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QRFM
2,1 The banking and financial crisis
in the UK: what is real and what is
behavioural?
6
Yaz Gulnur Muradoglu
Cass Business School, London, UK

Abstract
Purpose – The purpose of this paper is to reflect on the recent banking and financial crisis in the UK.
It discusses the triggers of the crisis from a UK perspective and then examines the immediate reactions
in the form of short-term policies and concludes with a discussion on longer-term policies.
Design/methodology/approach – This is a conceptual paper that argues that some of the triggers
of the crisis are real and some are behavioural.
Findings – The crisis has its roots in the sub-prime crisis of the USA with spillover effects for the UK
due to its well-developed and international financial sector. The systemic environment of high leverage
in the financial, corporate and household sectors, the international nature of finance, and the opacity in
banks’ balance sheets are real triggers. In contrast, the underestimation of risks by almost all agents in
the economy is behavioural.
Practical implications – The paper argues that some of the conditions that led to the crisis will not
change and should now be incorporated in new banking regulations. This is particularly true in the
case of behavioural factors. Optimism, greed, herding and underestimation of low-probability
high-impact events, are all parts of human nature. Human nature will not change. Thus, it need better
regulations.
Social implications – Less privileged groups, such as the poor, the uneducated, and the elderly,
need better regulation to make them less vulnerable not only to others’ biases but also to their own
biases.
Originality/value – The paper is original in discussing behavioural side of the crisis along with the
real side of it.
Keywords Banking, Economic conditions, Behavioural economics, United Kingdom
Paper type Conceptual paper

1. What triggered the crisis?

The triggers for the recent financial and banking crisis can be classified into four
groups. The first is the globalization process over the past 30 years. The crisis started
in the sub-prime markets in the USA and spilled over to the UK, Europe, and the rest of
the world due to the high integration of world markets and the international structure
of the financial services sector. This is a real trigger. The second trigger is the high
leverage, not only of the household sector through sub-prime mortgages, but also of the
corporate sector and thus the financial system as a whole. This is also a real trigger.

The author would like to thank the participants of seminars at COBOT Financials, Behavioral
Qualitative Research in Financial Finance & Economics Research Symposium TANK, BFWG Meeting in London and
Markets
Vol. 2 No. 1, 2010 International Finance Symposium as well as Richard Ackley, Alec Chrystal, William Forbes,
pp. 6-15 Paul Hamalainen, Mez Lasfer, Alistair Milne, Robert Olsen, Martin Sewell, Angela Stanton,
q Emerald Group Publishing Limited
1755-4179
Giorgio Szego and Stuart Trow for useful discussions at different times, helpful suggestions and
DOI 10.1108/17554171011042353 constructive criticisms.
The third trigger is the underestimation of risks, not only in newly issued assets but Banking and
also in corporate sector leverage ratios. This is a behavioural trigger[1]. There is a financial crisis
distinction between appearance and reality (Russell, 1997). This distinction was at
work in financial markets in the beginning of the twenty-first century. The fourth in the UK
trigger is the inadequacy associated with accounting systems that we use in presenting
newly designed assets and liabilities leading to opacity in banks’ balance sheets. This
was not only a trigger for financial institutions, but also important in inducing fragility 7
into the corporate sector. I argue that these triggers require new regulations that takes
into account both real and behavioural issues in financial decision making. I will
discuss the triggers in more detail below and analyse the policy responses necessary to
address these issues.

