The Effects of Bank’s Liquidation in an Economy: A Case Study of United Kingdom
The Effects of Bank’s Liquidation in an Economy:
A Case Study of United Kingdom
Introduction
Financial institutions like banks encounter different challenges most especially in the later years of 2008 wherein the financial crisis spread widely across every nation. The economic crunch both felt by the developing and developed countries. However, there is a slow recovery recorded on each economy and the full recovery is somewhat difficult to forecast because of the involvement of various complexities (economic policies, unstable monetary supply, etc) and influences (globalization and internalization). The difficulty increases if the banks and other financial institutions experience the difficulties in handling the monetary supply, inflation, financial instruments, and as well as loans and non-performing liabilities.
In this event, the banks should provide an adequate solution in order to minimize the effects of financial challenges. Many studies showed that there are solutions to minimize the risk and improve the performance of the banks. Various financial analysts concluded that the banks should perform regulations and applied appropriate policies to minimize the anticipated risks. The financial stability of one country should start in the competitiveness of the financial institutions or banks in facing various economic and financial problems. Therefore, the proposed solution from the previous and relevant studies is to create a center of performing and facilitating the investment, growth and development that will contribute in the overall economic performance. Despite of bunch of proposed option to survive the economic, the greatest question would be how.
Within this paper, the topic is centered in the idea of bank liquidation and the associated in the economy. The investigation will navigate through the various areas in the banking operations and processing. In order to facilitate the investigation, there are objectives that should take into consideration. First is to assess the current performance of the banking system after the financial challenges. Second is to assess the factors or reasons that lead on bank liquidation. Third is to discuss the applied solutions to avoid or reduce the risk towards bank liquidation. And fourth is to measure the effects (both benefits and drawbacks) and the extent of bank liquidation in the economy. These objectives will serve as the guideline of the paper towards its completion in order to draw recommendations on how to make the liquidation successful and gain positive outcome in the economy.
Through the aid of the objectives, the study can identify the important aspects or applied techniques in banking to demonstrate the competency and in the long-run financial stability. Most of the financial institutions as well as the central banks around the world are seeking the effective way to provide the valuable solution in improving the level of banking in their country. Moreover, the influence of the financial drawbacks from the crisis creates a great burden for the banks to engage in another activity with confidence. The changes, therefore, serve as a great instructor for the financial institutions to provide better banking operations and processes.
Research Questions
What is the current performance of banking system such as impact of technological revolution in the banking performance and operation, changes, and challenges?
What are the factors that might contribute in banks liquidation?
What are the benefits of deposit insurance on the users/clients of bank? on the bank?
What are the perceived effects of bank liquidation for the users, in the financial system, and in economy?
Literature Review
The study finds its significance in a way to contribute in the academics through identifying the various methods imposed, used, and possible options in banking policies that the financial institutions can use. In addition, through investigating the elements on the banking processes and operations, it is also important to identify the risk that might involve and the ways on how those risks should be minimize. The paper sought more on the discussion and attempts to provide quality assess through applying the concepts to improve the performance of the banks.
The Role of Banks
The term bank refers to an entity duly authorized by the Monetary Board of the Central Bank that may engage in the lending of funds obtained from the public through the receipts of deposits of any kind and all entities regularly conducting such operations. This idea emphasizes the lending and investing functions of a bank for they are institutions that do not use the money they accumulated to buy buildings, land, machinery, and raw materials, but advances the money to others who would be in need of such purchases of similar ones (Brealey, et al., 2001).
By doing its function of accepting deposits from the public and extending loans also to the public, a bank accumulates and allocates savings from the savers to the borrowers. Some authors also define that banks as financial institutions charge with the responsibility of accepting deposits from the general public and lending the funds to those in need.
Banks, in general, serves as a depository of idle funds. Individuals having excess funds deposit them in banks for the interests and services that they may obtain. The prospective depositors consider the total assets and the liquidity of the bank that they will choose. Banks serve as a major source of loanable funds. The deposits received by the bank are immediately lent out by the bank. In this way the banks makes money out of other people’s money. Banks are also render assistance in the collection of companies’ receivables through their collection and remittance functions. Banks also give counsel on financial matters. With the employed people who are experts on various fields can advise the companies and businessmen on their financial problems. However, the advice may be in a form of financial and managerial know-how (Allen, et al., 2004).
