The Financial crisis – A Case Study

The financial crisis is only easing very slowly and the finger of blame continues to be pointed
at the banks for unethical conduct. The Governor of the Bank of England, Mark Carney, is
calling for a change of culture from the Banks. As recently as 19th September 2013 Morgan
Chase has been fined £527 million (combining UK and US fines) for failure in control and
culture after London traders lost £4 billion. Other recent issues that have come to light include
mis-selling of financial products (such as complex interest rate swaps to small businesses and
the manipulation of LIBOR by several UK Retail banks (This short term interbank borrowing
rate is critical in providing a base rate for many other interest rates charge by banks to their
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customers). However the origins of the current controversy go back several years.
In September 2011 the UK Govt. accepted the findings of the Independent Banking
Commission led by Lord Vickers, which recommended wide ranging reforms to our banking
system, most significantly the separation of retail and investment banking, and a requirement
for banks to maintain higher capital ratios to support their lending. The intention is to prevent
a recurrence of the 2008 banking crisis, the most serious crisis since the Great Depression.
Subsequent to the crisis, it appears that Banking bonuses are back, even for the British High
Street Banks supported by Government guarantees and funding. This is despite the fact that in
2009 the world entered a deep recession, still forecast to be the most severe in the last 70 years.
Britain, whose economy relies on income from international banking based in London, is likely
to be one of the worst affected of the developed countries, and the economy remains in a
dangerous phase.
The difficulties affecting the economy appeared first not in the UK, but in the U.S. Banking
sector, where a crisis was triggered by problems which arose in the subprime mortgage market.
However British financial institutions such as Northern Rock and Bradford and Bingley were
following similar business strategies such as offering 125% ‘loan to value’ mortgages and
granting loans based on self-certified income declarations. The crisis in the banking sector
stemmed from two main factors – the first was related to high levels of deposits and the need
to make a return on capital. American banks were awash with Chinese money deposited with
them after years of Chinese export surpluses, and looking around for new lending opportunities.
The second factor was deregulation, allowing banks much more freedom as to how they run
their business. In the years following deregulation of the banking sector in the 1980’s, banks
became progressively less conservative in their lending policies, until the point was reached
where loans were being granted for the purchase of homes to people with poor credit history
and little prospect of being able to ever meet repayment schedules in the medium to longer
term. Often this grim reality was masked by short term discount periods with ‘teaser’ rates set
artificially low, which temporarily reduced the extent of actual monthly payments that would
become due once the discount period ended. Banks became progressively much less risk averse
in their pursuit of new business, in some cases lending out up to 40 times the amounts that had
been deposited with them. This was in some cases combined with rash acquisition and
diversification policies. The drive for new business was caused by a shift in banking culture
following deregulation which increasingly linked staff bonuses to sales volumes and so
incentivized them to maximize bank lending.
However the banks were in fact building up loan books which were riddled with bad debt, and
subsequently in order to shore up their balance sheets were then ‘bundling’ loans in to packages
which they subsequently sold on in the financial markets – known as C.D.O’s (Collateralized
Debt Obligations). But hidden within these bundled package were ‘toxic assets’ consisting of
loans unlikely to ever be fully repaid. This situation created a bubble which would inevitably
burst, as the banks were broadly aware of each other policies, and therefore of the underlying
weakness of their financial position. It all finally came to light when the banks lost confidence
in each other and began to charge high rates of interest for short term interbank loans (the
‘LIBOR’ rate), or even to refuse to lend to other firms. This created a crisis, because aggressive
lenders such were not able to borrow to finance their operations – the beginning of the ‘credit
crunch’.
Before long other institutions with weak balance sheets were failing, notably in the U.S.A
Lehmans brothers, and in the UK Northern Rock (which relied heavily on the money markets
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to finance its business) were the first banks to run out of money. As rumours of the difficulties
spread, both companies and individuals started to queue up (in some cases quite literally) to
close their accounts. A bank has not failed in the UK within living memory, and if it were to
happen it would create a public loss of confidence in the banking system, and lead to massive
withdrawals of deposits. This could easily cause the whole banking system to fail, so not
surprisingly the UK Govt. stepped in and nationalized Northern Rock.
