Bank restructuring in UK and specific to royal bank of Scotland

Abstract

Before the start of the current financial crisis, the UK economy had experienced a sustained period of economic growth. In a speech in 2003 Mervyn King, Governor of the Bank of England, termed the previous years as “NICE” i.e. Non-Inflationary Consistently Expansionary. While key macroeconomic indicators, such as inflation and growth appeared benign during the past twenty years or so, vulnerabilities were forming in the world economy. Enormous capital imbalances had developed in the world over the last 10 or 15 years with huge deficits in the United States, the UK and other developed economies . Sustained strong and stable macroeconomic and financial conditions increased the risk appetite of the financial institutions. They undertook leveraged corporate lending at very low levels of compensation for bearing credit risk. The growing use of credit risk transfer increased the risk bearing capacity of the system but at the same time brought substantial risks . Failures in the international monetary system led to imbalances in capital flows between countries that created the conditions of remarkably low interest rates and encouraged risk-taking. This increased risk taking became known as the ‘search for yield’, a desire by investors to maintain high returns in a low interest rate environment. Financial institutions had been placing increased emphasis on the so-called ‘originate and distribute’ business model, which provides a source of finance for new loans, but also makes financial institutions’ funding more dependent on sustained demand for credit instruments in capital markets. This model had boosted credit supply and contributed to a large expansion of financial institutions’ balance sheets in recent years. It had also allowed risk to be more widely dispersed across the system as a whole. But a number of serious concerns emerged in recent years as this model became widely implemented. One source of trouble was the decline in "due diligence" in making loans. Those at the beginning of the subprime chain received fees to originate mortgages, and felt secure in the knowledge that someone else would buy them. Banks at the centre of the securitisation process focused on the profits associated with distributing these instruments, rather than on possible threats to their reputations and their capacity to provide liquidity. Those closer to the end of the securitisation chain probably placed too much trust in the due diligence of originators and packagers, the judgments of the credit rating agencies, and the capacity of modern technology and diversification to manage financial risks. As a result, when the quality of mortgage credit declined in the subprime area, much of this ended up being held in highly leveraged positions. Although the US sub-prime market was small in relation to the global financial system, information problems led to huge uncertainties about the nature and source of losses. These uncertainties spilled over with unexpected speed and force across global markets, affecting the United Kingdom and other banking systems. A key trigger for the more recent rise in spreads was when delinquencies on some types of sub-prime loans rose to levels which threatened losses on seemingly low-risk, highly rated tranches of sub-prime Residential Mortgage Backed Securities (RMBS). These developments provided a wake-up call to those investors who had not discriminated sufficiently between different assets leading to sharp rise in Valuation uncertainty4 . Most of the time Government became crucial during the crisis, as traditional sources of funding for financial institutions dried up. Banks’ issuance of debt securities and equity instruments dropped off considerably in the third and fourth quarters of 2008. Bank mergers and acquisitions, which could have provided a private sector solution to bank restructuring, also remained subdued.