1.1 The international nature of the finance industry

The crisis emanated in the USA. It flowed through to the rest of the world hitting
countries at a speed and impact commensurate with their linkages with the USA. The
UK had the first impact due to its close economic relations with the USA, followed by
the rest of Europe and then the emerging markets. The recent developments in Dubai
and Greece indicate that the crisis has already hit the rest of the world. We are now
going through a phase whereby the crisis is flowing back to the USA following the
same route. The speed and impact, however, are much weaker.
The UK has well-developed financial markets and institutions that are international
in nature and has the largest derivatives and commodities markets in the world. The
financial sector produces about 7 per cent of gross domestic product. The first trigger of
the crisis for the UK was the connectedness between its financial institutions and
markets and those across the Atlantic. Northern Rock, a very successful mortgage
provider in July 2007, was the first to experience a bank run for more than a century. In
the first half of 2007, Northern Rock revealed that it had sold mortgages worth a record
£10.7 billion, up 47 per cent from a year ago which was equivalent to 19 per cent of all
new mortgage policies sold in the UK making it the market leader. This was particularly
impressive given that it was the eighth largest bank in the UK at the time. What
happened over the next three months? Northern Rock was borrowing from the
short-term money markets in the USA and lending for long-term mortgages in the UK.
When faced with a liquidity run in the US money markets, by September 2007, Northern
Rock had no where else to turn to but the UK Government to provide the liquidity. The
international nature of the financial sector accompanied by maturity mismatches of
assets and liabilities imported the crisis to the UK. Finally, in February 2008, Northern
Rock was nationalized “ [. . .] as a temporary measure [. . .] until the market conditions
improved [. . .] ”[2]. At the time, it was not envisaged that others would follow[3].

1.2 Increases in leverage

Increases in financial institutions’ leverage ratios and excessive risk taking were
highlighted as major triggers of the crisis (Davidoff and Zaring, 2008; Financial
Services Authority, 2008). Financial institutions globally were financing their
portfolios with less equity thus increasing the rate of return on that capital. In addition,
household sector leverage was as a key reason for the sub-prime crisis in the USA in
2007 (Goetzmann et al., 2009). Leverage through mortgages, both sub-prime or prime,
increased in the household sector mainly due to increasing real estate values.
QRFM According to nationwide, the UK house prices index rose from 100 in 2000 to 240 in
2,1 2008[4]. Equally, leverage ratios in the UK corporate sector have increased from about
15 to 32 per cent over the past-three decades[5]. These increases in leverage were
systemic and introduced fragility into the economy that was largely unnoticed for a
long time. It made not only the financial system itself, but also the household and
corporate sectors fragile, thereby amplifying the overall fragility of the financial
8 system. Increases in leverage are a real phenomenon, but the fact that they went
unnoticed for so long is behavioural. Choices depend on the reference points and
changes in reference points change our preferences (Tversky and Kahneman, 1991).
Higher and higher leverage ratios over time moved our reference points up. Leverage
ratios of all three sectors are public information. Research, academic or practitioner
oriented, on the fragilities imposed by high-leverage ratios, is almost non-existent. This
might be due to the reference points used for what is acceptable as leverage changing
over time as leverage ratios continued increasing.
What are the reasons behind increasing leverage? Of course, optimism and
underestimating fragilities is one behavioural explanation. Declines in interest rates
are an important reason stemming from the real side of the economy. For example, in
the UK, interest rates declined from about 15 to 5 per cent in 30 years[5]. The
availability of funds at lower rates created the illusion that one can de-lever at the same
speed as leveraging. Benign economic conditions accompanied by optimism created
another illusion, that, interest rates will not increase significantly again nor will
liquidity be constrained, in the foreseeable future.
Leverage in all sectors, financial, corporate and household, induces fragility. If, for
any reason, the value of assets deteriorates or becomes more uncertain, then the higher
the leverage, the higher the probability that capital would be at risk, and the risk that the
institution or household will become bankrupt. During the crisis asset values declined
for various reasons which I will describe below. In the corporate sector, by May of 2008,
850 UK companies had gone into administration, a rise of 54 per cent on the previous
year. In the household sector, despite several efforts by the government to keep home
ownership intact repossessions increased in October 2008, by more than 70 per cent to
over 11,000. The Bank of England estimates that 500,000 UK homeowners are in
negative equity predicting that this number could rise to 1.2 million if house prices fall by
another 15 per cent (www.telegraph.co.uk/finance/financetopics/financialcrisis/
3270387/Bank-of-England-1.2million-face-negative-equity-as-property-slumps.html).
The loss of asset values in banks, accompanied by liquidity problems due to over
leverage led to numerous bank nationalizations and part-nationalizations. Following
massive asset write-downs and estimations that further write downs will follow,
Bradford and Bingley was nationalized in September 2008 with the government taking
control of £50 billion of mortgages and loans while selling the savings side to Santander.
In October 2008, Lloyds took over HBOS the largest mortgage lender with about 20 per
cent market share for £12 billion with a deal engineered by the government, and RBS
was effectively under government control due to a large capital injection in the same
month.