But this did not halt the rot, and the Government subsequently was quickly forced to offer up
to £70 billion financing to support UK banks and so prevent widespread banking failures. In
the U.K the banking sector has rapidly witnessed a reduction in the number of building
societies, and consolidation among the clearing banks combined with partial State ownership
through increased Gov’t funding – for example the Govt. at present owns over 90% of RBS
(Royal Bank of Scotland), and is the majority shareholder in Lloyds TSB. The credit crunch
rapidly spread across the banking sector globally, and also to other sectors needing loans to
finance their business activities. In other regulatory regimes where the Govt has less ability to
support the banking sector, failure has followed (e.g. in Iceland and the Isle of Man) and it
appears that depositors may have lost most of their savings. In the USA the housing market
was also badly affected very quickly, and the Government had to step in with rescue packages
to bolster up its key mortgage broking firms (known as ‘Freddie Mac ’and ‘Fanny Mae’).
As might be expected, shareholders in some of the banking institutions are pretty displeased
with the current situation. In the case of Northern Rock the value of shares have been
effectively reduced to worthless, and share prices of all the major banks have suffered badly,
particularly those where ownership has been diluted due to the Government taking a minority
stake (some of the banks which had remained more prudent and risk aware during the race
increased their loan books, and in the subsequent crisis the least affected was HSBC, which
alone of the UK banks has not needed to raise extra funds in order to weather the storm).
Towards the end of 2008 the result of this crisis was that loan funds for companies looking to
the banks for working capital finance dried up, and confidence began to drain from the world
economy. The resulting sharp contraction in world trade continued into 2009 and 2010 with no
immediate prospect of recovery this last year. What went wrong? On the face of it, this could
all perhaps be blamed on aggressive selling of loans and mortgages initiated by American
banks, but in truth the UK was in no better a position. Here, house prices have risen relative to
incomes more than anywhere else in the world except Ireland, and much of this ‘boom’ had
been driven by aggressive lending policies of the banks themselves. Now house owners are
faced with negative equity and an inability to sell. In previous times, it was not easy to apply
for a mortgage but this all changed in recent years. Bank managers became driven by sales
targets linked to very high bonuses and began to ignore the assessment of risk in favour of
meeting sales targets in order to increase the bonuses they would receive related to sales targets.
The apologies of senior bankers to a UK Parliamentary Committee for unwise policies has not
been generally well received or believed to be genuine – particularly since Sir Fred Goodwin,
former CEO of RBS has since refused to give up any part of his pension package initially
calculated at £704,000 per year which is now supported through tax payer funds.
There are regulators in the banking sector, whose responsibility was to monitor banking
activities. The Financial Services Authority (FSA) set up under Gordon Brown’s
Chancellorship had adopted a light touch regime, which with hindsight was totally
inappropriate and ineffective. The Bank of England, also in a position to influence the
commercial bank policies, has for a decade been preoccupied with controlling inflation as its
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main task. It was a Conservative Govt. that had brought in deregulation to allow the banks to
lend significantly more than they were holding in deposits in the 1980’s, but a Labour Govt
had been in power since 1997 and had done nothing to step in to control the situation as the
banking sector began to run amok. As of today, it looks likely that the impacts of the lending
and borrowing spree of the last decade will be a sustained and deep recession affecting the
global trade for at least the next two to three years. Moreover, to rescue the banking sector the
UK Government has taken on liabilities which could potentially rise to over a trillion pounds,
and will certainly result in higher taxation and cuts in public expenditure which will start next
year and continue for years to come. Both large and small businesses are complaining of loans
being recalled, and the banks’ unwillingness to provide new finance, despite consumer credit
still being widely available. An initial announcement at the London G20 summit this year of
intentions to develop a global banking regulatory framework has to date not resulted in any
concrete proposals. Meanwhile the UK Govt. has announced that it intends to provide further
powers to the F.S.A to enable it to rip up contracts of bank executives and traders in future
years where excessive bonuses not linked to share price are still in place. However it is likely
that for this year at least the Govt. bail out and underwriting of bank business may have
provided the banks with the cash to enable a something of a return to the bonus culture which
originally led to the banking sector crisis.
Since the onset of the banking crisis, the ripple effects continue. National Governments
borrowed heavily to shore up the global banking system, and this has subsequently led to a
protracted sovereign debt crisis, with counties finding it increasingly difficult to borrow at
reasonable rates, which increases their risk of eventual default. This in turn could lead to further
difficulties for Investment Banks, particularly in mainland Europe. The risk of Government
defaults across Southern Europe in particular also threatens the viability of the Euro as a
currency.
Every month brings fresh revelations as to the extent of questionable business practices by
banks. It is now emerging that many rural Italian towns are in serious financial difficulty
through financing of loans through C.D.O’s which have subsequently left them with further
liabilities – in effect if Greece defaults on its bank loans Italian towns become liable for the
debt ! Only Milan has to date refused to accept the liability and threatens to prosecute the banks
for mis-selling of C.D.O’s. The banks making these deals were based in London and benefitted
from its light tough regulatory policies.
