Analyse and Evaluate the Impact of the 2008 Global Financial Crisis on the Bank Sector

Introduction

Things were unnoticed until it happened. The sudden shock in 2008 caused large number of unexpected outcomes to the global banking industry. The purpose of the essay is to analyse and evaluate regulations that governments issued to deal with the consequences that exposed after the crisis. Since it plays a crucial role on the recovery process and calm taxpayers’ emotions at the same time try to protect their right such as the issue of Basel III stress testing system. 

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The global bank sector especially in western countries heavily suffered from the subprime crisis. The US mortgage-backed securities and collateralized debt obligations with initially offer higher investment return and seductive risk ratings such as Triple A products absorbed many countries’ banks to do a cross-broad investment (Zandi, 2009). Naturally, the meltdown of financial instruments would spread through the global banking industry.

The negative impact mainly appears on worldwide banks business performance according to the credit crisis. As the table below shows the movement of ‘average global return on capital fell to 2.69% in 2008/09, from 20.02% in the previous year’ (IFSL, 2010, p.4). The characteristic of these financial instruments appears to have high leverage rate, in other words, the debt level is higher than the expected cash flow. In addition, the market value of these products does not equal to its fair value. Consequently, in Europe and the US, some banks could not afford the spread of value and went to fail such as Lehman Brother, and some banks such as JP Morgan were restructured and bailed-out by governments.

The downward performance on banks raised the attention of governments and relevant regulations introduced to deal with the weakness that imposed in the financial crisis. Mishkin (2010) states that Investment banks expand on a large scale in the self-operated business of highly leveraged financial derivatives before and during the credit crunch. It is suggested that higher leverage rate usually follows with higher risk-taking, which may contribute the bankruptcy of these institutions.

As in the United State, in response to the great recession, the Dodd-Frank Wall Street Reform and Consumer Protection Act was issued by the Obama government (Congress, 2010). Still, the Volcker Rule proposed by Paul Volcker as a part of the Act mainly concentrates on the transform of bank sector. It offers two proposals to deal with the problems that financial institutions incurred during the crisis.

First, limiting the scope, or controlling the speculative trading activities of banks. Volcker Rule (Congress, 2010) documents the prohibition of banks to invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operation for its own interest and irrelevant to their clients. The rule aims to improve the transparency of the bank operation systems and arise the awareness of these institutions to take responsibilities. According to the policy, banks need to divide the commercial and investment sector strictly and being more cautious with the business of clients. However, critics pointed out some limitation of Volcker principle (Elizabeth, et al., 2010). As metric tools for banks to calculate the performance on investment and commercial sectors are flexible and the rule appears to vague on this part (Valladares, 2018). Thus, it is hard to trust the self-assessment result published by financial institutions. Yet, for the implementation of the rule, each bank has a transition period and grace period, and there are no specific items to restrict banks to comply with the rules (govinfor. 2010). Therefore, Volcker Rule is relatively loose and gives the possibility of companies to escape and extend the date of execution.

Second, limiting the size, ending ‘too big to fail’. Paul (2010) proposed forbidding government bailouts some troubled systemically important financial institutions (SIFIs). In addition, investment banks have undergone ownership transformations. For instance, Morgan Stanley and Goldman Sachs transfer to be regulated as commercial banks with federal government guarantees (Guardian, 2013). However, the government would not always be capable to secure SIFIs in the long-term period since the creditability of it had been suspected.

Compared with the US, German’s central bank Deutsche Bank still put large efforts on the business of the investment sector. Instead of following the mainstream trend to decrease the derivatives exposure, Deutsche continued to respect the high leveraged business model and high-risk financial speculation.

This business model has brought considerable profits to Deutsche in the short as it accounted for 60% revenues, but in the long-term it does hurt the bank’s value. For instance, Deutsche bank cut a fifth of its global workforce especially in the investment sector to reduce the cost and ensure the daily operation (Pandey, 2019).

Moreover, when comes to regulations issued on saving reputation, Deutsche Bank concentrated on the recovery of shareholders wealth and the payout ratio (Y. Biondi, I. Graeff, 2017). However, the bank did not develop a sustainable policy to maintain the stability of the stock market and the uncertainty of dividend price is tightly connected to the company’s growth, cash flow and asset liquidity. For example, the dividend per share increased significantly with €1.30 in 2001 to €4.5 in 2007 which increased by 246%, then dropped considerably by 88%, € 0.50 in 2008 and then return (Deutsche Bank, 2016).

Different from Germany, the government strictly controls the investment sector on the UK. The banks in the United Kingdom are now partly or wholly owned by their government which intend to establish a much safer financial system. For instance, the largest banks ring-fence their investment department from the retail department which aim to protect retail banking sectors from other risks in the financial system and to improve the flexibility and solvability of banks (BBA, 2016). However, the ring-fencing might reduce the available activity of commercial banks and limits the variety of individual investment.

It is undeniable that these countries have actively remedy and reformed the damage caused to the banking industry after the 2008 financial crisis, but they all seem to stop at the urgent need and the effect of recovery tends to be slightly dull.