1.3 Underestimation of risks

During the 1990s, economic conditions were benign, asset prices were rising, and there
was a feeling of optimism. Although Szego (2008) discusses the large number of
fraudulent and criminal mortgages[6] and their late discovery in 2007 as one of the Banking and
triggers of the sub-prime crises, availability of mortgages for low income or volatile financial crisis
income households was perceived as a social motive. Numerous TV programmes
showed how one could buy a house redecorate and sell to make a handsome profit. in the UK
Mortgage companies were reporting high profits; banks were reporting high profits and
stock prices for corporations were rising; the mood was optimistic. People were betting
on trends (DeBondt, 1993). Projection bias led people to assume future will be similar to 9
the past (Loewenstein et al., 2006). When the news of Northern Rock appeared on TV
screens with pictures of people queuing in front of the bank – the first bank run in about
a century – it was so visible that things had changed. Boz (2007) puts very elegantly that
if preceded by a sequence of positive signals, even a small, negative noise shock can
trigger a sharp downward adjustment in investors’ beliefs and the magnitude of the
adjustment increases with the level of optimism prior to the negative signal. Optimism
was high prior to the sub-prime crisis in the USA and the problems at Northern Rock in
the UK. The first negative signal was to be accompanied by more and more.

1.4 Opacity of balance sheets

The accounting systems that we use today stem from the 1950s and do not accommodate
the need to reflect the complex financial instruments we use today. Securitizations have
become popular over the past-two decades. This process led to complex assets that are
hard to value and reflect on banks’ balance sheets. In mid-2008, more than 60 per cent of
all US mortgages were securitized. In the UK, HBOS had securitized £55 billion worth of
mortgages rated AAA in 2008. Of the two other part-nationalized institutions, RBS had
£36 billion and Lloyds £23 billion of securitized mortgages. The opacity of balance
sheets to reflect these and other complex assets that embed contingent liabilities is one
major reason for the crisis of 2008. Ryan (2008) discusses the implications of the
sub-prime crisis for the accounting profession in detail. Market values were perceived as
“fair value”, implicitly making historical values being perceived as maybe “unfair”.
Mental frames (Thaler, 1999) are important in processing information.
Securitization is a major improvement in risk allocation. Shocks can be absorbed by
a large group of investors rather than just one. However, the complexity in the design of
instruments and the lack of capacity in our current accounting systems to represent
them fully led to opacity. Different tranches were combined into one security; derivative
securities were constructed from derived tranches of mortgages and the original
mortgage was translated into a security that was very hard to value. These difficulties
in valuation were not in any way represented by the traditional accounting practices,
we know of that are limited with historical costs and market values at the time of
valuation. The contingencies embedded in those instruments were not reflected in any
form on the balance sheets. At the time of the first round of bank recapitalizations in
October 2008, these difficult-to-see on balance sheet and difficult-to-value toxic assets
were estimated to be up to £200 billion for the economy. Later in 2009, estimates for one
bank, the RBS were £300 billion.
When faced with liquidity shortages, institutions have to sell assets and asset
values decline. But when the assets are opaque and thus difficult to value, the increase
in uncertainty leads to a greater risk of solvency, and thus further bank runs.
Deleveraging by reducing the size of their assets is no longer an option. Thus, the only
option remaining is to cut credit lines to borrowers and reduce the maturity and
QRFM quantity of loans. With the fear that this might lead to a catastrophe on the real
2,1 (corporate and household) sector the UK Government promised continued access to
mortgage and small business lending in every intervention including recapitalizations.

