1.0 CHAPTER ONE: INTRODUCTION 1.

1 Background Information The financial system within the UK suffered very profound and quite traumatic shock following the 2008 global economic recession that was triggered by the collapsing of Lehman Brothers, which was a US investment bank. Players within the financial market withdrew, credit was hardly accessible and the international trade did collapse and the fear of another great depression experienced in the 1930 crept in (Samuelson, 2011). Some years after the global financial recession, there has been a growing amount of optimism that the banking industry as well as the global economy is now on the path of recovery from the impact of the crisis. However, what is clearer now than before is that the financial world has actually changed permanently in terms of its financial management system and who really holds power in the global industry. The increasing power of the markets that are emerging has been seen as a phenomenon that is structurally long term; this has accelerated within the banking industry (Rizzi, 2008). As would have been expected in such a scenario, the national surveys and statistics carried out did simply provide very generalized findings of what has been termed as the current state of business at the time of the recession and after, but failed to give any substantial insight into the manner in which the UK banking sector did or failed to come up with any strategic responses to the financial management of their operations during and after this period. Many observers are of the view that even after surviving the recession, the future of the UK as an economy and its banking sector is still quite gloomy and some pessimism still lingers on the longer term management of these financial institutions (Perna, 2000). However, the hope generated from the recent financial crisis was that it showed some fundamental differences with the other global recessions recorded in history and this was attributed to the impact that was

created by a number of factors which include credit crunch where banks had serious liquidity based issues and shifted towards very risk averse attitudes to lending; globalization of the economies across the world where the businesses and finances have become globalized a case that has led to high levels of inter-dependencies among various economies (Soriano, 2011). This meant that one country having a recession would potentially pose a huge impact on other economies, something that was not experienced during the other recessions; and finally there was the impact of public finances belonging to the UK where problems of public finance deficits in the UK did bring about serious concerns for all sorts of businesses. A number of risk management techniques as well as instruments had been put in place to guard against economic collapses in different economies. But the fact that this recession affected the UKs banking sector to a large extent shows that these financial management instruments and techniques were in themselves not sufficient in proactively avoiding the collapse of the banking systems in the UK. Some financial observers have argued that it could be prudent enough for banks in the UK to revert to those simpler days when all banks were Basic Retail Banks. However, other financial analysts have pondered that this could not be practical based on the fact that there have been major changes that have occurred in the banking sector since the 1970s and could thus be quite difficult to reverse them (Dowd, 2009). Banks in the UK have been seen and heard to be pushing for various strategies that could propel them to greater heights while preventing them from sliding back to the dark days of recessions in future. This could be due to the fact that banks, especially those in the UK and US were largely blamed for the recession that occurred due to their malpractices that were carried out by practitioners at different levels. The strategies were both long terms and short term and were formulated as a result of the recession. Based on these observations, it could be clear that

the global economic recession impacted heavily on the strategies that were formulated for the sole purpose of managing the financial system within the UK banking sector. Such a move could be seen as welcome, especially at a time when calls to learn from the past mistakes a notch higher (Honohan & Laeven, 2005). As was stated in the research proposal, the aim of this research was to investigate what strategies banks in the UK have been employing in the global economic recession and the credit crunch which kicked off in 2008. This was important because to a large degree, banks have been blamed for contributing substantially to the creation of the crisis because of their practices and strategies leading up to the crisis itself. It should be mentioned at this stage that there has not been many studies carried out in to this subject matter and hence, this provides a very important rationale for carrying out this research. Much of the research which has been carried out on the subject matter has been based on the impact of the global financial crisis and not much has been done in terms of understanding how specific financial institutions have reacted in terms of their financial management strategies. Hence, this research was able to provide a very significant contribution to the body of existing research on the subject matter. Defining what financial management strategy is was seen as the best starting point in this research process. Landesman (2010) notes that in itself, strategic financial management is viewed as an approach to management which takes a keen look at the various financial techniques so as to formulate an effective decision-making plan for a business establishment or bank. In this context of the banking sector, Weaver and Weston (2007) think that financial management could be defined as the activity of management that is more concerned with the process of planning as well as controlling the financial resources of the bank in question. A more broad view of this process could encompass planning, directing, organizing, monitoring and