Technological Innovation and Responsiveness
Banks in general are expected to remain strong even in the threat of economic instability and other associated financial crunches. From the simple perspective of lending processes, banks have a traditional role as the best institution to manage the savings. Due to the progress in technology, the banking operations and processes become more competent and spread all over the country. There comes the introduction of ATM (automated teller machines), cheques, credit and debit card, online banking transactions, and other forms of services (Humphrey, Pulley, & Vesala, 2004). Because of the adoption of the banks in the offering of technology, their operations became widely known same as the operations became more complex and challenging. However, the application of technology and innovation also made the banking operations efficient thus it provides the systematic approach on the operations such as handling the documents and retrieving them when they needed it, searching and filing for other essential transaction and organizing the operations well. In this case, the opportunity lies in seeking for the competent and potential employees. Overall, banks are important in transposing the liquid deposits liabilities into liquid loan assets which are considered as the fulcrum of the payment system. The confidence of the banking operations arises from the ongoing relationship between the depositor and the financial streams and therefore, it is vital that there is a continuous viability on the arrangements, transactions, and stability of the financial system (Webster, 2003).
The introduction of the systematic approach of banking services is within the broad concept of physical transactions, exchanging of information, and online banking services. The convenience in Internet banking is mostly referred by the clients to perform their transactions and payments through accessing the certain bank’s website. In order to both accomplish the agendas in saving their time in going in waiting in lines and securing their funds, the online transaction is applied (Humphrey, Pulley, & Vesala, 2004). However, the banking services should ensure that there is a security in every electronic communication and computation.
Bank Loans and Risk
In general, the credit or loans received from the banks is based on the confidence in the debtor’s ability to make payment at some future time. Its existence is dependent of the debtor’s capability to merit the creditor’s confidence. Basically, the reason for credit is the need or desire to obtain the economic goods ahead to obtain money, goods, or services at the present time in exchange for a promise to pay with the money upon demand or at future determinable time. Not all individuals or institutions have the same capability to obtain loans because of the fact that it greatly depends on how the debtor merits the trust and confidence of the creditor. The loans seem to be a very important part of the business in order to complete their capital framework and increase their investments pertaining in one activity (Laman & Bernardo, 1995).
For every credit or loan issued by the bank, there is a perceived risk involved. This risk refers to the possibility of non-payment of the obligation when it falls due. The credit risk may be minimized by a careful examination of the Cs of credit which is defined as character, capacity, capital, collateral of the borrower and the prevailing conditions surrounding the business. In determining credit risk, it is advised that banks to assess the Cs of loan applicant in order to guide them in their day to day business and have the assurance that the applicant will comply in the agreement (Epstein, 2009).
Financial Distress in Banking Industry
In amidst of financial challenges or also called financial distress, there are numerous local banks that are either forced for closure by the regulatory authorities or for re-structure under the regulatory supervision. The local banks became the very same institution that is losing the competency in performing in the domestic markets. This is because, following the closure of the banks, the liquidation should be settled. If there aren’t changes in the financial economy, many local banks are expected to endure the same situation. Looking beyond this situation, there are cluster of reasons causing the last resort of decisions of the banks to be hooked with the liquidation. Other than the international banking environment, like the rate of exchange, the banks are distressed and can be subject for investigation because of the bank’s inappropriate handing of transactions. From the case of some developing countries like in Africa, the estimation of assets over the deposits failed to meet the standard in banking operation. Furthermore, loan losses from the banks are difficult to assess due to the lack of information. In addition, the issues of frauds seem evident, especially among the banks that labeled to be “political banks”. Too much bank liquidation might lead to the failure of Central Bank to control liquidity support which leads to the major cause of the loss of monetary control and inflation in the economy (Brownbrdige, 1998).
In all the reasons for the bank failures, the non-performing loans are considered to be the major cause of financial challenges and overall economic stagnation. Each non-performing loan means non-profitable transaction and if there are loans coming from the unprofitable firms, the financial institutions will deliberately realize both losses and consequences. The impact of the non-performing loans are shared by both local and commercial banks and at this point, the only option that left on the banks is to endure the losses by eradicating the identified non-performing. In assessing the impact of non-performing loans in the microeconomic level, it derived that there should be a paid attention in evaluating the non-performing loans and the extent of their impacts.
There is no global standard in order to define the non-performing loans. However, the variations in terms of the classification of the system, scope, and contents can be taken into consideration. The classification maybe in (1) passed or solvent loans; (2) loans which may pose some collection difficulties (e.g. consecutive losses of the loaning enterprise); (3) substandard or the loans with extended months in payment, either interests or principal; (4) doubtful or full liquidation on the outstanding debts with an undetermined exact amount of losses; and (5) virtual loss and unrecoverable loss which pertains to the bankruptcy of the enterprises (Hou & Dickinson, 2007). If two or three of these classifications exists in the banking institution, it is advised that the banks should prepare a timetable to address and target the possible solutions before the development of financial predicament. Deregulations of the banking industry are permitted however, there is no specific actions pertaining to the processes of international banks such as the regulatory barriers and transitions, particularly in the significant market shares (Berger & Deyoung, 2006).