2. Immediate reactions to the crisis of 2008: short-run policies

The lessons from the crisis of 1929 shaped the immediate reactions of governments
10 worldwide, including the UK, and were used effectively in designing short-run policy
responses. The fear that we were facing another Great Depression, led to a dramatic falls
in confidence in the UK and thus falls in the stock market and cuts in consumption.
Short-run policies were geared towards restoring confidence and limiting bank runs.
Under those circumstances, the first action was to provide liquidity. The first notable
effort of the UK Government to restore confidence was to facilitate interbank lending
when overnight rates jumped from 3 per cent to a record high 6.5 per cent in October
2008. A cash injection of £40 billion was made and Gordon Brown recommended that
that the group of seven should guarantee all interbank lending. Banks were reluctant to
lend to each other overnight at 6.5 per cent while they were lending to the Bank of
England at 4 per cent. This was successful in restoring confidence. But of course, the
monetary base expanded; in the two years to December 2008, M4 increased by about
one-third from about £1,500 to 2,000 billion. I will discuss this issue further when
I examine the long-run policies.
The second action was for government to restore banks’ balance sheets. This can be
done in two ways; either by leaving the assets on the balance sheets of the institutions
and providing a floor to their values or through the government taking-over the assets
altogether. The latter leads, of course, to transfer pricing issues. The UK Government
opted for buying the assets of the banks in exchange for shares. This method gives
ownership of the banks to the taxpayers and if asset prices increase, returns will be
transferred to tax payers. This was successful in partially restoring banks’ balance
sheets. It also led, however, to changes in ownership structures. Mass- and
part-nationalizations became inevitable and Northern Rock, Lloyds, RBS and HBOS
are now wholly or partially state owned. Further blanket guarantees were discussed; for
example for RBS toxic assets estimated to be about £300 billion might need to be insured
by the government. After lengthy negotiations, in December 2009 RBS shareholders
agreed that the bank should join the governments’ insurance scheme known as the asset
protection scheme. The cost to RBS is £700 million for the first three years and £500
million thereafter. I will discuss this in detail when I discuss long-term policies.
The third action was for the government to restore consumer demand and output.
The immediate reaction of the Bank of England to provide liquidity and restore
confidence was to reduce interest rates. Interest rates fell from 5.5 per cent in January
2008 to 0.5 per cent in March 2009, the lowest in the 315-year history of the Bank of
England. This was helpful in limiting house repossessions and providing credit lines to
the corporate sector. The downside of this monetary easing is, however, to limit the
scope for further monetary policy mechanisms. Thus, focus was shifted to fiscal policy.
The stamp duty exemption was increased from £125,000 to 175,000 and VAT was
reduced from 17.5 to 15 per cent. Both measures were successful in restoring
confidence and thus preventing sharper declines in consumer demand and national
output. However, monetary policy cannot be effectively used any longer at such low
interest rates. The Bank of England’s only option is to pump money into the economy
directly. In 2009, the bank has expanded the amount of money in the system by £200 Banking and
billion through a process known as quantitative easing. financial crisis
in the UK
3. What next: long-term policies
Long-term effects of short-term policy will be absorbed slowly. Historically, we know
that recessions associated with credit crunches and house price bursts tend to be deeper
and longer than other recessions (Claessens et al., 2009). The current crises fall into this 11
category and may result in the deepest recession since the crisis of 1929. Firms are now
credit constrained and have cut spending, starting with research and development,
employment and capital spending, and selling assets. Equally, unconstrained firms are
reluctant to use their lines of credit to reserve their reputation in financial markets
(Campbello et al., 2009). The government guarantees provided for portfolios of toxic
assets at Lloyds and RBS were necessary to restore confidence and prevent deposit
withdrawals. But they create severe moral hazard. The moral hazard dilemma that has
arisen from this crisis will not easily be reversed.
Some of the conditions that led to the crisis will not change and new regulations are
being introduced to address some of the previous issues. Behavioural factors should
not be overlooked in designing the post-crisis regulatory response (Daniel et al., 2002).
The current regulatory landscape has its roots in the US framework designed more
than 70 years ago in response to the 1929 crisis. The conditions that led to the current
crisis are different. In particular, regulation is constantly lagging behind the latest
financial innovations. As a result, there is a need for better regulation that takes into
consideration biases in human behaviour.
From a long-term perspective, the first trigger of the crisis, the internationalization
of financial markets, will not fundamentally change. Globalisation provides a much
better allocation of risk and boosts economic growth rates. The UK is a mature
economy with relatively low-growth rates and an international financial sector. The
internationalization of the financial sector is important for world economies, because in
the long-run, it will reduce poverty. If anything, the nature of financial markets and
institutions will become more global in the future.
The second trigger of the crisis, higher leverage increases investment and boosts
rates of return in both household and corporate sectors. As a result, neither
securitization, nor complex derivative securities, will disappear from the financial
landscape, because they provide a much better allocation of risk. The challenge we face
today, however, is to provide better information flows thereby reducing the opacity of
complex instruments. Equally, the opacity of financial statements should change.
Leverage in the banking system will decrease due to the regulatory authorities desire
to tackle this issue. These regulations tackle real aspects in the financial world; they
should be supplemented with regulations that take into account the people making
these financial decisions in the households, corporations and financial institutions.