controlling the financial resources of the banks in the UK. Hempel and Simonson (1991) are of the view that this process of financial management is carried out through three important decisions which include financing, investing, and dividend allocation or retention. Financial management strategies come into place when the various disciplines of strategic planning, portfolio management, and financial management are put into combination to come up with effective and efficient ways of planning for finances, executing financial decisions of a firm, and managing these resources as well as activities. The financial management strategies that have been adopted by banks in the UK during and after the recession have been geared towards improving the strategic alignment as well as transparency required in the management of funds so as to achieve the required goals (Hempel & Simonson, 1991). The financial management strategies therefore give the banks necessary support by means of procedures and controls. These strategies are often implemented in stratified stages. The financial management strategy of a bank would encompass a financial model and financial management plan. The financial management plan is simply a qualitative document which gives a description of the capital needed to undertake a given operation and why. The financial model on the other hand makes use of this information in creating forecasts or revenue and expenditure, which is simply a quantitative document. For financial management strategies to be effective there is need to provide the required effect to the various strategies that have been identified at the level of corporate and operational plans as well as the business management plan. The strategies also need to show viability in the long term and be integrated within the broader financial goals and plans of the organization. There is also need to make it iterative for regular review and change. The financial management strategies of these UK banks also have to comply with the regulatory, legislative, and administrative requirements and also be able to

provide the necessary mechanisms that could ensure effective monitoring process as well as review. Measurement of how successful or not the strategies adopted by banks in the UK during and after the recession were measured by considering various factors such as Share price, profitability, financial statements, return on investment, level of stakeholder involvement in the operations of the banks, amount of customer complaints, and general observance of the statutory and regulatory frameworks that have been established after the incidence. A comparison of these measures was done on banks that were seriously affected by the crisis and those that were not. For those banks that were seriously hit, the researcher considered the Bradford and Bingley Building Society and Halifax Bank of Scotland (HBOS); while for those that were not seriously affected included HSBC and the Nationwide Building Society (Anderson, 2009). Some of the strategies used by banks in the UK before the financial crisis were unethical and focused on short term gain. Anderson (2009) asserts that there was a general creation of mortgage-backed securities that were very shaky. The rating of mortgages to the AAA level at the time of issue was undermined by the high default rates and subsequently dropping their values. Poor managerial practices were also reported in handling of these mortgages. However, these practices were stopped when the financial crisis struck and banks in the UK changed their financial management strategies (Mizen, 2008). This research was based on a positivist approach and thus used empirical evidence and scientific testing to draw conclusions from the data collected for the research topic. A case studybased approach has also been employed on the selected banks. Detailed methodology used has been provided in the methodology chapter.

1.2

The Research Question The main research question that sought to be answered by the researcher in this research

project was: How has the global economic recession impacted the financial management strategies of UK Banks? The answer to this question was to be supported by both empirical and qualitative evidence in order to justify certain claims or dismiss other intuitions held by the researcher prior to the research process. 1.3 Research Aim The main aim of this research process was to find out how the global economic recession

impacted on the financial management strategies of UK Banks. This aim was formulated based on the research title that had been chosen for this research project. It was informed by the fact that the recent global economic crisis had a serious impact on a number of issues within the financial sector and banks were blamed for having contributed a great deal to the recession. It was thus imperative for the researcher to find out if the strategies being employed by banks in the UK are still the same as those applied earlier or if there have been any changes to the strategies employed in the financial management of these UK banking sectors. 1.4 Specific Objectives of the Study The above main aim was supported by a number of objectives that were specific to the

research project and helped in guiding the researcher throughout the research process. The various specific objectives have been presented below: To understand the financial management problems that contributed to the global economic crisis and the credit crunch in UK To investigate the financial management strategies which banks are using in response to the global economic crisis To explore the strategies which banks can use in order to avoid the occurrences this took place prior to the beginning of the crisis