Not only to solve problems exposed after the crunch on the bank sector, governments and authories also trying to protect the right of taxpayers. Basel III offer a global stress testing system designing to enhance bank capital requirements by increasing bank liquidity and reducing bank leverage (BIS, 2018). In other words, it works as a supervisory standard for checking whether banks have capabilities to meet another extreme situation such as a new financial crisis.

The stress testing would benefit the market participant such as taxpayers to invest in a safer environment. Firstly, stress testing forces banks to disclosure some internal information to public which reduce the opacity and information asymmetry between taxpayers (Kapinos et al., 2018). As more information be more transparent, taxpayers can keep the mindful of avoiding investing on residual financial products and make more wisely decisions. Secondly, stress testing can act as a clock to remind taxpayers when financial system appears to have a fundamentally unstable behavior. Under the period of economic and financial calm, the market would be vulnerable to huge losses and easy to fall into collapses (Kapinos et al., 2018). Hence, taxpayers would need the stress testing system to recognize the uncertainty investment portfolio and perceive the following development would not respect the current market trends. For instance, during the great recession, almost all market participants expected a higher mortgage price on the US housing market instead of the considerable devalue and nearly several companies created a stress testing to predict the movement.

Basically, stress test would be efficient on disclosing the information and risks of bank industry. However, some scenarios would bring unmeaningful outcomes, although the risks have been revealed (Thun, 2013). For example, since Deutsche Banks’ American subsidiary passed the stress test, but it developed delinquent conducts such as money laundering (Stacey and Morris, 2019). Thun (2013) stats that the hardest barriers might be insufficient data and uncapable designer to establish a complete scenario that not only focus on the know defect, but also the foreseeing risks. The misleading from the root may directly affect the method that taxpayers supposed to follow. Therefore, the wrong guidance would be an approach that damage taxpayers’ benefits.

Conclusion

Governments and authorities offered regulations positively response to the negative impact fallen in the global bank industry after the 2008 financial crisis. America, Germany and the United Kingdom as typically western countries concentrated on reforming the industry rules to control and intervene the operation of investment banks’ businesses. However, the regulations would only solve the urgent need, not establishing in a sustainable development perspective. Taxpayers’ rights have also been concerned, as taxpayers blindly invested on the US mortgage, large amount of them suffered losses. Basel III stress testing works as a guidance to support market participants perceive the movement of market. Critics pointed the limitations of current stress test on inappropriately using scenarios to mislead the industry. The system needs more data and talent to continue the future adjustment.

References

Biondi, Y. and Graeff, I. 2018. Rethinking bank shareholder equity: The case of Deutsche Bank. Accounting Forum.41(2017), pp.318-33

BIS. 2018. Stress Testing Principles. [Online]. [Accessed 19 August 2019]. Available from: https://www.bis.org/press/p181017.htm

Congress Gov. 2010. the Dodd-Frank Wall Street Reform and Consumer Protection Act. [Online]. [Accessed 19 August 2019]. Available from: https://www.congress.gov

Deutsche Bank. 2016. Annual Report. [Online]. [Accessed 19 August 2019]. Available from: https://www.db.com/company/index.htm

Elizabeth, H., Ashley, M., Violeta, S. and Jayne, F. 2010. Bank Regulatory Reform in the United States: The Case of Goldman And the Volcker Rule. Journal of Business Case Studies. 6, p64.

Govifo. 2010. Implications of the ‘Volcker Rules’ for Financial Stability. [Online]. [Accessed 19 August 2019]. Available from: https://www.govinfo.gov

Kapinos, P., Martin, C. and Mitnik, O. 2018. Stress Testing Banks: Whence and Whither? Journal of Financial Perspectives. 5(1), pp 3-4.

Kay, J. 2016. Don’t Always Believe A Balance Sheet. Financial Time. [Online]. 16 February. [Accessed 19 August 2019]. Available from: https://www.ft.com/content/

Stacey, K. and Morris S. 2019. US Fed quizzes Deutsche on ‘bad bank’ plans. Financial Times. [Online]. 24 June. Accessed 19 August 2019]. Available from: https://www.ft.com/content/5f70594e-9463-11e9-b7ea-60e35ef678d2  

Maslakovic, M. 2010. IFSL Research: Banking 2010. [Online]. London: IFSL. [Accessed 19 August 2019]. Available from: https://www.ifrs.org

Mishkin, F. 2011. Over the Cliff: From the Subprime to the Global Financial Crisis. Journal of Economic Perspective. 25(1), pp.49-70.

Pandey, A. 2019. Deutsche Bank’s uncertain road to recovery. DW. [Online]. 5 July. [Accessed 19 August 2019]. Available from: https://www.dw.com/en/deutsche-banks-uncertain-road-to-recovery/a-49470411

Thun, C. 2013. Stress Testing: European Edition. The Journal of Risk Perspectives. 1, pp 24-39.

Valladares, M, R. 2018. BankThink Getting the Volcker Rule right may be a waste of time. American Banker. [Online]. 15 August.  [Accessed 1 September 2019]. Available from: https://www.americanbanker.com/opinion/getting-the-volcker-rule-right-may-be-a-waste-of-time