However not all stakeholders agree with the UK Gov’t proposed reforms. The Confederation
of British Industry has added its voice to the banks in claiming that structural reform will reduce
lending volumes and also render London less competitive as an international banking centre.
If fully implemented the reforms will make Britain (alongside Switzerland) the most tightly
regulated international banking centre in the world. The reforms however are planned to be
enacted over an 8 year period, and doubts have been expressed as to whether they will ever be
fully implemented.
Question: Answer all five parts.
1.1 Identify each of the stakeholders and how they are affected. What are the main harms and
benefits in this case for the different stakeholders based on the current situation?
(20 MARKS)
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1.2 From a utilitarian perspective, would you argue for or against the proposed tightening of
UK banking regulation?
(20 MARKS)
1.3 Using arguments based on the ‘maxims’ of duty, would you consider the UK banks to
have acted ethically in their operations?
(20 MARKS)
1.4 What clashes of rights are involved in this situation? Is it possible to judge their relative
importance? Whose rights matter most in this situation?
(20 MARKS)
1.5 Select and apply two other normative theories to critically examine the current situation?
(20 MARKS)
NOTE:
(Word guideline 1,500 words not including appendices)
APPENDIX : A Basic Methodology for applying Normative Ethical Theory to Case Studies:
1. Identify key stakeholder groups
(in most cases more concerned with ‘external’ than ‘internal’)
This forms the groundwork for a balanced and thorough discussion from different perspectives.
It is reasonable to expect each stakeholder group to act in their own legitimate ‘self-interest’,
and therefore to have their own expectations in any given situation. Specific normative theories
should then be further applied to develop a pluralistic critique.
2. To consider a ‘utilitarian’ perspective:
a) identify and compare ‘harms’ and benefits for each stakeholder group
b) reach an informed conclusion on ‘the greatest good for the greatest number’
3. To apply ‘rights’ theory:
a) for each stakeholder group identify which basic human ‘rights’ are relevant
b) rank ‘rights’ according those which are most ‘inalienable’
4. To consider ‘duty’ (this is Kant’s de-ontological theory) apply three tests:
a) MAXIM 1. For the issue being considered, ask ‘What if everyone acted in the
same way? (The consistency test)
b) MAXIM 2. Are the actors treating other people the way they would like to be
treated? ( a test for respect of persons, i.e. treating them as of intrinsic value and
not just the means to an end)
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c) MAXIM 3. What if the whole world knew what the actors are doing? (the
Universality test, sometimes referred to as the ‘New York Times’ test, by
assuming the actions were put on a newspaper front page
5. Select and apply any other relevant ethical theory giving insight into this specific
situation. This could include:
a) Virtue ethics
This focuses on the actors, rather than the business situation, and considers how character
both shapes and is shaped by actions and habits of behaviour developed.
The perspective depends on first identifying what are appropriate ‘virtues’ in any context –
these are often the ‘values’ identified in Codes of Conduct, and ‘Values’ Statements
The theory can be applied at an individual and an organisational level – often people who
become ‘whistle-blowers’ find that their own personal values are in conflict with their
organisation, and that to preserve their own character and integrity they are forced to become
disloyal to an organisation, and to break an unwritten code of silence
b) Environmental ethics
This is of growing importance as the impacts of enterprise on environmental degradation of
air, land and water is recognized. There are two main approaches:
i) the ‘polluter pays’ principle – this argues that use of natural resources should not be
free to business, nor should the costs of cleaning up the environment be external to
companies. It results in initiatives such as Carbon Trading
ii) a ‘biocentric’ view, known as ‘deep ecology’. This approach refuses to consider
economic activity from just an ‘anthropomorphic’ standpoint, and sees human social
systems as part of a wider bio-system with which they are interdependent, and on
whom they are dependent for survival – business activity should leave no footprint.
Both approaches are similar in viewing the need for ‘sustainability’ as a key business
objective.
c) Discourse ethics
This relies on building mutual understanding through debate and dialogue. It assumes people
will do what is rational, if enough discussion can be conducted to determine an optimum
course of action.
d) Post-modern ethics
This doubts the wisdom of even pretending that man is a purely rational creature, or that
common understanding is even truly possible. It instead relies on personal emotive reactions
to specific situations, and the responses which follow from personal feelings.
e) Other theories
N.B. There exist very diverse theories on ethics, these are just a few of the most influential
ideas. Personal study may identify other useful ideas to apply e.g. contractualism.

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