The above specific objectives were formulated with the overall aim of the research in mind so that the researcher avoided going outside the scope of the research project. The objectives were also measurable and realistic as far as the research process was concerned. 1.5 Rationale The negative impact that the global economic recession had on the general economic

outlook of the UK cannot be ignored. Besides, the banking sector was largely blamed for having fuelled the crisis and was also affected more than other sectors in the economy (Samuelson, 2011). The UK banking sector has been thought to have come up with a number of strategies that could aid in its tackling of the economic recession and strategically addressing the financial management in the UK. These strategies were both short term and long term. Much research has been carried out on the global economic recession since it started in 2007. However, most of these researches have dealt with the global economic crisis in general but failed to address certain specific areas such as how the recession impacted on the financial management strategies that are being employed by the UK banks in comparison to what was being applied in the past before the recession (CIMA, 2010). The powerful shocks exhibited by the global economic recession did not only come with unprecedented attention to the stability of the banking sector, but have also brought about awareness of the serious significance as well as implications of poor financial management strategies within the banking sector in the UK. This is why the researcher thought it wise to investigate the impact that was created by the global economic recession on the financial management strategies that are being employed by the UK banks. The findings of this research will be instrumental in adding to the existing knowledge within the field and also elicit informed debate on the matter. The global economic crisis resulting situation meant that banks had to begin fresh strategies that would see them grow again and avoid another crisis. A number of financial

measures had to be enacted to prevent a future financial crisis that is bank driven. A number of financial measures and strategies had to be enacted and these mostly involved public and government interventions. The strategies that were enacted required a restructuring of the banking sector in order to work as most of the strategies in place had put banks at risk making it difficult to continue using them. The first strategy used by most governments to get banks out the crisis was allowing banks access to more liquidity which meant that money was flowing as opposed to the initial problems where there was no money (Soriano, 2011). As explained earlier, the financial crisis was made worse by the growing problem of banks not borrowing from one another due to the problem of securitization. This period was termed the liquidity crisis and was putting the financial systems at risk necessitating urgent measures to be taken to solve the problem (Lou & Sadka, 2011). At this time, the crisis had begun to build making governments to initiate micro strategies of ad hoc nature aimed at specific banking institutions where most were either sold or merged. In the UK it is possible to identify the example of the Northern Rock which requested security from the Bank of England. This threw investors into a state of panic in 2007 until when the bank was nationalised in early 2008 (Soriano, 2011). As such no liquidity was available as there was no borrowing or lending and thus no money flowing in the financial system. Central banks were at the centre of this strategy with many of them using the traditional approach that was seen as the only way to make the banking industry to survive. The central banks thus reduced interest rates drastically with most of them conducting traditional market operations that were aimed at increasing the liquidity in capital markets (Soriano, 2011). This continued for some time and was proving difficult for many governments. The central banks had made so much investment into this strategy until there was no room for further reduction in policy rates (Soriano, 2011). The banks had to find others ways to continue this supporting the

financial markets and they came up with the idea of expanding the credit supply through the expansion of the supply of money by way of quantitative easing and secondly use of direct interventions in broader segments of the credit market and this was done for the purpose of easing the general credit conditions within the economy (Soriano, 2011). A second strategy used by the government to avert the crisis was capital injections. The economic crisis was straining banks and a lot was taking place at the same time in the economy. Banks continuously faced negative impacts as concerns their capital (Mavrotas & Vinogradov, 2007). Many banks not only in the UK but also in the rest of the world were facing liquidity problems as well as serious risks to solvency and governments saw this as a threat to the economy and introduced capital injections to help salvage the situation (BBC, 2009). There are those banks that needed to be bailed out and thus the government intervened in several ways. There are cases where the government only provided the funds but in other cases capital injections were being made by way of acquisition of preference shares and this was done without changing the private ownership of the bank in question (Soriano, 2011). Other cases such as was the case of Northern Rock, banks were nationalised making the government acquire majority of the stakes in them. The UK government is on record to have injected the largest volume of capital of about 5% of the GDP in 2009 as well as a massive public recapitalization which occurred in the largest banks in the UK namely: the Royal Bank of Scotland which received 50.1 billion and Lloyds banking group which received 25.2 Billion. When the European commission accepted the bailout it advised the banks to divest and centre their business outside core banking (Soriano, 2011). The financial crisis thus brought into perspective a number of important issues that had a great impact on financial management in Banks. The first issue is that of high risk taking a