Banking Situation in UK and the Financial Crisis
Bank credit or bank loans are actually intended to apply in the short-term credit needs of the borrower. The repayment is oftentimes done within the short period of time because the turnover of the goods or the interest is fast. According to the traditional theory, the commercial banks are limited to granting short-term loans because they sometimes fail to meet all the needs of the customers thus the commercial banks have embarked on a wider variety of loan programs. They also took the functions of savings bank and investment houses. With the advent of universal banking to do all the banking functions as long as they can keep up with the minimum requirements of the Central Bank (Laman & Bernardo, 1995).
During the late 1980s and early 1990s, series of recessions are recognized that can possibly left a mark in the banking system around the world (Nuxoll, 2003). The global financial crises started in 2008 from Europe and United Stated. The explanation is based on their way of living. The effects are seen on the operation of the banks because of the high loans and the demand of people in financial assistance just to purchase houses (Joseph, 2002). Due to the increase of the housing needs, the variable rate mortgages burst and people found themselves not fully entertained in purchasing the houses (Laulajainen, 2003). This unusual housing cycle played the central part in global financial crisis that broadly triggers the increase in housing prices and deteriorates the lending quality (Stapledon, 2009). Businesses, both domestic and international firms, governments, and household are presently affected in the financial turmoil. Globally, the crisis slows the economic growth. Both developing and well-developed countries shows the signs of financial and economic crisis. The supply of food, fuel, and the financial stream of the country are in danger, most especially in less-developed countries. Recession is the negative impact of the economic crises and the tendencies that it may create might fall right through the business owners which in return increase the loans in the banks in order to enhance their business performances and effectiveness.
The phenomenon of bank runs has been part of the banking theory that can be addressed through the use of consumption risk model or risk-taking model. The liquidation starts in the stochastic withdrawal of deposits but illiquid investments. The illiquidity of investments provides the rationale for the existence of banks and for their vulnerability to runs. However, the excessive withdrawals of deposits would force a bank into costly liquidation. As a train of consequence, if a depositor expects that others will withdraw, he will also withdraw to avoid losses from such liquidation (Schoenmaker, 2003). The panic that the depositors felt can be the cause of the global recession or the announced losses of the banking institution. Definitely, if there is an arising numbers of depositors claiming their deposits and investments in the twilight of banks liquidation, there is a great threat that instead the bank may continue to have banking process, they are forced to provide the demand of the clients.
Bank Liquidation
Due to the increasing number of reasons to implement the last resort, there is an automatic declaration of "bank insolvency" or "bank liquidation" procedure. In this process the bank will summon a trustworthy officeholder who is a "bank liquidator". The responsibility is to implement equality among the affected depositors in the event of liquidation. The special "bank administration" procedure enables the liquidator to deal with the affairs of the residual bank when there has been a partial transfer to a bank. In the start of liquidation, there should be a notification from the bank administrator when in time of liquidation. The claims of depositors should be the first priority of the banks wherein the responsibility of the bank liquidator is to conduct it as an ordinary liquidation. The bank liquidation procedure is proposed to be managed by the liquidation committee in order to extend the protection for the depositors (Robertson, 2008). The supervision is basically important in order to monitor the process as well as preserving the integrity and promote the public confidence in the banking system.
Before reaching the liquidation, the banks should provide the risk-taking approach and capitalization with the assumption that there is uncertainty in the cash flow. During the liquidation, it is expected that the bank is unable to issue the new equity because of the negative returns on assets can trigger temporary periods of financial distress during which time the bank has less capital than it desires. Therefore, the bank may then respond in terms of altering the riskiness of its assets, until such episodes are ended either by liquidation or by a rebuilding of prudential capital back up to desired levels. The banks are encouraged to engage in extreme risk-taking and perform a random regulatory audit. Whenever this audit reveals capital less than some minimum regulatory threshold the bank is liquidated, imposing deadweight costs. Avoiding these deadweight costs provides the bank with an incentive to reduce the risk of liquidation by holding a margin of capital over and above the regulatory minimum. If the cost of deposits - including any servicing costs and deposit insurance premium paid by the bank - is less than the shareholders discount rate so that, were it not for the need to reduce the risk of liquidation (Milne & Whalley, 1998).
