For past few decades the world economic system has been dragged to new system of Globalization. This new economic system has an adverse effect in financial system particularly but not exclusively in world banking system. Hence in many countries the banking systems are unable to extend the credit to real economy. In the further discussion we are going to look at how this modern economic system caused the world economic downturn and various reasons for 2007 global financial crisis. We are also discussing the preventive measures to be taken in order to prevent another economic crisis for United Kingdom.

Root for Economic downturn

The causes for banking failure which let the economic crisis are macro-imbalances, complex credit instruments, shadow banking and imperfection of forecast tool. Let’s analyse these causes in detail.

The core reason for the crisis is the macro imbalance between nations in the past 10 yrs. Countries like china, Japan have current account surplus while US and UK have current account deflect. The driver for this imbalance is high saving rates which exceed domestic investment in china, and other nations. These surpluses had been invested in risk-free government bonds. But far past years the yield from bonds has been reduced to 1%. These low bond rates let the investors to invest in providing credits for residential mortgages which increased credit extension in US and UK. But these credits are given without proper security standards and hence there is boom in property prices.

This boom had let to more complex securitised credit instruments where banks would pool their various loans into sellable assets, thus off-loading risky loans onto others which prevents banking system failure. A key function of this complex securitised credit system is maturity transformation, holding longer term assets than liabilities and thus enabling the non-bank sector to hold shorter term assets than liabilities. Both the banks and near banks relied on this ‘liquidity through marketability’, they believed that those long term assets could be sold rapidly in liquid market if needed. But when debtors failed to repay their debts this concept of liquidity went invalid since many firms attempted simultaneous liquidation. Hence the banking systems failed and let to economic crisis.

In recent years there has been increase in ‘shadow banking’ i.e. maturity transformation been carried by SIVs and Investment banks without regulation of central bank. When the problem rose the holdings of the securitised credit were not with end investors intending to hold the assets to maturity, but with leveraged banks and bank like institutions. This let to banks failure.

As a home country for several global banks UK suffered from the crisis since there is growth of securitised credit model and shadow banking activities. In UK till 2007 the property prices grew rapidly since there is a strong demand for households sector compared to supply. The total mortgage debt to GDP increased from 50% to over 80%. The lenders and borrowers assumed that the loan-to-value ratio continues to increase and the debt burden will fall off as the property price rises. Nearly 18% of UK mortgage credit was funded through securitisation. The US mutual funds and SIVs are potential buyers of UK securitized credit, when they stopped buying the credit extension disappeared.

Another problem is with concept of Value-at-Risk (VAR), which is a mathematical tool used to measure risk in future. This technique uses past observations to predict the future failure. This method didn’t work for complex securitised credit market.

Davis (2009) has argued that present economic crisis is due to changing nature of world economic system. US play a major role in determining world economic system so the shift is due to change in US economy for past 3 decades. They are shift in corporate employment from manufacturing to service sector, considerable growth in institutional investors, corporate reorganization with major tasks are outsourced, Deregulation of financial sector allowed growth in hazardous securitization which is the major cause for present economic crisis.

Stiglitz (2009) stated the crisis is the result of at least eight distinct and related failures. (i) Too-big-to-fail banks had perverse incentives; (ii) Financial institutions are too intertwined to fail; (iii) Correlated behaviour of banks which fuels systematic risk; (iv) Short –sighted and risky incentive model of banks; (v) Lack of focus on external impacts during risk assessments in banks; (vi) Poor risk assessment model used in banks; (vii) Investors seemingly even less informed about the risk of excessive leverage than banks, led banks to undertake excessive risk; (viii) Flawed risk assessment model and incentives used by regulators.

Cable (2009) stated that Alan Greenspan, Federal Reserves chairman’s freewheeling approach for financial regulation is a major cause for present crisis.

Avert another crisis for UK

To prevent another financial crisis in UK the government must change the approach to capital adequacy, liquidity, accounting policies, and institutional coverage so as to create a sounder banking system (Financial Service Authority, 2009). There must also be new approaches for banking and non-banking regulations and supervisions.

When determining bank capital adequacy rules for systemically important banks it should be expressed in terms of high quality capital. There must also be increase in quantity of bank capital. This helps the future banking system to absorb risks.

Major changes to trading book capital should be introduced, and a fundamental review of risk assessment method is essential. (i) an incremental capital charge to cover default and credit risk mitigation; (ii) increased charges for securitisations and (iii) The present Value-at –risk (VAR) method fails to capture the danger of low probability high-impact tail events so stressed VAR calculations are required.

Basel II, which is issued by the Basel Committee on Banking Supervision aimed at avoiding procyclicality in its implementation. Basel II introduces more risk sensitive approach. It uses ‘through-the-cycle’ methodologies for the estimates of loan losses likely to arise in different categories of assets rather than ‘point in time’. The Basel II will significantly reduce pro-cyclical impact but will not eliminate it. So to reduce this impact and have a better quality capital a countercyclical capital buffers need to be created. These buffers are to be built during strong economic periods and are used in downturns. This helps to reduce the impact of banking system cycle on real economy. But the crucial problem lies in determining the buffer size.

Introducing countercyclical buffer in published accounts will reduce the procyclicality. This will impact in remuneration and management behaviour less influenced by irrational exuberance. Absolute limit on gross leverage ratio will guard underestimation of risk and limit system-wide financial instability risks by limiting aggregate positions.

Changes to capital and liquidity regulations will improve stability of banking system but it will impose some cost. Hence it is important to regulate the shadow banks within regulated perimeter. The essential principle in implementing regulations internationally is to focus on economic substance and not legal form.

The Regulators must have power to obtain information, regulate and even restrict on new forms of financial activities which are forming bank like characteristics.

These approaches discussed above will reduce the bank failure but not reduce the probability to zero. Hence to reduce the failure a new system of Retail depositor insurance must be implemented to insulate the depositor in the event of failure.

It is also necessary to implement bank resolution which will ensure orderly wind by and avoid knock on effects to rest of the banking system. The UK authorities (Bank of England and treasury) must have power to ensure orderly resolution.

Greenspan (2009) stated that the world will suffer another financial crisis. In order to recover, he suggested financiers and government should clamp down frauds and increase capital requirements for banks. He also added regulations should be made for the banks to hold money for covering their operations and honour withdrawals. Myners (2010) suggested that international co-ordination is needed to bring major benefits to the whole financial system and prevent repeat of financial crisis.

Group of thirty (2009) report suggested that systematically important banks should be restricted in undertaking proprietary activities that present high risk. It recommends 4 core proposals for changes in policies and standards. (i) Weaknesses in coverage of prudential regulation must be eliminated; (ii) Quality of prudential regulation must be improved; (iii) Institutional policies must be strengthened, with emphasis on standards for governance and risk management; and (iv) Financial markets must be made more transparent, with better-aligned risk and prudential incentives.

Conclusion

To conclude, the core principal of the banking system should be focused on value-adding functions of banking which is most essential for a market economy. The world banks and near banking systems has to be regulated properly in order to make an efficient and stable financial system. It is also important that these regulations have to be brought out immediately for the prosperous of all the nations in the modern world of globalization.