strategy that banks in the mortgage sector have employed for quite a long period of time. All businesses involve some aspect of risk taking. However the amount of risk taking should not exceed a certain threshold as it puts others in danger. The idea behind high risk taking by banks is due to the ability to pass on the risk to the people. The banks thus take risks knowing that they would not be affected by the risk (Dowd, 2009). If they were in any way subject to the risk then there is a very high probability that the banking institutions would act responsibly. In the earlier days banks granted mortgages with the view of holding them to maturity. In case the mortgage holder faulted, the bank would make a loss. This was very crucial and thus banks did a lot of screening of borrowers to make sure they would not default. However, in the recent crisis banks originated mortgages with a view of selling them on. The ability to sell the mortgage to another party whether or not it defaults weakened the whole system as the bank is only concerned with the payments it gets from originating the loan. This was the same situation that led to the crisis as the prices kept going up and profits continued to pour in. when interest rates began to rise and the price to fall everything came tumbling down causing the crisis (Rutherford, 2009). This is what is known as a financial bubble. Many banks have learnt from the crisis and have come up with measures aimed at ensuring limited risk taking that would not plunge them into losses. This meant that the banks can only take subsidized risks that would make their endeavour successful. The second issue that has also arisen and which is of great importance is the issue of risk management which is as a result of the above mentioned issue in financial management in banking institutions. Scholars argue that practitioners of modern day qualitative risk management often make a range of inadequate assumptions (Gupta, 2010). Most of them assume that the financial risks follow Gaussian distributions; they also assume the fact that correlations are constant and lastly they also make market liquidity assumptions that break down when they are

most needed. Many banks are using such assumptions, risk models and risk management strategies which ignore strategic or systematic interactions (Rizzi, 2008). The risk models on the other hand are too focussed on the normal market conditions which in many cases do not matter at the expense of ignoring the abnormal market conditions which actually matter. The result is a worrying conclusion that actually the risk management strategies that are being employed by most banks are ineffective and counterproductive and leave the financial system vulnerable if not exposed in a crisis (Honohan & Laeven, 2005). Thus the financial crisis opened up the eyes of most banking institutions on the need to establish newer and better methods of managing risks associated with investments and finances to avoid the repeat of the crisis (Samuelson, 2011). The third issue has to do with cooperation within the banking industry in order to avoid more problems. As the financial crisis became even worse, it was evident that it was spreading to other parts of the world very fast and something had to be done as soon as possible. However, it was too late and everything that was affecting the US and the UK spilt over to other countries. The reason to this as explained earlier is very simple (Samuelson, 2011). The financial system is interlinked together such that the operations of one side of the coin affect the other. Therefore all the operations in the US spilt over to the UK and other banks followed suit. Thus there has been a continued outcry by developing countries on the need to ensure cooperation in setting up of monetary policies so that the policies are similar across the world. This would ensure that banks operated on the same level using similar monetary policies that would minimize the effects of another crisis. Scholars argue that cooperation is one such factor that would have minimized the effects of the crisis if it had been done earlier. When one bank realises that its operations would affect the operations of other banks, it becomes responsible for its actions and employs strategies

that would not affect the others. Such strategies lacked in the 2008 and 2009 leading to the crisis (CIMA, 2010). The fourth issue is that banks especially in the UK have realised that the financial crises would continue taking its toll on them if they do not implement strategic measures aimed at helping revive the economy. Such measures are built on innovation and not the traditional methods used in financial management. Most have come up with measures that are helping the economy grow rapidly. Such financial management strategies are seen in the Bank of Englands move to offer new low cost loans to banks. The aim of this is to protect the banks from high interest rates of international markets as well as encourage lending in the rather shrinking UK economy. The Bank of England has embarked on this strategy and is advising banks to use that money to fund UK households and businesses so as to boost the economy that has been on the downward trend. Such newer methods of investing in the local economy are geared towards ensuring that the country is shielded from the drastic effects of the crisis (Enright, 2012). The banks also on the other hand are investing in the local economy making it stable and the banks continue to have liquidity making it easier for them to continue borrowing from one another and thus minimising the would be effects of another recession. 2.1 Review of FM Strategies of UK Banks before Recession The beginning of the recession came with a run on the main high-street banks and

eventually led to the part-nationalization process of some of the worlds largest banking institutions leaving the UK economy in limbo and quite vulnerable. It has been clearly articulated that the recession was actually as a result of failure by the UK and US banking institutions to properly manage their business operations in a more prudent and acceptable manner and also partly by the financial sector regulators failing to spot risks which had started building up in the financial system (Morsing & Schultz, 2006). This meant that UK banks were