Human nature will not change but behavioural factors that led to the crisis can be
integrated into regulation to make it effective. The global nature of financial markets
means that these regulations will require international co-ordination.
Leverage in the banking industry was under scrutiny through several Basel Accords.
The main problem in the banking sector was the opacity of financial statements so that
the risks of newly designed complex assets were not represented. We now need a
framework for the regulation of mortgage originators and subsequent producers of
QRFM structured products. This is not sufficient, however, we must go beyond the financial
2,1 system and consider leverage for the economy as a whole. Highly levered corporations
and households are also exposed to small fluctuations in their asset values. The crisis
started in the household sector and so attention has focused on leverage in this sector,
largely ignoring leverage issues in corporate sector. Leverage in the corporate sector has
increased over time and investors were paying a premium for low leverage firms
12 (Sivaprasad and Muradoglu, 2010). We know from emerging markets that both
borrowers and lenders benefit from debt relief (Arslanalp and Henry, 2005). There is now
a need to focus on reducing the indebtedness of the corporate sector.
In the corporate sector, tax rules favor leverage, because debt is tax deductable.
Harvey and Roper (1999) argue that corporate managers “bet” their companies through
increasing leverage. The tax deductability of interest, therefore, needs revisiting. In
market-oriented systems like the USA, bond pricing is made by markets and rating
agencies that rate corporate bonds. Financial fragility is, therefore, integrated into
interest rates. In bank-oriented systems, the availability of funds may diminish due to
financial fragility, but leverage of the corporation is not a major consideration in
determining interest rates commensurate with the financial fragility of the corporations.
Regulations should be tailored to impose better risk pricing of bank products.
The tax deductability of interest payments is not restricted to the corporate sector.
Tax rules in the UK favour leverage in buy-to-let properties as interest payments are
tax deductable. In Sweden, tax deductability applies to homes that one lives in. We,
therefore, have to revisit tax rules in the household sector as well. In the UK, interest
rates on mortgages are not linked to the leverage of the household. The mortgage
products are priced according to time maturity of the product but not according to the
leverage/income ratio or wealth/debt ratio of the households (although interest
payments have been linked to the loan-to-value of the particular mortgage transaction).
Regulations are, therefore, required that imposes better pricing of mortgage products
in relation to the financial fragility of households.
New and complex derivative instruments were largely unregulated before the crisis
of 2008. For the USA, there are recommendations to establish separate regulatory
function for market risk and market stability oversight (Arewa, 2005). The problem is
that regulations always lag financial innovation. This lag between the introduction of
new securities and their regulation leads to a misperception that there is no need for
regulation. During benign economic conditions, risks will be underestimated and thus
underpriced as a result of unfounded optimism. This is why in response to the financial
crisis the EU, UK and US authorities are introducing organizational structures to
oversee systemic risk in the financial sector.
Introducing new regulation is not an easy task. It requires collection of a different
set of information and even a different accounting system to collect some of it. Some
information is simply not available today. For example, we do not know the extent of
unbounded contingent liabilities in the UK. New accounting procedures are, therefore,
needed to represent the risks encapsulated in complex assets. They are now called
toxic because we cannot observe them in traditional balance sheets and we cannot
assess their risk or value using existing accounting practices. There is a need for a new
system of accounting that enables us to present and value those complex asset
structures and any underlying contingencies embedded in their composition.
 Information opacity is not restricted to the UK. International financial services Banking and
require international transparency agreements that extend beyond international financial crisis
accounting standards. For example, information on the distribution of complex
derivatives on securitized assets worldwide must be made available. Equally, there is in the UK
need for co-operation between exchanges and in moving trading to exchanges from
over-the-counter. Discussions are currently taking place in this regard.
A further trigger ascribed to the crisis is excessive risk taking by bank traders who 13
were enriching themselves via short-term bonuses, while destroying the long-term
value of their companies (Zingales, 2009). Greed is in human nature and, therefore, has
to be regulated. The mismatch of the timing of profits and thus the bonuses to
management and the timing of loss realizations of contingent liabilities is an important
issue. This is all the more important due to the changing ownership structure of
corporations – today 70 per cent of ownership is institutional compared to less than
10 per cent in the 1930s (Zingales, 2009). Financial markets are used extensively by
pension funds. Unsophisticated investors no longer need direct protection as they did
before 1929 but they need indirect protection through regulating the securitization
process and corporate accountability. New regulation needs to restrict practices that
exploit biases in human nature.
Goetzmann et al. (2009) argue that econometric analysis of housing prices
systematically generated forecasts for long-term price growth and low estimated
probabilities of extreme price decline. Such optimism is fueled by the extrapolation of
past trends into the future. Why were the fundamentals not recognized? Optimism is in
human nature and cannot be avoided. Greed is in human nature and cannot be avoided.
Therefore, they must be regulated. Thaler and Sustain (2008) and Shiller (2008) have
come up with several details of how one can integrate human nature into regulation.
From the design of mortgage products to the sales of them, from the presentation of
complex instruments in bank balance sheets to corporate governance, human nature
should be taken into account in new regulation.