Reliability
It is already recognized that the banks handles various transactions and activities such as the collection of deposits and guaranteeing the loan applications. Therefore, it is important that all of the transaction being held in a particularly is recorded (Feyzioglu, 2009). The bank’s procurement system should be reliable to enable the banks in integrating the data to perform quality management systems and provide the transparency and accountability towards the continuous effective process (Wright, 2008).
As part of the relationship in the financial system, is the insurance that the banking institutions give to their clients. In covering the parts of the financial system, the banks generally placed insurance on the deposited amount of money and thereby subject it with interest. The insurance placed by the banks gives are fully in favor of the depositors that will gradually provide the necessary protection towards their depositors in the event that the bank reached its liquidation and consequently, reduce the risk on the bank itself. In this way, the insurance can enhance the both the client’s protection and the promotion of the system stability outcomes from the financial sector regulation. However, in the insurance of deposit scheme, there would be additional cost on depositors to justify the benefits they will soon receive in the financial system (Webster, 2003). The insurance on deposits are meant for the protection of the depositors among the maintained deposits of the members of the banks. However, the insurance in the deposits has limitations or have the maximum amount of insurance coverage for a closed bank.
The idea of sound economic policy should reflect in the sensible fiscal management and strong legal system towards the effective regulation. All of the benefits of the banking regulation should fall favorably on the depositor’s safety. Within the deposit insurance schemes, the Government can have the formal engagement with the banking institution to assist the financial system in delivering the normal operation in the relationship of the clients and banking market. The deposit insurance, in broader view, is essential and usually exists as a scheme with a purpose to protect the depositor preferences to reduce the inevitable risks on the liquidation of the banks.
Perceived Effects
The bank liquidation, in some studies, is caused by the failure in the bank relationships with the economic value. The failure of the bank in achieving the profitability on its clients may relatively have an effect on the client itself (firms’ entity and quality) and the banks operating rights. In the long run, the liquidation might have affected the client more seriously (Hori, 2004). As a domino effect, if all the firms that performing in the economy will have a “financial shock”. In addition, the banking system might also find difficulty in engaging with the stockholders, especially from the other countries (Wagster, 2007). Due to the bank’s liquidation, there are challenges in promoting the continuous economic growth and impairing the economic efficiency. The further consequences might take an effect on the market risk regulation, wherein the government may raise its control over the bank’s liquidation probability through the bank’s changed recapitalization decisions.
Contagion Risk
One of the most controversial issues in the banking regulation is the existence of contagion risk. Both banking system in US and UK are threatened by the trend of bank failure. The same thing was experienced by Japan and the cause of the risk is undetermined. However, through the study of the business and financial analysts, there is an indication that the contagion risk really exist in the banking industry. First, the initial failure of the bank can be generated from the business operation without the intervention of the authorities. Because of this fact, it suggests that there should be an important role played by the Central Bank as lender of last resort to assist the ailing banks and whose failure is anticipated to have a systematic impact.
As observed in the bank run model, the banks are affected by the expectations that are present in the market most especially when the branches of the bank are consecutively closing because of the prevailing bank’s condition. The investment risk appeared in more realistic setting because it affects both investments and consumptions. The depositors’ true value of loans is actually the key element in the bank-run model. Therefore, the information of the depositors serves to be an important factor in loaning process. On the other hand, the depositors who decided to withdraw the large sum of investment are unaware that their money is important in order to accommodate the loaners and may decrease the fraction of the loans received by a borrower and leads to the low outcome of the loan repayment (Nobuyoshi, 1999).
If the long withdrawal syndrome continues, there is expected bad information to the other uninformed depositors that in later will create tight belting inside the bank towards insolvency. The train of risks will be soon realizing in the banking system due to the effects of panic. The contagion risk or also referred as a systemic risk wherein the financial difficulties at one or more banks spill over to a large number of other banks or the financial system as a whole. Contagion can spread either through the information channel or the credit channel. However, this kind of risk are described into two types: first is the pure contagion which occurs when there are negative information such as fraud or losses reached to the risky investment; and second is the noisy contagion reflects when there is a failure on the bank and reveals the bad signal regarding the other banks common characteristics (Schoenmaker, 2003).
Conclusion
Based on the paper, too much bank liquidation might lead to the failure of Central Bank to control liquidity support which leads to the major cause of the loss of monetary control and inflation in the economy. This cannot be only applied among the developing countries but also among the developed countries like United Kingdom because there is a high monetary value. Always, there is a risk that the current banking regulation has some negative consequences on the banking industry. Based on the liquidation rules, since the liquidation take an effect on bank and creditors the operation should therefore provide specific protection on both parties. The application of liquidation does not only apply among the local and domestic banks but also among the international and commercial banks. Aside from the identified reason that promotes the liquidation, the banking system is also challenged by the financial environment that it moves. The inability or unwillingness to share information and documents among the banks can delay the good relationship in banking process. This can be a simple problem but might take a great effect in the negotiations with the existing clients, target clients, and other users of banking services. In addition, the lesson that each bank realized during the recession might be the most basic solution that were applied in the recession during the 2008, which is actually felt until today. Bank runs are possible and it is important that the banking system is strong in order to guarantee the depositors. Through the risk-taking approach of the banks, there is a possibility that the regulators can assists the protection of the depositors.