applying some of the worst financial management strategies that could not ensure proper functioning of the financial system. The strategies applied by banks in the UK before the recession were deemed to be short term based, lacked accountability, transparency and the whole idea of engagement was neglected. Short term gains were given priority without looking at the repercussions that would emanate from such greed-based practices (Carmen & Kenneth, 2008; Raghuram, 2005). Before the recession, the banks that were later affected by the crisis had a significant level of weaknesses in their capital position because of the poor management decisions that were also permitted by lack of adequate capital based framework. The banks also had strategies that did over-rely on the short term wholesale funding which was actually very risky as compared to other funding options that were long term, which they did not take. The banks thus entered into the recent recession having very extensive reliance on the said wholesale funding and created a wide gap in this kind of funding option because they over relied on overnight funding as well as unsecured funding with the view to make quick gains (Baltagi, 2008; Llewellyn, 2006; Masciandaro, 2007). Asset quality of the banks because of the failure to utilize financial ratios in which could have been a form of fundamental analysis did also fuel the volatile situation. There were also huge losses in terms of their credit trading activities that eventually worked in eroding the level of market confidence. This is because the strategies applied by the banks did underestimate the severity of losses that were to come with the structured forms of credit. Acquisition of assets were also deemed to have been carried out without taking heed of the huge risks that were involved and very little due diligence was exercised (Morsing & Schultz, 2006). Although the level of capital was poor and the regulation of liquidity by the regulatory authority were inadequate and gave a likelihood of getting into a recession

systematically and leading to failure in the banking industry in the UK, the ultimate responsibility still lie with the banking institutions for having applied poor financial management strategies in their business operations (Masciandaro, 2010). This is the point at which financial management ratios such as liquidity position estimated by the Basel III termed as the Liquidity Coverage Ratio (LCR) could have been quite instrumental in averting such a crisis if the banks did apply this strategy. When put into practical use, most of the banks that faced problems in the recession had an LCR in currently calibrated terms of between 18% and 32% when correlated with a future standard requirement of about 100% (Baltagi, 2008; Llewellyn, 2006; Masciandaro, 2007). The individual banks in the UK that failed would have been required to increase their liquidity by between 125 billion sterling pounds and 166 billion sterling pounds in their stock that they had held of high-quality liquid assets that are unencumbered. Alternatively, they would have had to reduce their over reliance on short term wholesale funding so as to be in compliance with the LCR standards. Projecting this into the period after the recession, it is evident that the financial institutions fell significantly way below what could have been considered as the future Basel III requirement (Amromin & Sharpe, 2008; Carmen & Kenneth, 2008). Flaws of Decision making processes Poor decisions made by individual banks could have been as a result of flawed analysis as well as poor judgement in some circumstances. A pattern of some poor decisions, especially with hindsight could suggest that there were certain underlying deficiencies when it came to the management capabilities and style of these banks; poor governance arrangements; lack of sufficient checks and balances; absence of or lack of following the mechanisms for oversight and challenge; and the corporate culture adopted by the banks in particular their attitudes towards the balance that existed between risk aspects and growth (Morsing & Schultz, 2006). The existence

of misaligned incentives where individual banks did make decisions which appeared very sensible and desirable to them on the basis of their perspective; did happen to cause problems in other banks and resulted in some aggregate outcomes that were quite unfavourable (Amromin & Sharpe, 2008; Carmen & Kenneth, 2008). The falling asset prices during the recessionary period meant that fast sales were to be made on the distressed assets. To this extent, the strategy was to withdraw the short term deposits in the money market and this in turn did work by weakening the balance sheets of banks forcing them to even sell more of their securities that had their values on drastic decline (Baltagi, 2008; Llewellyn, 2006; Masciandaro, 2007). Such strategies were short term and could not tackle the long term effect that the recession had. Examples of such short term strategies that were seen to be applied by the fallen Bradford and Bingley Building Society and Halifax Bank of Scotland (HBOS) encompassed remuneration arrangements in the banks with incentivised practices because they appeared profitable in the short term without having taken into consideration the risk exposures in the long term (Luo, 2003).

