reasons of financial crisis. It is very hard or rather impossible to imagine carrying out business in the absence of banks or financial system. Hence, it is very important to study and conduct a research about the crisis that have impacted the financial industry, so that some lessons can be learnt and in the future, and mistakes can be avoided.
In this dissertation, chapter 1 will discuss the role of banks in a nation's economy, globalization and its effects on UK and Indian economies, Sub-prime bubble and other risk hedging instruments which led to crisis, rescue steps taken by central banks and other agencies like Basel, IMF etc. Chapter 2 is literature review which will discuss various researches of bank performance that have been carried out across the world by researchers and economists. Chapter 3 will talk about methodology to be used in this dissertation and justify the selection reason. The data that will be collected will be analysed in chapter 4. And lastly, chapter 5 will be conclusion which will also include suggestions and recommendations if any.
1.1: Role and Importance of Banks and FIs:
The financial sector plays a very crucial role in the development of the economy. Banks fulfil the credit needs of the society. Fulfilment of credit needs is important because investors and corporate houses need capital to invest in big projects which would be important for economic development of the country. Cheap credit to farmers helps them meet their short or medium term credit needs which than contributes in the growth of rural sector of a country. Banks also provide savings option to common man. They borrow excess funds from people as deposits and pay interest on regular basis.
Today, however, with the improvement in technology banks are able to provide better service to their customers. With internet banking, mobile banking, ATMs the need for better branch network has reduced as people can access from their home, office or any part of the world with the help of the internet. With the help of SWIFT, Society for Worldwide Interbank Financial Telecommunication, customers can easily transfer money from one bank to another and in different countries too. SWIFT enables its customers to automate and standardise financial transactions, thereby lowering costs, reducing operational risk and eliminating inefficiencies from their operations. By using SWIFT customers can also create new business opportunities and revenue streams (SWIFT website). As funds transfer became easy and safe and thereby increased global trade and globalisation.
1.2: Globalization:
Globalization is not a new term today. Global trade has increased post World War II. And more recently, with countries like China and India, have made their presence felt in the international trade. As mentioned by Hutton J (2008), there are three mains reasons for globalization. They are - open economic policies, advanced technologies and low-wage developing economies. Agreements such as GATT, regional trade unions like EU and NAFTA contributed well towards globalization. Moreover, lifting of restrictions on Foreign Direct Investment (FDI) liberalized capital movements. Advancement in technology, particularly in IT sector helped to reduce operations cost, efficiency levels improved and production increased which encouraged global trade on a higher level. These agreements removed trade barriers which encouraged easy movements of resources from one part of the world to another. These resources included raw materials, labour, capital, technology. It was believed that everyone would benefit from globalization.
However, there are some ill-effects of globalization. There can be increased unemployment, allocation of resources to one place, etc. Developed economies where labour costs are high may lose out to developing economies where labour is cheap. Firms may outsource manufacturing or some processes in order to reduce costs. This can result in increase in unemployment. Economies like USA and UK are growing at about 3% and 1% respectively while China and India which are growing at about 10% and 9% (IMF 2010) respectively are an attractive place to invest and hence there is increased flow of foreign funds. This has resulted in increased allocation of funds in these economies which is an advantage for them but disadvantage for other economies of the world.
As global trade increased, the risks involving foreign trade like credit risk, foreign exchange risk, market risk etc. also increased. In order to protect themselves from such risks, firms started using sophisticated financial instruments like derivatives. This led to financial globalization. Financial globalization also carries some risks. These risks are more likely to appear in the short run, when countries open up. One well-known risk is that globalization can be related to financial crises. The cases of the 1997-98 Asian and Russian crises, as well as those in Brazil 1999, Ecuador 2000, Turkey 2001, Argentina 2001, and Uruguay 2002 are just some examples that captured worldwide interest (Schmukler SL, 2004). The current financial crisis, subprime bubble, is also because of financial globalization which is discussed in next section.
1.3: Risk hedging instruments - Securitization & Sub-prime bubble
The term subprime refers to the credit worthiness of the applicant. Subprime lending is a common phrase that refers to the method of making loans available to borrowers who do not necessarily qualify for normal-market interest rates. Subprime mortgages became popular over past decade or so. Normally subprime borrowers have weak credit histories, including delinquencies, debt charge-offs, related judgements, and possibility of bankruptcy. The end result is that they have considerable reduced repayment ability and relatively low credit scores and higher debt-to-income ratios. In essence, subprime loans are meant to be risky for both the borrower and lender, especially if the dodgy combination exists of higher interest rates, poor credit history of the applicant, and the generally less than ideal personal financial situations of the applicants (Smith 2010).
There are many different forms of subprime mortgages options available to borrowers. The most widely used options comes in the form of an initial fixed rate mortgage that quickly converts into a variable rate mortgage. These loans offer a low initial interest rate that remains fixed for two years after which the loan resets to a much higher adjustable rate for the remaining life of the loan. As house prices steadily increased from 2000 to 2005, subprime borrowers having difficulties were at the very least building equity, making it easier to refinance or sell their homes. This strategy became less available to subprime borrowers as the housing bubble burst in early 2006. Loan incentives and the long-term trend of housing prices going up encouraged borrowers to take for granted mortgages, thinking they could refinance at more favourable terms when necessary in the future. However, once housing prices started to drop in 2006 to 2007 period in the USA, refinancing became a lot more difficult, inserted additional pressures on an overall stressed and volatile system. Defaults and foreclosure activities increased significantly as ARM interest rates reset to drastically higher rates. In 2007, nearly 1.3 million US homes were subject to foreclosure, up 79% from 2006; with subprime mortgage defaults probably reaching a level of approximately $200 to 300 billion in 2008 (Smith 2010). Major financial institutions reported losses which were more than $100 billion mainly because of the default risk surrounding subprime mortgage lending. The risk was far more widespread as many of the mortgage lenders pooled their mortgages and sold them to third party investors in the form of Asset backed securities (ABS) and Collateralised Debt Obligations (CDO). The situation became worse as house prices were falling which also declined the value of the collateral which investors were holding.
The overall exposure to bad loans, the increased perception of risk had combined which decreased the amount of cash available for loan and also increased the cost of borrowing money, which resulted in the 'credit crunch', mainly all thanks to the subprime mortgage crisis. These factors led to a reduced amount of capital banks were willing and able to lend which consequently lead to increased cost of borrowing. As many banks were international players, this credit crunch was experienced worldwide and hence it was known as global financial crisis (Smith 2010).
1.4: Its effects on global economy or UK and Indian Economy
Poor supervision by banks, lack of proper policies and regulations by the government resulted in subprime crisis and credit crunch which impacted the global economy. The effects of this crisis were that many companies and institutions had to shut down because of bankruptcy; many people lost their jobs, stock markets collapsed, there was increase in food prices, investments in developing countries (FDI) also decreased significantly, there was outflow of funds, which resulted in lesser growth of those countries, many countries were on the verge of bankruptcy, which were rescued by the IMF and World bank. Thus we can say that the crisis in the U.S. had domino effect on the global economy.
1.5: Rescue measures by IMF, World Bank, Basel & respective economies
1.6: Concluding Paragraph: Why comparing Banks performance is important