4. Conclusions
In this paper, I discuss the recent banking and financial crisis in the UK. I start with the
triggers of the crisis and then examine the immediate reactions in the form of
short-term policies and conclude with a discussion on longer-term policies. I argue that
some of the triggers of the crisis are real and some are behavioural. The systemic
environment of high leverage in the financial, corporate and household sectors, the
international nature of finance, and the opacity in banks’ balance sheets are real
triggers. In contrast, the underestimation of risks by almost all agents in the economy
is behavioural. Some of the conditions that led to the crisis will not change. These are
mainly behavioural factors. Optimism, greed, herding and underestimation of low
probability high impact events, are all parts of human nature. Human nature will not
change. Thus, we need better regulations. Less privileged groups, such as the poor, the
uneducated and the elderly, need better regulation to make them less vulnerable not
only to others’ biases but also to their own biases.

Notes
1. See DeBondt et al. (2009) for a survey of directions in behavioural finance.
QRFM 2. From Alistair Darling, UK Chancellor, the BBC web site: http://news.bbc.co.uk/1/hi/
business/7249575.stm
2,1
3. Refer to Hamalainen et al. (2008) for a full description of the events leading to the failure of
Northern Rock.
4. See www.houseprices.uk.net for house prices in the UK.
5. Author’s calculation from data used in Sivaprasad and Muradoglu (2007).
14
6. See, Szego (2008) and FBI (2006) Mortgage Fraud Report for details.

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Further reading
Leaven, L. and Valencia, F. (2008), “The use of blanket guarantees in banking crisis”,
IMF Working Paper No. WP/08/250, International Monetary Fund, Washington, DC.
Mizen, P. (2008), “The credit crunch of 2007-2008: a discussion of the background, market
reactions, and policy responses”, Federal Reserve Bank of St Louis Review, September/
October, pp. 531-67.

Corresponding author
Yaz Gulnur Muradoglu can be contacted at: g.muradoglu@city.ac.uk

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