Discussion on strategies of UK banks It is evident that the strategies adopted and practiced by most banks in the UK were overly focused on gaining high revenue, profits and recording higher earnings per share as opposed to strategies that could strengthen their capital, liquidity and the quality of their asset holdings. The board of such banks like Bradford and Bingley Building Society and Halifax Bank of Scotland (HBOS) were found to have formulated remuneration packages for CEOs that made it rational for them to focus on such quick gains with the view of satisfying the aforementioned demands. While for those that were not seriously affected, in this case HSBC and the Nationwide Building Society were found to have had more prudent remuneration packages for their CEOs a factor that

made them pursue long term and sustainable growth (Amromin & Sharpe, 2008; Carmen & Kenneth, 2008). Having looked at the above strategies that were applied by the UK banks before the crisis, a number of issues have to be tackled. One of the issues is the extent to which the capital and leverage ratios could be related to the poor strategies that were applied by the fallen banks to the point of getting into the banking crisis and distress experienced by these financial institutions. The other issue is the type of capital ratios, for instance those related to tangible common equity, Tier 1 capital and Tier 2 capital which are deemed to be able to reduce the possibility of such banks incurring financial distress (Carmen & Kenneth, 2008; Raghuram, 2005). The final issue could be if the higher leverage ratios that relates to lower total assets to capital could be associated with having the lower likelihood of getting into financial distress considering that the other two banks, HSBC and the Nationwide Building Society, did not face serious problems in the recession (Lo & Lu, 2006). The new strategies that have been seen to be applied by the banking sector in the UK after the occurrence of the recession have fundamentally increased the capital ratios in order to give the banks some additional margin of safety given that they put in place larger cushions of capital that are able to absorb any risk of potential losses (Halkos & Salamouris, 2004). However, economic and financial observers are of the view that the strategy of banks having higher capital and leverage ratios could bring about the possibility of having a second order of consequences which range from higher costs of borrowing capital, especially for end users of such credit facilities, to having reduced rates related to return on equity for such banks (Amromin & Sharpe, 2008; Carmen & Kenneth, 2008). And to the extreme of these second order consequences, there could be a reduction in the level of appetite for investments from investors

who are actually the suppliers of equity. Besides, there has not been found a quantity that could measure how enough the high is especially in cases of minimum ratios. Evidence from the recent financial management strategies adopted by banks after the recession shows that banks are opting for higher quality capital (Kao & Liu, 2004). A further look into the reports and other journals show that in 2007 to 2009s crisis, banking institutions that had higher capital together with higher leverage ratios in the pre-crisis period actually ended up having lesser likelihood of encountering financial distress due to such cushioning capital strategies. A look at the recent distress rates show the same argument is true. The capital ratios that were found to be based on having higher quality types of capital were more crucial predictors of the level of distress banks in the UK underwent and have been proven to be even more effective than the ratios which are based on broader measures imposed by regulatory capital (Halkos & Salamouris, 2004). 2.2 Financial Management Ratios A number of financial management ratios have been proposed by different scholars and

are also applied in the banking sector. Some of these ratios could have been very useful to the banks in the UK in giving the true picture of what was happening. One of such measures is the solvency indicator. Solvency indicators are measured by some ratios such as debt/asset ratio, equity/asset ratio, and debt/equity ratio. Solvency is seen as the measure of the amount of debt and other forms of expense liabilities that a firm has relative to the owners equity that has been invested (Lo & Lu, 2006). Liquidity indicators are measures of liquidity and this is the ability that a firm has in meeting its financial obligations without putting distress to the operations of the business. This is calculated based on the balance sheet data and the ratios which define liquidity are current ratio and working capital (Masciandaro, 2010). Profitability indicators on the other hand do measure the level to which a business is able to generate profits from the use of factors

of production such as labour and capital. It is measured by such ratios as rates of return on the assets, rate of return on equity, operating profit margin ratio, and the net income resulting from operations. The last measure to be considered is the financial efficiency indicator and this measures the degree of intensity that a firm uses the assets it has in generating value in production, purchasing, financing, marketing, and pricing decisions (Carmen & Kenneth, 2008; Raghuram, 2005). A number of ratios exist that could be useful in measuring the financial efficiency level and these include asset turnover ratio, operating expense ratio, depreciation expense ratio, interest expense ratio, total expense ratio, and net income ratio. Consideration of these ratios is important because they could be able to give useful information on how effective the financial management strategies applied before the recession were and after the recession (Carmen & Kenneth, 2008; Raghuram, 2005).