Recommendations
Risks arrived in every institution. It can be also natural but can be avoided, prevented, and reduced. However, there are circumstances that the financial institutions cannot help but meet those risks.
Through the help of the technological innovation such as databases, the banks can move to its outmost competency and reliability. The internal function of the banks can be a part of the bank’s focus towards the sustainable and superior growth through promoting the sound financial discipline and application of strategies. In this way, the bank can maintain their operation in achieving the most efficient and effective manner such as managing the operation and transaction among the international markets and even within the challenge of diversification. Therefore, the use of databases should be systemized to properly organize the everyday transactions and significantly create an impact in the financial performance of the bank.
The banking institutions should emphasize the portfolio diversification, and in terms of the non-performing loans, the banks should adopt better consensus practices. For an instance, in substandard account of loan, the banks should provided 10% provision for the unsecured portion of the loans. There should be 50% provision for doubtful loans and 100% provision for loss loans (Hou & Dickinson, 2007).
Financial distress can be felt where the responsibility for the bank in terms of handling problems is neglected. Therefore, supervision on the banking processes and operations should be promoted among the banks (Berger & Deyoung, 2006). However, aside from the skills of the manpower in banking system and the combined credibility of the technological processes, still, the banking performance can be protected through regulating the consumer protection and market integrity. And when the bank obtained the last resort, such as liquidation, there should be coordination and cooperation between liquidators such as the capital control policy and restructuring of banking institution by buffering the capital dynamics (Basel Committee on Banking Supervision, 1992; Keppo, kofman, & Meng, 2009).
The Central Bank
The Central Bank can act as a mediator in the existence of bank liquidation. As a fiscal agent of the government, the Central Bank has the following functions:
- to be the official representative of the government towards the financial entities;
- to be the depository banker of the government;
- to be the financial adviser of the government; and
- to manage the public debts.
Thus actions of the Central Bank are actually expected, especially when there is a trend in liquidation or the contagion effect (Laman & Bernardo, 1995).
First, they must control the collateral required on banks. The power of the Central Bank arises in imposing the conditions or requirements on the securities against the loans extended by the bank. This in effect increases the loan value of the collateral. However, during the inflation, the Central Bank may increase the collaterals required on loans which will result in the decreasing effect towards the loan value of the collaterals. And in the event of deflation, the Central Bank may decrease collaterals which may be an incentive to borrowers.
Second, the Central Bank may impose the Portfolio Ceiling which refers to the upper limit that the bank may place on the loans and investment of banks. It is instituted only during inflation. It is a direct limitation on the volume of loans and investments that banks may extend. Such restrictions may not be instituted during deflation. In order to execute or implement this strategy, the Central Bank needs to set a date and whatever is the total amount of loans and investment of the bank has on that date is its limit.
Third is addressing the minimum capital ratio. It is the maximum ratio that the combines’ capital account of surplus may bear on the banks’ corporate assets. The Central Bank requires 10% of the risk assets of a bank as its minimum capital required. Thus, total assets minus non-risk assets equals risk assets.
Fourth is the use of moral suasion. This is a more of a psychological approach in which the Central Bank may use its persuasive power to make the banks follow or support the credit policies without the direct imposition of restrictions. There are cases when the Central Bank shies away from imposition of credit restrictions because of possible unfavorable repercussions such that the Central Bank may just use their influence among banks for voluntary support of a credit policy. This influence is mostly appreciated in the foreign transactions wherein the banks will agree in limiting the transaction to an agreed foreign exchange rate.
And fifth is the use of monetary policies to stabilize the banking operations according to the following options. The Central Bank may fix the maturities of bank loans for the purpose of credit control or as means of payment. They may also fix the maximum interest that the bank may pay on deposits substitutes for the purpose of preventing competition among banks in attracting depositors. The Central Bank may establish priorities for bank loans especially with respect to funds which have been borrowed from the Central Bank. In addition, the Central Bank can make the periodic examination on the banks accounting records and requires the banks to submit their financial statement at the end of the quarter. And lastly, the Central Bank can look into the character and integrity of the bank’s incorporators and members of the board as well as the top ranking executive of the bank.
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